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The Bloomberg report on M&A for 2011 shows acquisition premiums were in the +30% range 2011, so in keeping with prior years, considering potential acquisition targets within your portfolio can enhance your equity strategy. I am advocating tilting your strategy towards companies that might be viable takeover targets and have other desirable characteristics. That way you are not solely exposed to the chance of acquisition, which is risky, but also have a stock you are happy to own if M&A doesn't happen.

Focus on under $500M in market cap.

In can be tempting to focus on the big deals which grab the headlines, but 97% of M&A deals involve targets valued at under $500M, and these companies are about 40% of the companies on public markets. Therefore, if you want to own an acquisition target, your chances are significantly higher if you own smaller stocks.

Some industries have more M&A than others.

In addition to the size bias, certain industries are more prone to M&A than others. The top five sectors for 2011 (by total volume) were:

  1. Financials
  2. Consumer, non-cyclicals
  3. Energy
  4. Industrials
  5. Communications

Note that unlike, the size effect, industry bias in M&A can change over time.

Investment Implications
To make this recommendation actionable, we look at stocks that:

  • Meet the merger target criteria (<$500M), and still above $100M to ensure reasonable liquidity.
  • Are in the top three sectors listed above for M&A (financials, consumer non-cyclicals and energy)
  • Might be consider attractive holdings anyway with below average price/book and better than average 6 month price momentum
  • And have high institutional ownership, so that an acquisition is likely to succeed if insiders don't have enough shares to block or drive up the price to prevent a deal.

Potential Acquisition Candidates

In financials, there are a range of potential targets. Kaiser Federal Financial Group (KFFG) has a $126M market cap, 73% institutional ownership, yields 1.8% with a p/e of 13x. However as a Californian bank and given the state of the banking system right now, you would have to be happy owning it as a bank rather than solely as a target. Viewpoint Financial (NASDAQ:VPFG) is another idea, but at $464M on the larger side for M&A and slightly more expensive at on a p/e basis 19x. Banking is an industry that typically sees consolidation over time and 2011 was no exception, but in the current regulatory environment and with tremendous uncertainty over balance sheets the outlook for 2012 M&A remains uncertain.

In energy the two companies that appear in the screen don't appear to be attractive candidates as they are both services focused, and services are less likely to yield synergies through acquisition, given that a lot of the M&A in energy has focused on pipeline companies and physical assets more generally.

In consumer non-cyclicals, Smart Balance (SMBL) is an interesting name to consider. The have recently acquired a company themselves (Glutino), but are positioned relatively well in selling heart healthy and enhanced dairy products. The category leader in healthy spreads is Unilever (NYSE:UL) with I Can't Believe It's Not Butter, but Smart Balance enjoys reasonably good brand recognition. The stock is acquisition-sized at $309M market cap and has 82% institutional ownership.

However, it does not pay a dividend and is expensive on p/e ratio basis at 59x. However, they are experiencing a number of one-off events this year, such as integration costs and a class action lawsuit. On a more normalized basis the p/e ratio is closer to 17x. The key question is whether Smart Balance can sustain organic growth to accelerate the brand portfolio of a larger business, currently they are growing at double digit rates, but that is primarily driven by the Glutino acquisition.

Conclusion

Picking acquisition targets is hard, but when it succeeds you can expect 30% price appreciation, based on historical averages. Owning smaller stocks (<$500M) is the best single thing you can do to improve your chances of owning a company that gets acquired. Specific ideas for 2012 include KFFG, VPFG and SMBL. These are the right size, in the right sectors with a high level of institutional ownership. However, since any acquisition is a low probability event, you should ensure you are happy to own these companies based on their fundamentals regardless of whether they get acquired.

Source: Google Finance for stock screen data.

Source: 3 Potential Acquisition Targets For 2012