In recent years, investors have reaped gains of roughly 25% when they own a merged or acquired stock. Here’s how it works: Suppose you own ABC Tech Co., now trading at $50 a share. Say XYZ Computer Corp. decides to take it over. A month after the announcement of the deal, ABC Tech’s stock is likely to be trading at $60-$65, some 20%-30% higher than the pre-takeover price.
As you might expect, such profitable plays have been hard to find ever since the stock market swooned in 2008. According to Bloomberg, M&A activity in the U.S. dropped by about 50% from 2008 to 2009, falling to its slowest pace since 2003. Toward year-end 2009, though, merger activity picked up. Takeovers involving U.S. companies rose from $26.6 billion in August to $49.1 billion in September.
Why the increased activity recently? A somewhat healthier economy and a stronger stock market builds confidence among prospective acquirers. At the same time, stocks remain far below their peak prices so buyers can find possible bargains. Perhaps most important, as a recent Goldman Sachs report put it, “Companies accumulated historically high cash balances over the past twelve months as they sought stability in face of an uncertain macroeconomic environment. Cash-rich balance sheets are ripe for use.”
Among those uses, big-fish companies may use their cash to feed on tasty littler fish. “There are only so many things companies can do with cash,” says Seth Ellis, co-founder of RWE Private Wealth, a financial advisory firm in Orlando. “They can pay dividends to shareholders, invest internally, or purchase other companies. Recently, nonfinancial companies were holding around 5% of their assets in cash, which is extremely high by historic standards. A lot of that cash probably will be used for acquisitions.” The best acquisition targets, according to Ellis, can be found among companies with market capitalization of $250 million to $2.5 billion. In that size range, they’re big enough to be worth buying but small enough to make an acquisition practical. (Market capitalization is found by multiplying a company’s stock price by the number of outstanding shares. For perspective, Apple has a market cap over $175 billion.)