Six ways to spot a great takeover target

As I write, the stock market is soaring. A midnight press briefing in Euroland has flung a firework under the market.

It looks like investors were just waiting for an excuse to let loose. And you can see why. As I said last week, many of our biggest and best companies look great value at the moment. They are stuffed full of cash and with interest rates priced for a depression, these firms could also borrow stacks of money on the cheap.

And if investors are looking to pick up cheap stocks, you can bet that companies are on the hunt as well. This could be the time for cash rich companies to pick off one of their rivals while it's cheap. We could see a series of mergers and acquisitions in the months ahead.

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Is that a good thing? Well it is for the target companies! There could be a massive upside for them. And today I would like to point to six ways you can spot a company that is primed for takeover pointing to two sectors in particular that look really interesting right now.

Rule #1: Small is beautiful

Though the markets have been tumultuous of late, takeovers have never been far from the news. One of Britain's largest software firms Autonomy recently got snapped up by US giant Hewlett Packard, while Northumbrian water became our latest utility to be taken into foreign ownership.

But it's in the small cap domain that I think things are really set to heat up. Small and mid-caps are easy targets. A market cap somewhere between £100m and £500m is about right. Any less than £100m and it won't be worthwhile for the advisory banks. Why?

Because more often than not, the idea for a merger comes from one of the big investment banks. They want to earn some fees, so they find a potential acquirer and suggest a great' deal for them. And that means one that makes the matchmaker a lot of fees!

Of course anything more than £500m can be a bit hard to swallow as G4S is finding out.

Rule #2: Look for cash on the balance sheet

In mid-August I wrote to you about a wave of buyouts in the biotech industry. Many look cheap simply because of the cash pile they're sitting on.

In fact, strange as it may seem, many firms in the biotech arena are barely valued at the cash on their balance sheets. Obviously this is great news for an acquirer. Just imagine, they can takeover the company and pay shareholders with their own money!

Holding a load of cash isn't a necessity. But a strong balance sheet is. If the business has tangible stuff like property on the books, then the acquirer can always borrow against these assets.

Rule #3: Obviously cheap is good

Serial acquirers like Capita Group help grow their business by constantly taking over rivals. And good growth means that Capita is held in high esteem by the market. Today Capita trades on around 16 times earnings, almost double that of the rest of the FTSE 100.

If Capita buys another business that's trading on a much lower multiple, it's going to add value almost immediately. The very fact that Capita takes somebody else's earnings and brings them on to her books may give the earnings twice the value beat that!

A low p/e multiple makes the proposition very attractive for a more highly rated acquirer. But it's not the most important thing

Rule #4: Great cash flow is even better

Surprisingly profits aren't the be-all and end-all with a takeover. Profits are what interests investors, but cash-flow is more interesting to acquirers.

If the target has a steady cash-flow, an acquirer can use it to secure a big loan. It's a bit like taking out a mortgage. The lender looks at your income (or cash flow); the fact that your expenditure may be even larger than what you bring in doesn't seem to bother the lender.

So if there's cash-flow, there's a chance of raising finance for the deal. And with today's low interest rate environment, that can be attractive.

The other thing about cash-flow is if you've got it, then there's a good chance you can turn it into profit. You'll see press comments from the acquirer: "Cost cutting, rationalising and implementing synergies."

Basically what they're talking about is taking a hatchet to the target firm once they've got control. That's easy. What's more difficult is getting the cash-flow in the first place so you start with a business that's already got it.

The classic target has great cash-flow, but bad profits

Rule #5: Terrible recent performance

You'll often find predators circling firms that are doing badly. Stocks that are trading near the low for the year make for attractive targets. Weak management too is like a dying corpse to a vulture.

A string of profit warnings and an abysmal looking chart is what you're after.

Even a low bid might be acceptable for shareholders if it's 50% higher than the prevailing market price. Many shareholders will be happy to accept a loss on their holding if they see that the price is higher than the market is currently offering.

Rule #6: Unique assets

What we've looked at so far are the fundamentals. You can set up a screen' using tools available on websites like advfn.com to filter stocks that fit the bill.

In fact, I've just been doing some research using the advfn.com takeover candidates filter. It's already set up to show you firms that fit the bill of a takeover target using some of the accounting fundamentals we've just looked at. You can have a play around with it too by clicking here.

Unfortunately, some of the most important things can't be extracted from the company accounts. And that includes one of the most important reasons that a business may become a bid target assets.

Often an acquirer will buy a business because they want some unique asset. This was exactly why Google bought Motorola. They aren't after the company's phone business. It's the library of old phone technology patents they want as the big tech companies enter a new world war on technology licenses and patents.

Two sectors set for a wave of takeovers

I'm quite excited about the prospects of buyouts in biotech at the moment. There are some great companies that look to me far too cheap to be passed up by big pharmaceuticals (who need to deliver blockbuster drugs from somewhere). I'll come back to these in forthcoming issues of The Right Side.

But one other sector looks interesting right now technology. Paul Hill has been pointing me in the direction of a few potential takeover targets in this sector. Just as in pharmaceuticals, the big tech groups are drowning in cash. And there are a host of niche tech industries that are thriving at the moment from cybercrime to cloud computing.

That's why I've been reading Paul Hill's Precision Guided Investments with great interest in recent months.

Paul uses the GARP approach to stock selection. Growth At Reasonable Prices. His system has an uncanny knack of picking stocks that acquirers are circling too.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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