How to Profit from the Deal Boom

07/15/2011 9:34 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

A spike in mergers is a sign of optimism on the part of CEOs—and a handy way for individual investors to make some money while the economy limps along.

The stock market may be more terrifying than campfire ghost stories were when you were ten. Doubts about economic growth litter the ground like beer cups after a NASCAR race.

But the mergers-and-acquisitions market is hot. Companies spent 20% more buying other companies in the first quarter of 2011 than in the first quarter of 2010. And the dollar volume of deals is up 40% from the first quarter of 2009, the low for this cycle.

The activity in some sectors is positively frantic. For example, in the chemical industry, 2011 is shaping up as a record year for M&A. The first half of the year saw $60 billion in announced deals, an increase of 41% from the first half of 2010.

It may seem odd that companies are willing to invest billions and millions when you and I are having nightmares about putting our thousands and hundreds to work. And it may seem strange that companies are so willing to buy other businesses when the global economy may be slowing. But it’s completely logical.

And that logic suggests a strategy that you and I can use to invest in the currently volatile stock market: Think about what’s scarce right now. And what’s cheap.

Cash Is Cheap
When so many of the world’s developed economies are growing at 2% a year or less—if they’re expanding at all—top-line growth is scarcer than hen’s teeth.

And with the cost of raw materials and energy climbing, any squeeze on top-line revenue growth can turn into real pain by the time the money flows through to the bottom earnings line.

But when developed economies cut interest rates to near 0%, and then dump additional cash into the global market—through policies like the Federal Reserve’s programs of quantitative easing,—cash becomes cheap.

In May, Google (GOOG) raised money at a yield of 3.63% for ten-year corporate bonds. Johnson & Johnson (JNJ) sold ten-year bonds at 3.68%. Take out the current 3.6% inflation rate, as measured by the Consumer Price Index, and you’ve got essentially free money.

And, of course, many companies don’t need to borrow. At the end of the first quarter, companies were sitting on $1.9 trillion in cash.

This leads to one logical conclusion: Growth is scarce, and money is cheap—so buy growth.

But isn’t this strategy risky if you’re a CEO? Here are three reasons it isn’t:

The stock prices of the companies that you’re looking to buy aren’t at nosebleed levels. The 12-month trailing price-to-earnings ratio on S&P 500 stocks is just 15.2, well within the range history calls reasonable.

The forward P/E ratio—if earnings estimates are right—comes to just 13.7, well within the range that history calls cheap. (And in many sectors, private-equity companies are looking for exits. The companies they’re looking to sell don’t always come with a low price, but the other available deals help to keep prices down.)

It’s less expensive to buy growth than to invest to create it. Buy a company doing $500 million in annual sales and you can be reasonably sure that even if the economy grows slowly, most of that growth will still be there next quarter, and next year, and the year after that.

Invest in growth in a slow-growth economy and you risk having the market that you want to capture recede into the future, so that your company is spending millions or billions chasing a will-o’-the-wisp. Just ask electric-car battery maker A123 Systems (AONE) when it will see that market reach significant volumes.

You aren’t investing for tomorrow. Individual investors may get spooked out of a position if growth is slower than expected for a quarter or two or three—but if you run a mining or oil company, for example, you’re looking at growth trends for the next decade.

Sure, Alcoa (AA) will be depressed if demand for aluminum doesn’t grow by 12% in 2011. But the really important number is the 6.5% annual growth in demand that the company projects for the next decade.

And this kind of long view isn’t limited to natural-resource companies. Nestlé’s (NSRGY) deal to buy a 60% stake in Hsu Fu Chi International, a Chinese snack and candy maker, for $1.7 billion, has the same long horizon. Hsu Fu Chi’s revenue in the company’s last fiscal year grew three times faster than Nestlé’s own worldwide sales.

I don’t know what’s more exciting for Nestlé—the chance to grow Hsu Fu Chi’s sales more rapidly using Nestlé’s product development and marketing expertise, or the opportunity to expand sales of Nestlé’s own brands in China using Hsu Fu Chi’s distribution network. But you can be sure that the company didn’t make the deal with an eye on next quarter’s results.

NEXT: 3 Lessons for Investors

|pagebreak|

3 Lessons for Investors
So what strategic lessons does the current M&A boom have for individual investors?

First, the willingness of CEOs to buy growth at a time of so much short-term uncertainty, both in share prices and economic conditions, should be heartening to investors who have built their investment strategies on buying long-term growth at a reasonable price. As long as the fundamentals are there, these deals say, the day-to-day gyrations of the stock market are just so much noise.

Keep in mind: At its current stage, the boom hasn’t forgotten that valuations in any deal have to make sense. This isn’t about buying growth at any price.

One of the most impressive deals in recent weeks is one that didn’t get done. Brazil’s Vale (VALE) decided not to top a bid from China’s Jinchuan Group for Metorex, a South African company with copper projects in the Democratic Republic of the Congo and Zambia.

The political risk in those projects ruled out a higher valuation for Metorex’s assets. That decision was made despite rooting from institutional investors and Wall Street analysts who called Vale’s bid 35% undervalued.

Second, watching to see which companies make what deals gives individual investors a way to separate the companies with solid, well-executed long-term plans from those that flip from strategy to strategy and from opportunity to opportunity.

For example, you can follow the intensifying war over the opportunities from the build-out of the smart grid for delivering electric power by looking at the acquisitions in that sector. General Electric (GE), ABB (ABB), and Schneider Electric (SBGSY, or SU.FP in Paris), have all made acquisitions in this space in the last year.

Indeed, the pace of deal making seems to be picking up. The acquisition that gives the buyer the most leverage in this space is, in my opinion, Schneider Electric’s $2 billion purchase of smart-grid software company Telvent (TLVT). Until that deal, Schneider Electric hadn’t been on my radar screen.

Third, better a seller than a buyer be. The recent bid by Peabody Energy (BTU) and ArcelorMittal (MT) for Australia’s Macarthur Coal (MACDY, MCC.AU in Sydney) hasn’t done much for Peabody’s share price, which is up 1.6% in the three days after the bid was announced. However, it has done a great deal for Macarthur’s share price—up 37% in the three days after the bid.

So all you have to do to make a truckload of money is to find acquisition candidates like Macarthur before some company puts in a bid. Sound like hunting for a needle in a pile of prospectuses? Well, I have some suggestions for winnowing your search.

Finding Acquisition Targets
I’d focus on sectors such as coal and iron mining, where companies are used to working with very long lead times, and where supply—hence growth—is hard to find. It helps that even if the company you pick doesn’t wind up being acquired…you’ve still bought a stake in a very attractive sector.

I haven’t found a coal company yet to replace MacArthur in my portfolio—although my Jubak Global Equity Fund (JUBAX) does own Whitehaven Coal (WHC.AU in Sydney). You can be sure I’m looking, though.

I’d also target sectors, such as chemicals and video games, where the market is very, very fragmented, meaning that there are lots of players with small market shares.

On July 13, Electronic Arts (ERTS) announced that it would buy PopCap Games for as much as $1.3 billion in stock and cash. PopCap is the producer of such online games as “Plants vs. Zombies” and “Bejeweled.”

Electronic Arts—and every other maker of console games—is looking to buy market share in the online gaming world. Most other US casual game producers are, like PopCap, still private. Take a look at Mumbo Jumbo and Big Fish Games to get an idea of this space.

One public company that might make an interesting buy for, say, a Korean game maker looking to expand outside its home market, is Activision Blizzard (ATVI).

Lastly, I’d look at sectors where established companies have lots of cash flow but relatively little possibility for organic growth. The commodities sector is flush with these situations.

The international oil majors need to acquire growth by buying into unconventional oil share or heavy oil production, for example. Eagle Ford shale producers such as Petrohawk Energy (HWK) and Pioneer Natural Resources (PXD) suggest the dimensions of potential acquisition candidates.

In our strange present economy—in which corporations are sitting on tons of cash, and many have substantially strengthened their balance sheets—I think it’s worth adding an M&A component to your portfolio.

After all, it’s not like this stock market is bursting with opportunities to make money.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Google, Macarthur Coal, Nestlé, Vale, and Whitehaven Coal as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

Related Articles on STOCKS