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Stocks for the Next M&A Wave

Among the many discussions around Chez Melvin the past week, in addition to the baseball races, earnings reports and the probability and outcomes of quantitative easing, has been the possibility of a takeover wave developing in the second half of the year.

One would have expected more merger-and-acquisition activity in the past two years, given the lack of growth opportunities and low interest rates. It has never developed, in spite of enormous amounts of cash on corporate balance sheets. Sectors such as banking, energy and real estate that normally would have seen substantial consolidation as asset prices declined have been relatively quiet.

Some say that this will change in the second half of the year. As we are seeing this earnings season, it is getting tougher to generate substantial sales growth, and cost-cutting the way to profits is getting more and more difficult. Buying revenue and profits makes sense only if you have cash and an attractively priced stock to use as currency. The low borrowing costs should make many companies attractive to financial buyers such as private-equity firms, many of whom are awash in cash right now.

Others, including myself, believe that the lack of clarity regarding regulations, taxes and the election will keep a lid on activity on takeover activity. Until you know the rules and costs, it makes no sense for strategic or financial buyers to get heavily involved in M&A.

There is always a chance, if not a probability, that my view of the situation is wrong. With that in mind, I thought it might be instructive to look at companies that qualify as takeover candidates, according to the various metrics used by potential buyers.

Buyers are looking for companies which are not overly levered and which produce cash to drive earnings. The simplest screen to run is to look for companies that trade at low price-to-free-cash-flow multiples and have reasonable debt levels.

The first observation from running the screen this morning is that there simply are not a lot of qualifying companies. My initial screen returned just 115 potential takeover targets on the basis of free cash flow and debt levels. If I throw out the financial sector, very few companies that produce goods and services would qualify as financially attractive takeover candidates.

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