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Why Bayer's Takeover Bid For Monsanto Is Bitter Sweet

|Includes: Monsanto Company (MON)

Over the years, many investors have asked why so many of the stocks we recommend have attracted takeover bids. The answer is simple: when we look for stocks to buy, we pay special attention to hidden assets. These are valuable assets that investors overlook, discount or disregard altogether.

These same hidden assets have special appeal for companies that are using takeovers to grow. They agree with us: You get more for your money when you buy companies with hidden assets.

The conventions of accounting can keep assets out of view. For example, corporate balance sheets generally show the value of real estate at its purchase price. But many corporations own real estate that they bought decades ago, far below today's prices. The difference between the current value and the balance sheet value is a hidden asset. But it can quickly become apparent if the company sells the real estate, or makes profitable changes in its use.

Research spending is another source of hidden value. Companies mostly write off research costs immediately, just as they write off everyday expenses such as taxes, wages, utilities and insurance. As a result, research costs tend to depress a company's profits in the year when the research takes place. This highly conservative approach reflects the fact that research may not turn up anything of value. But successful research builds a company's body of knowledge. This can lead to new products and faster earnings growth.

Hidden assets can come out of existing brand names that can help launch new products. They can also grow out of government obstacles to the entry of new competitors into a market. They can come out of popular opposition to changes in technology.

I often have mixed feelings when one of our favourite stocks attracts a takeover bid. This provides a near-instant profit, of course. But it also takes away an attractive investment opportunity.

That's how I felt last week when Bayer raised its bid for Monsanto to $128 U.S. a share, and Monsanto accepted.

Monsanto was $86 a share in November 2012, when we first recommended it as a buy. The company was devoting 12% of its revenues to research. That represented a major investment in its business, and included work on genetically modified organisms. As reported by Scientific American, this attracted some vocal GMO opposition, from outside the scientific community.

We felt this opposition was holding down Monsanto's stock price gains. As such, it was a plus for the stock-it was weighing on the stock price, but without any impact on company profits.

Since then, scientific support for GMOs seems to have increased, and opposition seems to have waned. But today, a different issue weighs on Monsanto. Favourable weather around the world has led to bountiful harvests and low crop prices. This lessens grower incentives to pay higher prices for Monsanto's help. Better to stick with the cheaper, old-fashioned ways, and accept the lower yields.

Agricultural markets are cyclical, so those crop surpluses and low prices may be gone in two to four years. We would have preferred to hang on to the stock till then. We may have a chance to do just that. Regulatory opposition could kill the takeover before the expected closing date at the end of 2017. That's why Monsanto is trading at a 20% discount to the $128 takeover price.

Source: Yahoo Finance

We still see Monsanto as a buy.

Disclosure: I am/we are long MON.