M&A can be a huge value driver for both the acquiror and acquired if it unlocks larger future growth or leads to synergistic cost efficiencies. Add the fact that simple a M&A announcement can catapult shares of the target higher, and investors are incentivized to identify acquisition candidates and invest in them.
The problem with taking a concerted effort in finding acquisition candidates as an investor is that there doesn’t seem to be much written about the topic outside of general platitudes about what companies look for in an M&A target:
- Strong balance sheet with little to no debt
- Or, strong operating results where the acquirer can absorb a bad balance sheet
- Simplified share class structure, ideally with one class of shares
- No poison pill provisions which can derail acquisitions talks or approvals
- Likelihood of proxy votes approving the deal assuming a decent premium
- Lack of emotional attachment from major shareholders or the board (such as from founders or family)
- Obvious or likely synergies to reduce costs or leverage existing assets
- Little or no unknowns in the form of litigation risks, anti-trust concerns, etc
There’s other theories we can make about situations which can breed a higher likelihood for an acquisition, such as:
- Matured industry or market, where a matured company would buy growth from a smaller player
- An environment in the industry where deals are becoming more frequent
- The presence of an activist investor who may be pushing management to butter up the company to be acquired
- CEO with significant power (also the Chairman of the Board and/or a major shareholder) who is close to retirement
But let’s try and confirm some of these theories before we accept any of them at face value. Since data on the specifics are sparse today, let’s take a few random case studies of recent acquisitions.
Noting that learning how to find acquisition candidates might go hand-and-hand with pursuing these takeover targets as an investment strategy, we’ll try and structure the research to assist in applying this practically for the future.
With this in mind, here’s what to expect in this post today:
- The latest statistics about mergers and acquisitions in the U.S.
- Warren Buffett’s focus on special situations in the 50’s and 60’s
- Two Recent Acquisitions and their Characteristics
- Investor Takeaway
Hopefully you’ll find what you’re looking for today, whatever the application.
M&A in the United States: Some Basic Statistics
I wanted to get a sense of how practical it would be for the average investor to pursue actively identifying acquisition candidates as a consistent investment strategy, so I dug up a few stats which might prove useful.
From this Q&A guide about M&A in the US, the number of acquisitions involving US public targets totaled 338 in 2019 and 441 in 2018.
I also found this data point about the number of public US acquisitions in 2020, which falls somewhat in the ballpark with the understanding that 2020 was a very special year compared to any other.
Noting that at the time of writing this article, in early 2021, the number of public U.S. companies is almost 4300 (source: finviz), we find that somewhere between 5%- 10% of companies are likely to be acquired in any given year.
Completely anecdotally, I’ve found that in my portfolio where I purchase 1 stock per month, I’ve held 5 stocks which were acquired or eventually acquired over a 6 year period running the portfolio. This confirms the 5%-10% likelihood, since I’m accumulating around 10-12 stocks per year and 5 out of 72 stocks would be about 7%.
Keep in mind that the number of M&A deals is actually in the 10k- 20k range, but most of those involve private companies and are not relevant in finding a publicly traded acquisition candidate.
Now that we know the likelihood of finding an acquisition candidate, about 5%-10% per year, let’s talk about why this strategy could be so profitable, and how to reasonably research a process for finding these opportunities.
Warren Buffett’s M&A/ Special Situation Strategy
I recently wrote a post about how Warren Buffett, one of the most famous value investors of all time, used to allocate a serious part of his portfolio into special situation stocks.
Buffett called these “work-outs”, and they were defined by him in his Ground Rules as “Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc. lead to work-outs.”
He also defined his first category of investable stocks as “undervalued generals”, in which he would ride the “coattails” of dominating shareholders (activist investors). You could argue that the presence of an activist investor could greatly increase the chance of a company being acquired, depending on the activist/ firm.
Regardless, both of these key characteristics of stocks were his two primary allocations in his portfolio throughout his partnership days, where he earned returns of 30%+ annually from 1957 until he really became popular with Berkshire Hathaway and those long term growth+value stocks.
Market Environment Can Dictate Takeover Candidate Investing Success
I’d like to point out, like I did in the special situation investing post, that Buffett’s success in his Ground Rules strategy (which later became referred to as “cigar butt investing”) occurred at a time when interest rates were rising and the Dow wasn’t performing very well.
It implies that a strategy such as finding acquisition candidates in order to unlock value in undervalued shares is probably most likely to work the best during a time of rising interest rates and/or an overall struggling stock market.
Contrast those conditions to the time period where Buffett changed his approach from more of a “value investing/ cigar butt” strategy to a “buy a wonderful business at a fair price” outlook, which happened to coincide with consistently declining interest rates and strong periods of outperformance for growth stocks in general.
Does Takeover Candidate Investing Fit Your Investing Style?
The major corporate events proved to be a critical aspect of buying undervalued stocks for Buffett, which is not widely discussed in value investor circles at all.
Finding acquisitions candidates in concert with buying undervalued stocks (and/or companies with underutilized assets), can give you a great edge in the process if you are diligent and willing to research, and hopefully apply the concepts you learn in this post.
Of course there’s a dark side to M&A, in that it can result in uncertainty and mass layoffs for the target company.
Buffett’s partner Charlie Munger has commented how the cigar butt stock picking approach is a mostly unpleasant business, due to the fact that turnarounds are often ugly and have painful consequences for real people.
This seemed to have also driven Buffett to evolve his approach to businesses with superior compounding potential, in addition to the restraints that a large investable capital base brings to actually finding great turnaround deals.
The average investor likely doesn’t have the same capital constraints, but should examine whether finding acquisition candidates as a major investing strategy fits with values, beliefs, and temperament.
Real Life Examples of Recent Acquisitions
Because data for M&A can be hard to source, particularly because the acquired company’s shares will no longer trade on an exchange and are dropped from many useful stock market data tools, we’ll have to go the old fashioned way with some case study examples.
Please keep in mind the limitations of case study analysis, which has frequently been used in investment books but can provide seriously distorted conclusions for a variety of reasons.
I will try to mitigate this as much as I can, by picking mostly random acquisitions over the last several years.
They should have a stock price pop associated with the announcement of a deal, since these are probably more likely to represent the acquisitions candidates which were the most favored at the time (evidenced by the acquiror’s wiliness to pay a substantial premium).
I’m also going to stay away from the “biggest deals”, since they might have vastly different circumstances than what’s present with smaller (and more frequent) deals, which readers might be looking to capitalize on in the future for their investments.
To start, I’ll identify two stocks which I was intimately involved in at one time or the other and might be able to provide additional insight into those deals, and those are Tiffany (formerly $TIF) and Mentor Graphics (formerly $MENT).
Example: Louis Vuitton Acquires Tiffany
This acquisition was announced in October 2019, and propelled Tiffany’s stock price from the $90 range up to $130, with the original deal valued at $135 per share.
There was a long period of drama following the deal announcement, and the offer was eventually revised to $130, but it ultimately went through and long term investors had many opportunities to liquidate close to the eventual deal price over the following 10-13 month peruid.
Let’s pull a few key characteristics from the deal before it was announced. I’m going to look at the proxy statement and 10-k:
- Ownership percentages (major shareholders) for Tiffany
- Vanguard = 10.56%
- Qatar Investment Authority = 9.74%
- BlackRock = 6.28%
- Lone Pine Capital LLC = 5.58%
As we look to understand a proxy statement and disclosure of major shareholders, keep in mind that the big brokerages (like Vanguard and BlackRock) are holding the shares for individual clients and are not likely to represent an activist shareholder who is looking for major corporate action.
The Qatar Investment Authority is Qatar’s sovereign fund (SWF), and doing a quick Google search on the firm reveals this opinion, from a white paper online:
Qatar Holding has also been a leader with respect to obtaining board seats.
It is a matter of national pride that Qatar Holding has taken board seats at big companies, from the owners of Heathrow and Canary Wharf in the UK to Credit Suisse and Volkswagen, making decisions that are relevant to some of the world’s most prominent companies. The board seats are seen as a way to groom the next generation that is now taking over.
I don’t know the influence that the Qatar SWF had on this deal, if any at all, but it is an interesting finding on a company that had such a strong brand presence but relatively low growth before it was acquired.
We can do similar research for other major sharheolders on any company we are examining, and as you gather more of this information you may be able to identify institutional investors who are more likely to push for buttering up the company as an acquisition company.
Tiffany was also trading at relatively low metrics on its Price to Book (P/B), Price to Sales (P/S), and Price to Earnings (P/E), and had these financial metrics in the fiscal years before being acquired:
- Long Term Debt to Equity = 0.282
The company was almost net debt free (the difference between long term debt and cash and cash equivalents was very small). It also had high working capital and a value of zero on the balance sheet for Preferred Stock.
- Net sales
- 2019 = $4,442.1, +6.5% YOY
- 2018 = $4,169.8, +4.2% YOY
- 2017 = $4,001.8
You can see that top-line growth was satisfactory, at least matching nominal GDP growth, but nothing spectacular.
Although Tiffany mentioned in their 10-k that the jewelry industry is very fragmented, you have to wonder if the lower growth rates of revenues indicates a matured industry, which could’ve been an additional catalyst for the acquiror to want to make this deal.
Growth from operating results and in profits was relatively similar, and you have to think that Louis Vuitton saw serious opportunities for leveraging each companies’ operating costs in order to expand margins and squeeze greater value from each company’s top-line.
Example: Siemens Acquires Mentor Graphics
This deal was announced on November 14, 2016, and was valued at $4.5B, which was a 21% premium to the Mentor’s pre-deal share price.
Mentor Graphics is a great software company whose tools are invaluable in many engineering applications, not only in Siemen’s automotive and aerospace industries but in the constantly growing semiconductor design world.
Let’s dive into the proxy statement and 10-k before the announcement of the deal to see if we can observe anything that stands out.
- Major shareholders
- BlackRock = 8.83%
- Vanguard = 7.19%
- Victory Capital Management = 6.85%
- Directors and executive officers = 2.8%
Unlike the Tiffany case study, nothing much popped up when I searched for Victory Capital Management and its role as a potential activist investor.
From the Victory’s company website, it appears that they provide a wide range of services, funds, and strategies, which may limit the likelihood that they take a significant activist approach with any company they are involved in.
I was able to find this note from one of their documents:
“The INCORE team also looks closely at ownership by activist shareholders who may be inclined to encourage actions that favor equity holders over debt holders.”
But, this document described one of the company’s fixed income fund and would not have applied to this particular investment in Mentor Graphics. Based on the proxy statement for Mentor, we don’t appear to have anything that would’ve signaled a potential takeover was in sight any time soon.
Looking at the 10-k, I found that the CEO, Walden Rhines, was also the Chairman of the Board for the company. This could indicate he had more of an influence of the company’s decisions than other CEO’s might have at oter companies. Looking at Dr. Rhines’s bio:
Dr. Rhines has served as our Chairman of the Board and Chief Executive Officer since 2000. Dr. Rhines served as our Director, President, and Chief Executive Officer from 1993 to 2000. Dr. Rhines is currently a director of Qorvo, Inc., a semiconductor manufacturer, and GlobalLogic Inc., a privately held software development services company.
With him being age 69, and the fact he had other projects to work on, could’ve influenced his wiliness to sell the company to Siemens, which could’ve had a ripple effect on the other directors and shareholders who ultimately approved the deal.
Going back to the proxy statement, we see that Dr. Rhines has 1.1% of the outstanding shares before the deal, which totaled over 1.2 million shares. So, he was pretty significantly incentivized financially to receive a 21% premium on his substantial holdings, and would be a no-brainer if he was looking to exit the business anyways.
According to this article quoting a study by the London School of Economics and Dartmouth College (bolded emphasis mine):
“Companies with CEOs who work past typical retirement age (between 64 and 66) are 32% more likely to field takeover and merger offers”
I’m completely speculating, but these are all possible factors which I’m sure Siemens was looking at too during their due diligence.
It should also be noted that there’s no mention of any of the 3 original founders for Mentor Graphics in the proxy, so without that emotional attachment on the board a company is probably more likely to let go of control to an outside acquirer.
Fast-forwarding to the company’s financials:
- Long Term Debt to Equity = 0.18
- Preferred Stock on the Balance Sheet = none
It should also be noted that the company had basically flat growth of revenues, operating profits, and earnings over the last 3 years, as was their cash from operations (generally, and excluding a big change in working capital in 2019).
The company also had relatively low price-based valuation metrics in the time periods leading up to its eventual takeover.
This should be no means be an definitive guide to finding every stock that will be acquired, or every stock that makes for a pursed acquisition candidate.
There’s many reasons why people buy and sell anything, and it absolutely applies to companies like it applies to everything else.
Just because a company has low debt or meandering growth doesn’t mean it will be taken over soon, if ever.
And, just because a deal is accepted doesn’t mean it will always go through, as it has to pass through multiple stages of legal proceedings.
But it hopefully leaves you with more great ideas to pursue in your research, particularly if you are looking at purchasing deep value stocks that you hope will mean revert.