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Stockpickr: The Top Takeover Target Stocks

James Altucher

The main goal of Stockpickr is to boost your trading performance, and to that end we've created a new feature called System Trades of the Day. We've backtested several trading systems that have resulted in significant and consistent gains during the past five to 10 years during bull markets, choppy markets and bear markets.

Some of these systems are fundamentally based, like our Takeover Targets System. Other systems are based more on price action, like our 3x2 System, our Mega-Gap System, and our QQQQ Sweet Spot, which is a system for shorting the Nasdaq 100 Trust(QQQQ).

Each day, we put a collection of stocks in the System Trades portfolio that have triggered for that day and also have had the most success in the past.

The Takeover Targets System rebalances every month, meaning that it comes up with a new set of stocks that are most likely to be buyout candidates. In January, Houston Exploration(THX) was on the list and was bought out early in the month.

Here's the basic idea: If a company trades at a low multiple over cash flows, then it's worthwhile for other companies or investors to take on debt, buy the company and use the cash flows to pay down the debt. Essentially, they are buying the company for free once the debt is paid off.

For example, let's say company XYZ is worth $1 billion but has $100 million a year in cash flows. If interest rates are 6% and if you believe XYZ's earnings will grow, or at least remain stable, then it could potentially make sense to borrow $1 billion and buy XYZ. Then, with the $100 million in cash flows, you'd pay back the $60 million in interest payments, plus throw in some amount each year to pay down the debt.

The Takeover Targets System looks for all companies that are trading for less than seven times trailing cash flows and buys them on the first day of each month, holding them for a month. There are other criteria, based on market cap and debt levels, that are included in the system as well. Check out the Takeover Targets System here.

How has the system done? We tested it from 2000 to mid-2006 and it has performed very well. In the chart below, we simulated the results using only 2% of equity per trade. For different results, you can use 5%-10% of equity per trade, or more. However, the important part is that each year was up, in both bull and bear markets.

Stockpickr: Takeover Targets System

Source: Stockpickr

Additionally, the average return per trade was 5.73%. In 360 occurrences, 60% of the trades were profitable.

Some of the trades that have triggered for the month of February include InterDigital Communications(IDCC), Swift Transportation(SWFT) and Unit(UNT). When you're looking down the list of potential takeover targets, it helps to see the other mutual funds and hedge funds that own the stocks. They also probably figure the companies are likely targets to get acquired.

For instance, oil driller Unit trades at just 3.6 times cash flows, with all analysts expecting cash flows to improve over the coming year. The company has a market cap of $2.2 billion and a net debt of $145 million, but cash flows over the past 12 months of $656 million. In addition, analysts expect the company to improve revenue from $1.17 billion in 2006 to $1.26 billion in 2007, and improve earnings per share from $6.78 to $6.89. In other words, analysts expect cash flows to remain fairly stable for Unit. How have analyst predictions fared in the past? For the past four quarters, the company has either met or exceeded expectations.

I also like that the Royce Value Fund owns Unit. Royce is up an amazing 21% per year over the past five years, as opposed to an annualized 6%. They've done this by consistently picking stocks with a high margin of safety, like I believe Unit has.

For more stocks in the Takeover Targets System, check out and bookmark the system page here.

For more trades mentioned in our System Trades of the Day portfolio, please click here.

For information on the 3x2 System or the Mega-Gap System, click on their respective portfolio pages in the Active Trader section of Stockpickr.

Stockpickr tip of the day: Every weekend I've been sending Jim Cramer the portfolios entered into Stockpickr that I think have the highest quality analysis. I will also start featuring these portfolios in regular articles, beginning next week. If you'd like me to take a look at your portfolio, please send me a note with the name of the portfolio and I'll take a look.

Also, check back on Stockpickr every Sunday for our Barron's Roundup article, summarizing the portfolios and stocks mentioned in this week's Barron's. For a look at last week's article, click here.