As Potash Corp. of Saskatchewan Inc. looks around for a better takeover offer than the one floated by BHP Billiton Ltd., one thing remains clear: Mergers and acquisitions activity is heating up, and that can be good news for investors who are positioned right.
Potash Corp. shares jumped nearly 26 per cent on the day that BHP made its offer. Bullish analysts believe the stock can move even higher if the fertilizer producer can attract a rival offer. Either way, though, it is likely that the big money has already been made on the stock, forcing deal-seeking investors to look elsewhere for takeover candidates.
Where? Most investors are remarkably unimaginative, preferring to follow the most recent headline-grabbing acquisition. Most fertilizer stocks saw some interest following the BHP bid. Similarly, many software stocks jumped after Intel Corp. made its move on McAfee Inc.
But there's a better way to suss out - or at least narrow your search for - companies that could be in the sights of an acquirer: Look for stocks that are cheap relative to the amount of free cash flow (FCF) they generate. It's known as a high FCF yield, where FCF is simply the money a company generates from its operating activities, minus its capital expenditures.
"With corporate cash balances at record levels, and expectations for private equity and M&A activity at the forefront of investors' minds, attractive free cash flow multiples may be more rewarded than earnings - that is, investors may be better served valuing companies as potential takeout candidates," Savita Subramanian, quantitative strategist at Merrill Lynch, said in a note.
Okay, the process involves some legwork. But you can find the occasional analyst or stock screen whiz who has done most of the heavy lifting for you. I did a little digging and found a few U.S. nuggets: Biopharmaceutical company Cephalon Inc., dairy producer Dean Foods Co. and circuit board manufacturer Jabil Circuit Inc. all have very FCFs relative to their share prices, making them attractive takeover candidates.
Of course, that doesn't necessarily mean that they'll be snapped up. However, it might not even matter. Ms. Subramanian noted that companies with high FCF yields performed very well during the buyout binges earlier this decade and in the late 1980s.
If the recent spate of takeovers persists, this outperformance could return.
David Berman