Cash In On the Takeover Boom With These 3 Stocks

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When mergers and acquisitions (M&A) start shooting like fireworks through the proverbial roof, you can better position yourself to take advantage of some mind-blowing investment opportunities. 

So where are you going to be when the takeover boom hits? Hopefully you'll have done the research necessary to purchase some great stocks -- companies that have distinct qualities (we'll get to those soon) that can benefit from the flurry of activity that's about to explode.

Who says M&A is about to "explode"?
Much economic data suggest that activity increases in bull markets, when economic conditions are especially favorable. So why in the world is M&A about to increase right now? Three words:

Cash, cash, and more cash (OK, that's five words).

As stated by analysts at Credit Suisse, "Corporations are cash rich and balance sheets are healthy when compared to past recessions. Companies have the most cash in their arsenal targeted at growth strategies since 2001."

According to the Commerce Department, U.S. companies posted annualized cash flow of more than $1.5 trillion in each of the past three quarters -- the most since 1947, when such data started being collected. 

Liquidity is a critical component influencing merger activity. As debt markets continue to open up and private equity expands, companies are finding it easier to access more -- yup, you guessed it -- cash.

So put on your party hat, sit back, and watch the companies with the best balance sheets set off their M&A explosives.

Need some evidence?
Warren Buffett had his hands all over M&A in late 2008. In July of this year, IBM (NYSE: IBM) purchased software solutions provider SPSS for about $1.2 billion. In August, the federal antitrust authorities gave Sprint Nextel  (NYSE: S) the go-ahead to buy wireless communications provider Virgin Mobile USA. Walt Disney (NYSE: DIS) caught everyone off guard with its recent announcement to buy Marvel Entertainment for $4 billion, and shortly after, Kraft (NYSE: KFT) made an astounding $17 billion hostile bid for Cadbury!

These are just a few examples, but it's clear that the cream is starting to rise to the top, and companies in certain industries are taking advantage of attractive valuations. In times like this, if a company has the financial wherewithal to do so, it's often very easy to grow earnings by making prudent and tactical acquisitions.

How to position yourself as an investor
The best way to prepare yourself is to invest in solid companies with clean balance sheets and attractive valuations. First and foremost, you should always be prepared to hold a stock, whether or not it becomes an acquisition target. Hoping for a buyout should never be your sole reason for a purchase. However, if you happen to find a great company that also becomes a takeover target, you'll likely see its share price soar through the roof, and investors will recognize huge gains. For example, Dell (Nasdaq :DELL) recently announced the purchase of Perot Systems -- Dell shares fell 4.1% while Perot's shares surged by 65%. Similarly, Cadbury’s shares have shot up 39% since Kraft made its offer.

A very simple approach is to look for the same things potential acquirers covet. Namely, mid-sized companies with the following characteristics:

1. Limited or no debt
2. Impressive return on equity
3. Low valuations

Furthermore, a KPMG forecast has made it even easier for us. Earlier this year, its "M&A Predictor" forecast low valuations in a few sectors, including technology, energy, and health care.

So if you can find companies you really like that also: (1) have limited debt, (2) have high returns on capital, and (3) are trading cheaply -- well, you probably have some winners on your hands. Check out these three that are on my personal radar:

Company	Industry	P/E (TTM)	ROE (TTM)	Long-Term Debt-to-Capital Ratio
Compuware	Technology	11.4	17.2%	0.0%
Atwood Oceanics (NYSE: ATW)	Energy	8.6	30.5%	19.2%
Sepracor (Nasdaq: SEPR)	Health Care	12.7	28.8%	8.9%

Data from Capital IQ, a division of Standard & Poor's.

What now?
The three stocks mentioned above won't necessarily be snatched up, but they do have characteristics that are desirable to larger companies. What's more, these same characteristics are desirable to individual investors like you and me.

So if you're looking for help finding the next great stock that will deliver startling returns, you can get the latest buy and sell recommendations from Fool co-founders David and Tom Gardner at Motley Fool Stock Advisor.

Since inception in 2002, they're beating the market by 45 percentage points by consistently picking solid companies ahead of the pack. Want more proof? David Gardner's top pick, Marvel Entertainment, just got bought by Disney, capping off a run of about 1,300%! Right now we're offering a free 30-day trial to the service -- there’s no obligation to subscribe. Click here to get prepared for the boom.

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Fool contributor Jordan DiPietro doesn't own any shares of the companies mentioned above. Atwood Oceanics, Marvel Entertainment, and Walt Disney are Motley Fool Stock Advisor picks. Dell, Walt Disney, and Sprint Nextel are Motley Fool Inside Value selections. The Fool has a disclosure policy that is more than ready for some takeover action.