John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it here.
The global mergers and acquisitions market is picking up nicely in 2014. In the first quarter, deal-making was up 54 per cent versus last year's first quarter. With broader economic growth mediocre and more than $1-trillion (U.S.) sitting on corporate balance sheets, U.S. companies may continue to turn to M&A as a way to grow.
Morgan Stanley even recently offered a list of 44 multibillion-dollar companies that have a high likelihood of receiving at least one tender offer over the next 12 months. If these companies do make a deal, it could be good news for them and their investors over the long haul, as mergers create such benefits as economies of scale.
They can also be a big boost for shareholders in the short term, as the acquiring company pays a premium for the acquired firm. But be careful: Investing in a company simply because it's a takeover target can be dangerous. Many of the rumoured targets end up not being acquired.
That's why I think you should put potential takeover targets through the same fundamental scrutiny you would use on any other holdings. That way, you set yourself up for success even if a takeover doesn't occur. And if it does happen, you may get an added bonus.
Mutual fund legend Peter Lynch – one of the gurus upon whom I base my investment strategies – said that when he benefited from takeovers, it wasn't by design. "In spite of all the takeover rumours that fill the newspapers these days, I can't think of a single example of a company that I bought in expectation of a takeover that was actually taken over," Mr. Lynch wrote in One Up On Wall Street. "Usually what happens is that some company I own for its fundamental virtues gets taken over – and that, too, is a complete surprise."
Still, there's no reason you can't use a takeover target list as a starting point. So, when I saw Morgan Stanley's list, I ran the 44 stocks through my Guru Strategies to see which of them also had the fundamentals that I would want in any of my stock picks. While the vast majority of those on the list failed to make the grade, a few did have what it takes. Stocks like these have good potential, and if they are acquired, it could be a nice bonus. Here's a look at a trio of them.
Neustar Inc.
This Virginia-based firm ($2-billion market cap) provides real-time information and analytics to the communications services, financial services, retail, and media and advertising sectors. It took a big hit early in 2014 after announcing guidance that fell short of expectations, but the model I base on the writings of hedge fund manager Joel Greenblatt thinks it's a bargain. Mr. Greenblatt uses a remarkably simple strategy that looks at only two variables: return on capital and earnings yield, and he also takes metrics such as debt load into account. My Greenblatt-inspired model likes Neustar's 11.6-per-cent earnings yield and 69.2-per-cent return on capital.
Aetna Inc.
This Hartford, Conn.-based health insurer has a $27-billion market cap and has taken in $47-billion in sales over the past 12 months. It gets high marks from my Lynch-based strategy. Mr. Lynch famously used the price-earnings-to-growth (PEG) ratio to find bargain-priced growth stocks, adjusting the "growth" portion of the equation for dividend yield for large, dividend-paying firms like Aetna. When we divide Aetna's 13.7 P/E ratio by the sum of its long-term growth rate (12.9 per cent using an average of the three-, four- and five-year earnings-per-share growth rates) and dividend yield (1.2 per cent), we get a PEG of 0.97. That comes in under this model's 1.0 upper limit. The Lynch-based model also likes Aetna's 28 per cent equity/assets ratio and 4.2 per cent return on assets rate.
Ingredion Inc.
Based in Illinois, Ingredion ($5-billion market cap) provides ingredients to customers in more than 40 countries, across about 60 diverse sectors in food, beverage, brewing, pharmaceuticals and other industries. It specializes in nature-based sweeteners, starches and nutrition ingredients.
Ingredion is another favourite of my Lynch-based strategy, which likes its 38 per cent long-term EPS growth rate and 13.3 P/E ratio. That makes for a stellar 0.35 PEG ratio. The firm's debt load is not insignificant, but its 75 per cent debt-equity ratio comes in under this model's 80-per-cent threshold.