In last Monday’s column, I discussed why owning a company that gets acquired can be extremely lucrative. Today, I’ll talk about how to increase your odds of owning one of these takeover candidates.
You should never buy a stock only because you think the company will be acquired. The company should have some other redeeming qualities. Fortunately, most companies that do get acquired are bought because they are strong businesses or because they have a product or service that is needed by the acquiring company.
That makes perfect sense. As investors, we can get lost in the world of stocks, but stocks represent ownership stakes in businesses. And if a business is going to get bought, it’s likely because it’s a successful one.
Forget about stocks for a minute. Imagine you were going to buy a business, maybe a restaurant. What would make one diner more appealing to buy than another? There are a few things you’d probably look for.
- Rising sales. Unless the business is a turnaround situation, you usually want to buy one that is growing. If you’re choosing between two restaurants to buy, one of which has flat sales and the other of which is growing, you’re likely to be more interested in the one with rising sales.
- Attractive valuation. When buying a business, you don’t want to overpay. A business with growing sales will likely be priced higher than one with flat or declining sales, but that doesn’t mean the higher-priced business is not an attractive value. There are various valuation metrics that take growth into account. A shrewd buyer will not pay too much for a business or company.
- Low debt. If you were buying a business, you’d prefer to buy one with low debt. Who wants to be the new owner of a business and be on the hook for huge interest payments?
Keep in mind, not all acquisitions will match all three of these metrics. After a 10-year bull market, it can be tough to find stocks trading at a low valuation. If the valuation is a bargain, there may be a good reason that the business is cheap.
Consider IBM’s (NYSE: IBM) upcoming purchase of Red Hat (NYSE: RHT). Red Hat is growing sales and earnings at a rapid clip and has a reasonable amount of debt, but IBM had to pay up to get such a rapid grower.
On the other hand, Bristol-Myers Squibb (NYSE: BMY) is buying Celgene (Nasdaq: CELG) at a fairly low value, but Celgene has a lot of debt. That is an important reason why no one is willing to pay too high a price.
Even without an extraordinarily high price being paid for Celgene, the stock spiked 20% in the 24 hours following the takeover announcement.
That being said, Celgene still has a lot of debt.
Contrast that with Red Hat, which is being acquired at a high price but is forecast to grow earnings at more than 16% annually over the next five years and has a healthy balance sheet. Red Hat popped 49% in one day.
And just last Thursday, Immune Design Corp. (Nasdaq: IMDZ) spiked 310% in one day after agreeing to be acquired by Merck (NYSE: MRK).
The Immune Design situation is a little different because it is a small biotech company that is being acquired for its technology, not for its business. But it shows how lucrative it can be for shareholders to be in a stock when it gets acquired.
There’s nothing like waking up in the morning, scanning the headlines, and seeing that one of your stocks is up 20%, 30%, 50% or more because of an acquisition.
Buy great companies with the some of the financial metrics above, and you’ll increase your chances of waking up to a windfall.
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