Think Like a Dealmaker

Acquisitions can be great for investors. Companies are often bought out at prices significantly higher than the prevailing market prices, with the result that shareholders reap huge profits in a short time. Things can get particularly exciting when several potential buyers are involved: Bidding wars can develop that push share prices up on almost a daily basis.

Acquisitions can juice your long-term returns, but actually identifying buyout candidates before the deal is announced is challenging. At the Motley Fool Inside Value newsletter, we've had two companies in the past year acquired at prices significantly higher than our initial recommendation. We used the following strategies to identify potential acquisition candidates before the news was baked into their stock prices.

Ignore the rumors
One of the best ways to not make money on acquisitions is to listen to acquisition rumors. Generally, these rumors are used to explain an increasing stock price. That's why investing based on rumors is generally not profitable: By the time the small investor hears the rumor, everyone else has already heard it and the stock has already gone up.

If the story turns out to be false, the stock will likely fall as traders exit their speculative positions. If the rumor turns out to be true, then often the buyout speculation will result in a takeover offer close to the stock's existing price and may actually result in shares falling when the deal is announced.

So, you really want to buy stocks before rumors of an acquisition abound and the acquiree's stock gets overinflated. That way, you profit from the pre-acquisition hype. Take Washington Mutual's (NYSE:WM) recent offer to buy Providian Financial (NYSE:PVN). Rumors of Providian getting bought out have been around for years. So when the companies announced a deal a couple of weeks ago, Providian's stock fell.

A much better time to buy Providian was three years ago, before strong results and buyout speculation had pushed the stock price into the high teens. Back then, Providian's poor-quality credit card portfolio was being hit hard by a recession, and the stock price reflected that fact. But the company seemed unlikely to go bankrupt and was significantly undervalued. At that point, Philip Durell, who heads up Inside Value, stepped up. He bought shares at $2.10, much less than the recent $18+ acquisition price. Such huge returns are possible only by finding potential acquisitions before the hype develops.

Think like an acquirer
So, instead of listening to acquisition rumors, the way to find companies likely to be acquired is to think like an acquirer. If you ran a multinational corporation, what sort of companies would you look to buy?

In general, you'd want to purchase companies in related industries to gain economies of scale and improve pricing power by reducing competition. Furthermore, you'd want to buy companies that already had some competitive advantage, perhaps a well-known brand, an existing relationship with key customers, or an asset that is difficult to reproduce. After all, why buy an entire company and suffer the challenges of integration if you can just build a similar business yourself?

A recent example of such an acquisition was MCI (NASDAQ:MCIP), which Inside Value originally recommended at $14. MCI, which had reorganized through bankruptcy, was an attractive company way back in the summer of 2004. It had piles of cash, impressive free cash flow, a great customer list, and a global network including the largest Internet backbone -- an asset prohibitively expensive to build from scratch. It seemed like it could be a solid acquisition for almost any telecom, and, at the time, we valued the shares between $25 and $30.

Now, a year later, after several hefty dividend payments and an intense, antagonistic bidding war between Verizon Communications (NYSE:VZ) and Qwest Communications (NYSE:Q), MCI is being acquired above $25.

Consider price
The other factor that a CEO would seriously think about when mulling an acquisition is price. Sure, back in the bubble of the late 1990s, price wasn't an issue. JDS Uniphase (NASDAQ:JDSU), for instance, paid ridiculous prices for companies and had to write off tens of billions of dollars in goodwill a few years later. But those days are long gone. Now, price really matters. After all, a company acquires another to increase its future profits. If it pays too high a price, then the return on its investment will be disappointing. So you should also look for cheap companies.

For example, back in October 2003, I purchased Aventis, a major French pharmaceutical company, at about $50 because it looked inexpensive. At the time, I wasn't thinking about it as a potential acquisition. I was buying a solid, growing company trading at a price-to-earnings ratio (P/E) in the mid-teens. It had a diverse set of products, a decent pipeline of drugs in development, and sustainable recurring revenues from annual flu vaccinations. Aventis seemed like a reasonable purchase under any circumstances.

As luck would have it, Sanofi, another French pharmaceutical that now goes by Sanofi-Aventis (NYSE:SNY) following the acquisition, saw the same value that I did. Within weeks, Aventis started increasing in price, as stocks often do before an acquisition is announced. Three months later, the news came out of a merger in the $80 range. Both Sanofi and I bought Aventis because we were using similar investment criteria. We were both looking for an inexpensive company that would yield extraordinary returns.

The upshot
At this point, you may have noticed that the qualities that characterize a potential acquisition candidate are suspiciously similar to the qualities that characterize an outstanding value investment. This is not accidental. Marty Whitman, the manager of the Third Avenue Value Fund, describes his investment strategy as buying companies at half of their takeover value. In other words, Whitman defines value investing as a quest to discover companies that are attractive acquisition candidates.

So, it makes sense that Inside Value has identified two acquisitions, since that's a natural consequence of purchasing outstanding companies for less than they're worth. That said, the great thing about value investing is that the strategy doesn't depend on acquisitions for success. Value investments generally rise to their intrinsic value over the long term, leading to high returns irrespective of buyouts. Acquisitions just tend to speed up the process.

That's why, through mid-June, Inside Value's 2004 picks are up by about 25%, on average, vs. the single-digit return of the S&P 500. Acquisitions helped, but even companies that weren't acquired have done well. If you're interested in reading about our 2005 picks -- the stocks that we think are the spectacular bargains in the market right now -- click here to take a free one-month trial to Inside Value.

Richard Gibbons is a member of the Inside Value team. He still owns shares of Providian but no longer has positions in any of the other securities mentioned in this article. The Motley Fool has a disclosure policy.