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Merger Mania 2011: How to Profit From M&A Activity

Okay, I’m going to get right to the point here: In 2011, we’ll see a surge in mergers and acquisitions (M&A) that will drive the market higher.

If you want to profit from the merger mania, you just need one simple thing to get started: You need to think like a pro.

You see, while professionals watch the M&A market with zeal, most individual investors treat it as an afterthought, believing that it’s too hard for “outsiders” to profit.

However, that’s a long way from the truth.

There are actually multiple ways to earn your share of the M&A market – and if you’re going to pick a year to start, 2011 should be the one. Here’s why…

How and Why M&A Will Boom in 2011

Let’s take three statements from some top research and consultancy firms…

  • Freeman Consulting Services expects global deal activity to top $3 trillion in 2011.

  • PricewaterhouseCoopers predicts a “resurgence in deal-making in 2011.”

  • A recent study from McKinsey & Company reports that “boards of directors are less skittish in pursuing transactions.”
That bodes well, for sure… but I still think they’re underestimating.

You see, there are actually a couple of different types of acquisitions and it’s important to distinguish between them in order to see how the growth will be generated.

  • Hedge Fund Activists: As my colleague Marc Lichtenfeld noted last week in his 2011 outlook column, antsy, value-hungry activist investors will create some profit opportunities this year.

  • Strategic Acquisition/Takeover: The days of the highly leveraged, private equity buyout are gone for the foreseeable future. Instead, we’re seeing a shift to companies that are actively scouring the market for businesses that fit with their own line of work and are trading at “let’s make a deal” prices. The pieces are in place for this type of acquisition to explode in 2011, potentially jumping by 20% to 30%.
Here’s why:

  • Companies Hold the Most Cash in 51 Years: Non-financial U.S. companies are currently sitting on $1.93 trillion in cash – the most since 1959 and more than enough to pay off the 2010 federal deficit at once. The reason for this explosion is a move to fatten up balance sheets during the credit crunch. But even accounting for a “new normal” of cash-padding, company coffers need to go to fat camp and purge some of the cash. Especially since…

  • Cash Returns Are Pathetic: With bond yields and interest rates driven down to the basement, holding cash drains a company’s overall return. Executive boards will need to find a way to invest it for better returns, or give it back to shareholders.

  • Profits Are at An All-Time High: According to the Commerce Department, corporate profits totaled an annualized figure of $1.659 trillion during the third quarter. It was the highest amount on record – and again, this could cover the annual national deficit with billions to spare. Corporate margins are also approaching peak levels, with total profits reaching 11.2% of GDP. (It’s worth noting, though, that while corporate earnings have rallied out of the recession, cost-cutting and productivity/efficiency gains are responsible for a decent chunk of it.)

  • Valuations Are Tempting: In 2010, the average acquisition sold for 1.24 times sales. That’s why deals look so attractive. If you can cough up a $1.24 one-time payment, add $1 per share in annual sales to your company and convince your shareholders that you can grow those sales in the future, it’s a good deal for all involved. In addition, during the M&A boom of 2007, the average deal was completed at 27 times earnings. Last year, the average M&A deal was done at 20 times free cash flow. Right now, the S&P 500 is priced at only 12 times free cash flow, meaning there are plenty of enticing deals waiting to be done.
There’s another crucial aspect to the M&A equation, too…

A New Deal-Maker on the M&A Block

In 2011, the buyout cash won’t just come from America. Asian companies now have the cash and the desire to diversify their operations. For example…

  • Deals involving Asia-Pacific companies through November this year jumped 25% over last year, passing Europe for the first time.

  • More than 8,700 deals involved Asian companies and almost 70% of them were all cash.

  • Asian companies completed 421 acquisitions of North American companies.
And as far as targets go, European companies are getting snatched up left and right – Sanofi-Aventis and Alcon, Inc., for instance.

Sure, it takes a cast-iron stomach to buy into nations like Greece and Spain, but the guys with the big money apparently see a “blood in the streets” opportunity and a chance to strike a cheap deal amid crisis.

The point here is that if a company is considering a takeover, it will need to accelerate its process to compete with Asian buyers.

And as for profiting from all this…

Claim Your Share of the M&A Boom With These Three Investment Banks

When it comes to correlation and cause, it’s a bit like figuring out whether the chicken or the egg came first. Does M&A make the market go up? Or do rising stocks encourage more deals?

Historically speaking, high M&A activity is tied to a stock market uptrend. A rising market fuels more deals, as buyers need to complete them before shares rise too much. At the same time, takeover premiums cause adjustments in valuations, which also pull the market up.

And the common denominator is that each deal requires an investment-banking firm to facilitate the transaction. So you could benefit from the enormous fees that these banks command.

The biggest players are Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS) and JP Morgan (NYSE:JPM). Collectively, they capture 47% of the global M&A market.

The thing is, though, their enormous size means that an uptick in M&A might not move the needle enough to boost their share prices.

Instead, look to smaller, boutique firms like these in order to benefit more substantially…

Together, these guys derive 59%, 50% and 49% of their revenue from investment banking, respectively (as opposed to an average of 11% for the big boys).

Aside from that, the most exciting way to profit from acquisitions is to successfully pick out the takeover targets.

Three Companies That Could Receive M&A Offers in 2011

When a big company buys a smaller firm, they generally pay a premium of anywhere between 10% and 50%, with the shares of the target company often jumping by that much in a single day.

It’s tricky to pick these winners ahead of time, but here are my top candidates for 2011:

  • [b]ARM Holdings (NASDAQ:ARMH): The hottest area for technology growth is undoubtedly mobile technology – and ARM Holdings has the clear lead in processors for mobile devices. My Android phone uses an ARM chip, as does every iPad and iPhone. ARM designs the technology for specialty processors and then licenses it to other companies for manufacture, which keeps operating margins high at 91%. Blue-chip companies are just itching to capture more of the mobile market and with mobile processors so costly to develop, it could result in a company like Intel (NASDAQ:INTC) splashing out $8 billion to swallow up a competitor like ARM.[/b]
  • Travelzoo (NASDAQ:TZOO): Google (GOOG) just offered Groupon $6 billion to buy it. Groupon turned the offer down. Why is this important? Because all Groupon does is send e-mails with coupons for businesses in local areas, and Travelzoo is essentially the Groupon of travel, sending out daily announcements of travel offers. Analysts say the real value of Groupon was the 15 million subscribers on its e-mail list. Travelzoo has 13 million and can be bought for $700 million… much less than Groupon’s inflated valuation. The company isn’t cheap on a price-to-earnings basis, but with almost no long-term debt, a buyer should materialize before long.

  • BP (NYSE:BP): It would take a massive offer, but rumors are swirling that a beaten-down BP could get bought out next year. The most likely suitors are Royal Dutch Shell (RDS-A) and Exxon Mobil (XOM). A deal would make sense, too. BP currently trades for 30% less than its peers on a price-to-book basis. And in Exxon’s case, its own rule of thumb allows it to pay more for undeveloped oil field acquisitions than it would take to buy BP’s developed oil fields. BP would obviously fight a takeover, but either way, competing bids would benefit shareholders.
Whether you want to sit back and watch the market rise, or speculate on some takeovers, 2011 promises to be a big year for M&A deals. You should make a few moves to profit from the action, too.

Good investing,

Matthew Weinschenk


Rating: 3.7/5 (7 votes)


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