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Hardly a day goes by without news of a takeover of a public company by private-equity investors.
There's money to be made if you can spot a takeover target ahead of the news. Share prices usually move up on rumors of a deal and then move up further on the actual announcement. Typically, shareholders who were in before the first rumors surfaced enjoy a gain of 30% or more.
Last summer, I described a screen for spotting potential takeover targets. The screen was reasonably successful. Four of the 17 stocks listed -- Applebee's International (APPB, news, msgs), Dollar General (DG, news, msgs), JLG Industries and OSI Restaurant Partners (OSI, news, msgs) -- did get taken out, and a fifth, BJ's Wholesale Club (BJ, news, msgs), has been the subject of takeover rumors.
However, since that time, private-equity investors have broadened their scope, taking out companies they wouldn't have considered a year ago.
Given that the rules have changed and my original screen was only moderately successful, I've just concluded an analysis of recent acquisitions and have come up with a new, hopefully improved screen for spotting potential takeover targets.
In a nutshell, it looks for out-of-favor, profitable stocks that have relatively little debt and generate strong cash flows.
My screen is intended to spot targets that would appeal to private-equity investors. It won't spot firms that might be purchased by competitors for strategic reasons, such as Google's (GOOG, news, msgs) takeover of DoubleClick to fill a gap in its product line. Here are the details.
Not too big to buy
Recently, instead of sticking with smaller firms with market caps under $2 billion, private-equity buyers have set their sights on bigger targets, such as student loan provider SLM Corp. (SLM, news, msgs), or Sallie Mae, which recently agreed to a $25 billion sale.However, even given the Sallie Mae deal, most of the recent takeover targets have been companies valued at less than $10 billion.
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Market capitalization (recent share price multiplied by number of shares outstanding) defines how much you'd have to shell out to buy all of a company's stock. However, when you buy a company you're also on the hook for its debt, so you have to consider that debt as part of the purchase price. Since market capitalization doesn't include debt, I compensated by reducing the limit to $9 billion.
Screening parameter: Market Capitalization <= $9,000,000,000
Not too cheap
While private-equity buyers are bargain hunters, I didn't spot any deals where they targeted stocks trading below $2. The cheapest acquisitions I found were in the $3 range, and most were for stocks trading above $10 per share. I set my minimum share price at $3. However, stocks at that level are riskier than more expensive stocks. Consider moving your minimum up to $10 if you want to reduce your risk.Screening parameter: Last Price >= 3
Screens sometimes turn up stocks that trade at very low volumes or are no longer actively traded at all. Stocks trading less than 20,000 shares daily are subject to price manipulation and are generally bad news.
Screening parameter: Avg. Daily Volume, last quarter >= 20,000
Out of favor
One thing many recent takeover targets had in common was that they were trading well below earlier highs when the takeover rumors first surfaced. In fact, most were trading at least 25% off of recent (52-week) highs.That said, private-equity buyers apparently avoid severely depressed stocks. None was trading more than 50% off its 52-week high when it was acquired. The following two parameters, taken together, limit the field to stocks trading 25% to 50% below their 52-week highs.
Screening parameter: Last Price <= 0.75*52-week High
Screening parameter: Last Price >= 0.50* 52-week High
Services such as Zacks Research compile analyst ratings into these categories: strong buy, (moderate) buy, hold, sell and strong sell. Many investors consider only "strong buy" as real "buy" recommendations. To them, "moderate buy" signals ambivalence on the part of analysts, and anything less translates to "sell." Thus, consistent with their contrarian strategy, private-equity players avoid "strong buy" stocks.
Screening parameter: Mean Recommendation <= Moderate Buy
Along those same lines, private-equity buyers typically avoid stocks with strong analyst consensus earnings-growth forecasts. Instead, they target firms with modest expectations, usually below 15% average annual earnings growth over the next five years.
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