Profit From Buyout Mania

Kinder Morgan (NYSE:KMI) holds a very dear place in this Fool's heart. That business was the subject of my first commentary, and its continued success produced the cold, hard cash that turned me into a devoted value investor.

Because of this history, I was somewhat saddened by the news that CEO Rich Kinder plans to take the KMI side of the firm private -- saddened, but not surprised. It's just another in a string of buyouts affecting companies I partially own. Before this, for instance, Alcatel (NYSE:ALA) announced plans to buy Lucent Technologies (NYSE:LU) for an estimated price that's some 78% greater than what I paid for my stake in 2003.

For those of us at Motley Fool Inside Value, acquisitions like this seem to be all too common. Although we've been around for less than three years, three of our companies have either been acquired or agreed to be acquired. The loss of a good value firm can certainly be a bittersweet moment, because you may be forgoing greater future gains. Fortunately, that loss is often tempered by a little thing called a "buyout premium." It's a bonus usually paid by an acquirer in excess of the target company's previous market price, to entice shareholders to sell. With each of our acquired firms, Inside Value subscribers have been able to profit handsomely from those buyout premiums. In fact, here's just how well it worked:

The secret of our success
This style of investing works because stocks are not merely pieces of paper that change hands billions of times a day. In reality, they're fractional ownership stakes in businesses. The price tag on any given company may fluctuate on a minute-by-minute basis. The cash-generation ability of the underlying business, however, plays itself out over much longer periods. When all is said and done, you're really buying a fraction of that cash generation when you purchase shares.

In a nutshell, this means that sometimes the market wants too much for a company, and other times it wants too little. Inside Value investors understand this, and we use it to our advantage. We focus first on figuring out how much cash a business will likely generate. Once we have a good handle on that, we look at what the market is asking for that future money. If the price is right, we'll buy. In a nutshell, if our best estimate is that the company is going to generate $1, we're looking to pay $0.80, $0.70, or even $0.50 for that buck. Any time we can buy a genuine greenback for less than face value, we make money.

A dog-eat-dog market
Of course, we're still ordinary individual investors. Our investments certainly mean a lot to us, but in the context of a multitrillion-dollar market, they're most often droplets in the ocean. Just because we know we're getting a deal doesn't mean that market will immediately believe us.

Fortunately, we individuals aren't the only ones who take notice when a company's future cash flow is available at fire-sale prices. When other companies or executives with access to significant amounts of capital take notice, they can do something about it: namely, offer to buy the entire company. You'd better believe that sort of news gets the market's attention.

While those bigwigs want to take advantage of that same discount you do, you have an advantage. Simply put, it takes time to come up with the approvals and the financing to buy an entire company. Depending on the size and complexity of the transaction, it can take months to a year or more to get the details completed. When the market makes you an offer you can't refuse, you can buy your stake before it's too late -- before someone else has the chance to make an offer on the entire business.

Start digging for bargains
To really profit from the next merger, you need to own the target company before the acquisition is announced. Unless you have the type of insider information that makes it illegal to purchase, however, there's no way to know with certainty that a buyout is coming down the pike. Instead, you can profit by focusing on the conditions that make such a buyout likely. By buying companies that trade below what their cash flows indicate they're truly worth, we at Inside Value have found more than our fair share of acquisition targets. Join us today to be among the first to discover our next candidates.

Not quite sure whether Inside Value's style of bargain-hunting investing is for you? Be my guest for 30-days, absolutely free.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Kinder Morgan Management and Lucent. The Fool has a disclosure policy.