Before I became an investment manager 13 years ago, I spent a decade as a reporter at the Wall Street Journal. I had a rival at another newspaper who frequently wrote about takeover rumors.
One day he filed a story saying that Coca-Cola Co. might buy Wendy’s, the fast-food chain. Coca-Cola responded with a statement, which I framed and have held onto all these years. The Atlanta-based soft-drink giant said that its policy was not to comment on such speculation, and that in this case it wanted to add that the reporter “does not have a clue.”
People who invest based on unconfirmed reports about possible mergers or acquisitions often do themselves a disservice. If even well-connected pundits are often wrong, imagine how far you can go astray if you act on such gossip, whether it comes from friends, acquaintances or stockbrokers.
It’s natural to try to pick stocks that will become takeover bait. If you succeed, it can be very lucrative: purchases usually occur at a 20 percent to 70 percent premium over the previous day’s trading price.
And now is a good time to seek out such opportunities. The third quarter was the busiest for M&A activity in two years.
The best way to play this game is to invest in companies whose financial characteristics make them attractive to potential buyers. Frequently these are stocks you would be happy to own even if no deal were imminent.
Last week, I ran a screen to identify such situations.
I looked for companies with an enterprise value no more than six times Ebitda. Enterprise value is the market value of a company’s stock, plus the total of its debt. It gives an approximation of what one company must pay to acquire another.
Ebitda is earnings before interest, taxes, depreciation and amortization. Some investors consider it a truer representation of a company’s value than earnings under generally accepted accounting principles, or GAAP earnings.
For most purposes, I usually prefer GAAP earnings because I consider interest, taxes and depreciation real things, not phantoms. In takeover situations, however, Ebitda may be a better measure.
An acquirer may not care much about those factors because they may be nullified or changed after the acquisition. For example, the buyer might pay off the target company’s debt, and not have to worry about interest charges thereafter.
To make sure my potential takeover targets were not too big or too small for acquirers’ taste, I restricted my search to U.S. companies with a market value from $500 million to $5 billion.
I also looked for ones that sell for 15 times earnings or less, have cash or safe short-term investments of at least $50 million, and have debt less than stockholders’ equity.
Those characteristics make a company more attractive to a potential acquirer -- and they are good things to see even if no one comes courting. When I ran the screen, 75 companies made the cut.
Several were for-profit education companies: ITT Educational Services Inc. of Carmel, Indiana; Education Management Corp., based in Pittsburgh; Career Education Corp. in Hoffman Estates, Illinois; and Corinthian Colleges Inc. of Santa Ana, California.
Opportunities Pop Up
Another is Washington Post Co., which is known as a media company yet gets more than half its revenue from its Kaplan Higher Education unit.
Education stocks have been popping up on value screens for weeks. They are cheap because the U.S. government may end aid to schools whose students are too slow repaying federally backed education loans, or whose students have low job-placement rates.
In response to criticism that they recruit students indiscriminately, including some who have little chance of benefiting from their programs, several for-profit schools have begun no-fee provisional enrollment programs or instituted special training sessions to enhance the study skills of entering students.
The biotech firm Cephalon Inc. is the largest company on the list, with a stock-market value of about $5 billion. Based in Frazer, Pennsylvania, its drugs treat pain, cancer and central nervous system disorders. The company’s most successful product is Provigil, a drug that combats narcolepsy.
A few years ago I sold Cephalon shares short, betting on a decline. At that time the stock was expensive, trading at 20 to 40 times earnings. I was also concerned about off-label use of Provigil by truck drivers and others trying to induce wakefulness. I’m still concerned that if the U.S. regulators crack down, Provigil would quickly lose a lot of its sales, but valuations are now favorable with the stock priced at 11 times earnings.
Information-technology stocks that look like potential takeover candidates include Teradyne Inc., a North Reading, Massachusetts-based maker of semiconductor test equipment; Tech Data Corp., a Clearwater, Florida, distributor of technology products; and Malvern, Pennsylvania-based Vishay Intertechnology Inc., which makes transistors, capacitors and other electronic components.
Disclosure note: I have no long or short positions in the stocks discussed above, personally or for clients. Four stocks that I own did make the 75-stock list: Endo Pharmaceuticals Holdings Inc. of Chadds Ford, Pennsylvania; GT Solar International Inc. of Merrimack, New Hampshire; Mirant Corp. of Atlanta; and Rowan Cos. in Houston. Most of these have been discussed in previous columns.
(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)
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