The 3 Smartest Screens To Identify Takeover Targets

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 |  Includes: GE, LUFK
by: Lou Basenese

On Monday, General Electric (NYSE:GE) inked a deal to buy Lufkin Industries (NASDAQ:LUFK), a maker of industrial lifts, for $3.3 billion -- or $88.50 per share. Lufkin's lucky shareholders -- ones who had the wherewithal to pull the trigger at the perfect time -- then watched the stock soar more than 38% instantly. And that, my friends, is the appeal of identifying the market's next takeover target before a deal is announced.

With that in mind, in case an opportunity presents itself as early as tomorrow, let's be ready to shoot the next Lufkin "on sight." Indeed, the temptation to go hunting for takeover targets is bound to increase, as M&A activity picks back up.

Consider the following:

  • In the first quarter, the total value of announced, worldwide M&A activity increased 10.4% compared to the first quarter of 2012, according to Thomson Reuters.
  • If we focus only on U.S. M&A activity, it's up 88.7% -- to almost $270 billion.

And with deal premiums averaging 28.8% globally -- and 32.2% in the United States -- it's only natural that more and more investors are going to look toward identify compelling takeover targets. Before you rush out to join them, picturing yourself as a corporate raider on the hunt for the market's next delectable deal, I have a few words of wisdom for you. Hunt smart. Use your bullets sparingly. Or your portfolio is liable to get crushed.

Let me explain.

Always Hunt to Kill

The prospect of hefty takeover gains shouldn't be the sole reason for an investment. After all, we can never be certain that a deal will materialize. Realistically, in any given year, only about 1% of the thousands upon thousands of publicly traded companies in the world receive an unsolicited takeover offer. The craps table in Vegas offers better odds than that.

As a result, we should first look to invest in a company with compelling underlying fundamentals. Any takeover potential should serve as an added bonus. In other words, to book profits, we should always hunt to kill. That said, we shouldn't search aimlessly for attractive companies. If we want to increase our chances of benefiting from a takeover announcement, we should be on the lookout for fundamentally strong companies in the most takeover-rich areas of the market.

So let's go ahead and do just that. In three easy steps, we can identify the single most attractive sector and size of companies we should be targeting:

Takeover Screen No. 1: Cash Is King

No doubt you've heard about the gobs of cash sitting on corporate balance sheets. Well, it turns out that a lopsided amount is being held in a handful of sectors. According to S&P Capital IQ, companies in the technology, industrial, and healthcare sectors are holding roughly two-thirds of the $1.1 trillion in corporate cash. In other words, those three sectors possess the most deal-making ammo. Naturally, we should begin our hunt for opportunities here.

Takeover Screen No. 2: Go Where There's Deal Flow

Now that we've identified the sectors flush with cash, we want to narrow our search down to the one area where companies are putting that cash to work. That's the healthcare sector. In the last year, the number of healthcare deals increased 6% -- enough to rank as the second most active year in the last decade.

Rest assured, this wasn't some fluke, either. The healthcare sector is always a hotbed for activity. Ever since 1983, it's been the most active sector for takeover offers, according to a recent Morgan Stanley study. On average, 4% of stocks in the sector receive offers each year, compared to only 1.7% of companies in the consumer staples sector.

Takeover Screen No. 3: Go Small for Big Gains

After honing in on a cash-heavy sector with ample activity, it's time we pinpoint the most likely targets in that sector. And that's definitely small caps. How can I be so confident? For one thing, although the number of healthcare takeovers spiked last year, the dollar value plunged 38%. That means the majority of takeovers were smaller deals.

The other reason we want to focus on small caps is because Wall Street analysts routinely ignore them. But I'm not bemoaning their ignorance. On the contrary -- this limits investor information and leads to rampant mispricing. Or, more simply, the efficient market hypothesis is rendered null and void in the small-cap space, which creates a tremendous opportunity for us. You see, potential suitors aren't dummies. They know what a small-cap company is really worth. And once they make an offer, it leads to an immediate repricing.

All we have to do is position our portfolios in advance of an announcement to benefit from the sudden increase in price. And guess what? Doing so in the healthcare sector last quarter netted investors an average windfall of 37.2% -- in less than four weeks, no less. I'm pretty sure those profit prospects activated everyone's greed receptors. So what are you waiting for? Get hunting!