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Top 10 Potential Takeover Targets

James Altucher

The takeover targets system, which calls for buying a specific stock on the first day of the month and holding until month's end, has historically returned 5.7% per trade. The system also has not had a down year in the simulations we've run, in both bull and bear markets.

We update the takeover targets portfolio monthly so that the trades can be viewed for the entire month. The premise is fairly simple: When stocks become cheap enough (in our case, we believe less than five times cash flows is cheap), private-equity firms or other corporations are more likely to buy them for their cash flows -- even if the business is declining.

Two stocks on the list continue to catch our eye; we have watched them for the past few months. Let's revisit the bullish argument for each.

The first is InterDigital(IDCC Quote). Does your cell-phone ring? If so, then it may very well be making use of a patent owned by InterDigital and licensed by your cell-phone manufacturer.

Patent licensing is a business that results in very choppy revenue and cash flows. But don't worry about InterDigital; it has $190 million in the bank and had $110 million in cash flows last year. The wireless technology business is solid, and its core customers aren't going anywhere.

The King of Prussia, Pa., company has an enterprise value of $880 million, and I wouldn't be surprised if a company such as Qualcomm(QCOM Quote) swept down on InterDigital and bought it for just nine to 10 times cash flows (it currently trades for seven times cash flows).

Super-value mutual fund Heartland Value owns shares of InterDigital. Heartland is one of my favorite value mutual funds to piggyback. It has returned an average of 15.7% over its 22-year history by focusing primarily on value-based micro-caps.

More notably, one of the best hedge funds out there is also a very large holder of the stock. Caxton Associates, the $16 billion New York-based firm founded in 1983 by legendary billionaire macro trader Bruce Kovner, owns nearly 600,000 shares. Other of Kovner's holdings include Goodyear Tire & Rubber(GT Quote), Alcoa(AA Quote) and Lowe's(LOW Quote).

Pioneer Drilling(PDC Quote) is the second name we have been following on our takeover list. The company provides drilling services to oil and gas exploration companies. As long as people need oil, and as long as oil prices remain above $40 a barrel, oil companies will be willing to spend more money to drill in places where it's harder to extract the oil.

Pioneer has a pristine balance sheet, with $85 million in cash in the bank, giving it an enterprise value of just $650 million. I say "just" because the company's EBITDA (earnings before interest, taxes, depreciation and amortization) is $182 million, meaning it trades at just 3.5 times cash flows. It has margins of 30%, and analysts expect revenue to be pretty much even next year compared with this year.

But even if Pioneer's business were to suffer, it wouldn't change the thesis here. Right now, the company offers an earnings yield of almost 30%. In other words, if its revenue and earnings remain the same, then for every $1 you spend to buy shares of this company, you get a return of 30 cents. This is a ludicrous amount and cannot be sustained.

One of two things is likely here: The company's business will decline or the company will get acquired. Let's say you have $650 million to spend. You can either get 5% return in Treasury bills, or you can make 30% a year by buying Pioneer. OK, so that 30% is going to go down, but it doesn't matter -- you can get 10% on your money and you're still doing fine, particularly given the company's strong competitive position and clean balance sheet.

Pioneer is a holding of Keeley Asset Management, run by well-known small-cap investor John Keeley. Other stocks held by Keeley include Terex(TEX Quote) and McDermott(MDR Quote).

To see the entire list of potential acquisition targets, including Aaron Rents(RNT Quote) and Netflix(NFLX Quote), check out the Takeover Targets portfolio on Stockpickr.com.