You must have noticed stocks soaring instantly on takeover bids by
mega players. But you might not have been able to predict takeover
targets and hence missed lucrative opportunities.
Wouldn’t it be nice if you could spot the market’s next takeover
target before corporate raiders zero-in on it? The M&A
landscape for 2014 looks bright with huge cash sitting on corporate
balance sheets, favorable credit markets, low interest rates, and
strength in stock market, making this the ideal time for hunting
such stocks.
This is a tall order, but not out of the question. There is no
full-proof strategy to find a company that would surely get a
tender offer to be acquired, as it’s not all about numbers. A
suitor looks for a number of fundamental characteristics – such as
product niche, distribution network, geographic proximity,
litigation risk and management – in the acquiree. These are
basically the deal’s cultural/strategic value that may evade your
analytical eyes.
But you can shortlist companies with high chances of getting a bid.
For that you need to peruse a few ratios/numbers that corporate
raiders must consider to strike a deal. These are no doubt good
indicators, but not sufficient to ensure a takeover.
Actually, had it been that easy to look through the lens of a
suitor, the market would have made prospective acquisition targets
instantly overpriced, leaving no room for you to make a sudden
gain. In fact, it is this unpredictable nature that keeps the
appeal
alive.
To me, it’s a chance game. Buying a stock solely for the potential
takeover gain may not be a prudent decision. After all, you never
know if the corporate raiders are on the same page. But you can use
the right strategy to increase your odds of winning.
The Win-Win Strategy
In addition to using similar valuation techniques as corporate
raiders, I recommend tracking stocks with the right ingredients to
outperform. That way, even if your selected stocks fail to attract
takeover bids, they will not disappoint you in terms of price
appreciation. And always the chance of a takeover gain will be high
for each of these stocks.
Here I have discussed the method and created a screen (using
Research Wizard) that you can run to have your cake and eat it
too!
What an Acquirer Needs to Pay Matters Most
What an acquirer has to roughly shell out to buy an entire company
is the Enterprise Value (EV) of the latter. Here is the
formula:
EV = Market Capitalization + Long-term Debt + Book Value of
Preferred Stock – Cash and Marketable Securities
An acquirer will always prefer to pay as low as possible, but a
nominal number doesn’t necessarily indicate inexpensiveness. For
that, measuring the EV relative to its ability to generate profits
– Earnings Before Interest, Taxes, Depreciation and Amortization
(EBITDA) – is of utmost important to the acquirer.
A low EV/EBITDA ratio indicates larger profit generating ability
relative to its worth. The smaller the ratio, the more attractive
the target.
Screening Criterion: EV/EBITDA Range > 0 and <1
Cash Has a Solid Appeal
Companies that are sitting on a cash pile are darlings of corporate
raiders, as it reduces the cost of buying. But looking at cash is
not that simple; a high number doesn’t necessarily indicate
affluence. So cash as percentage of market cap is the key to
finding cash-rich bargains.
I searched companies with cash and marketable securities of at
least 75% of their market capitalization. These companies offer
significant discount to acquirers.
Moreover, from an investor’s perspective, buying stocks of these
companies will channel less than 25% of the investment to their
ongoing business -- the risky part.
Screening Criterion: (Cash and Marketable Securities/Market
Capitalization) >= 0.75
Low Financial Leverage Enticing
Companies that depend less on external borrowings for capital
expenditures are attractive to acquirers. This is because acquiring
it doesn’t add much debt load on the acquirer’s balance sheet. So I
selected companies with debt less than equity.
Screening Criterion: (Debt/Equity) < 1
Underpriced Stocks Preferred
Book value is a rough estimate of what equity holders tangibly own
in a company. Stocks trading at a low price-to-book ratio are
always assumed as cheaper. These stocks have a greater possibility
of getting acquisition bids.
Screening Criterion: (Price/Book Value) <= 1.5
Bet Big on Small-Cap Stocks
First of all, affordability matters. The lesser the company’s
market capitalization, the more its prospective buyers. If you look
back at the last few years, the majority of acquirers picked
small-cap stocks.
Secondly, the market hypothesis is not that efficient for small-cap
stocks as these are often ignored by analysts. Lack of market
insight keeps these stocks mispriced, which creates opportunity for
prospective acquirers to exercise a lucrative deal.
That is why the possibility of small-cap stocks getting acquired is
higher that that of the mega-cap stocks.
Screening Criterion: Market Capitalization Range > $50 million
and < $2 billion
Ensure Favorable Zacks Rank
Good market or bad, stocks with a Zacks Rank #1 (Strong Buy) or #2
(Buy) generally outperform. Stocks with these ratings have been
actually witnessing positive earnings estimate revisions, which
should ultimately translate into price appreciation.
This should actually ensure a return even if your selected stocks
do not offer a takeover gain. So lock your choice with these
ratings which have a proven history of success.
(See the performance of Zacks' portfolios and strategies here:
About Zacks Performance).
Screening Criterion: Zacks Rank <= 2
How Successful Is the Strategy?
I backtested this screen with a 4-week holding period over the last
5 years to see whether the group of stocks matching these
parameters had at least returned better than the S&P 500. I
found a promising result, as you can see here:
3 Potential Takeover Targets
Before adding the Zacks Rank criterion, the screen actually gave me
15 stocks, all of which should catch eyes of corporate raiders. But
if they fail to do so, the ones with favorable Zacks Rank should
not disappoint.
So I reran the full screen to find those that have favorable Zacks
Rank too. Here are the 3 stocks that finally got through:
Central Valley Community Bancorp (CVCY):
Headquartered in Fresno, CA, this Zacks Rank #1 pacific bank
provides various commercial banking services to small and
medium-sized businesses, individuals, and professional
communities.
EV/EBITDA = 0.84
Cash and Marketable Securities/Market Cap. = 0.91
Debt/Equity = 0.04
Price/Book Value = 1.02
Market Cap. ($million) = 123
Fidelity & Guaranty Life (FGL): This primary
life insurance and fixed annuity company is based in Des Moines,
Iowa and primarily serves the middle-income market. It holds a
Zacks Rank #2.
EV/EBITDA = 0.76
Cash and Marketable Securities/Market Cap. = 0.81
Debt/Equity = 0.23
Price/Book Value = 0.95
Market Cap. ($million) = 1,306
Genco Shipping & Trading Ltd. (GNK): This
Zacks Rank #2 company is based in NY and engages in ocean
transportation of drybulk cargoes worldwide.
EV/EBITDA = 0.96
Cash and Marketable Securities/Market Cap. = 1.59
Debt/Equity = 0.10
Price/Book Value = 0.06
Market Cap. ($million) = 75
Note: All data are as of Mar 28, 2014
Don’t Gamble, Play It Safe
This screen is just the starting point for your due diligence.
Don’t bet on a stock just because it has favorable numbers to get
acquired. You should also see if it suits your investment goals and
risk tolerance.
Pull the trigger if you anticipate a good return even if it doesn’t
get a takeover bid. The takeover potential may add a handsome bonus
to your return. However, the market reacts briskly, so the faster
you take action, the more you gain.
So what are you waiting for? Get started!
Want More of Our Best Recommendations?
Zacks Executive VP Steve Reitmeister knows when key trades are
about to be triggered and which of our experts has the hottest
hand. Then each week he hand-selects the most compelling trades and
serves them up to you in a new program called Zacks
Confidential.
Learn More>>
Disclosure: The author has no positions in any stocks
mentioned.
CENTRAL VLY COM (CVCY): Free Stock Analysis Report
FIDELITY&GUARNT (FGL): Free Stock Analysis Report
GENCO SHPG&TRDG (GNK): Free Stock Analysis Report
To read this article on Zacks.com click here.
Zacks Investment Research
FIDELITY & GUARANTY LIFE (NYSE:FGL)
Historical Stock Chart
From Jun 2024 to Jul 2024
FIDELITY & GUARANTY LIFE (NYSE:FGL)
Historical Stock Chart
From Jul 2023 to Jul 2024