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How to Choose Possible M&A Targets Before the Deal

By Bernard Condon, AP

NEW YORK -- If stock investing is like playing the lottery, your odds of winning the jackpot just got a little better.

Companies are buying each other at the fastest pace since before the Great Recession. Investors lucky enough to own stock in a company being bought are pocketing big money.

So far this year, $219 billion worth of deals have been announced, more than double the level over the same time last year, according to Dealogic. The value of deals is also slightly above the same period in 2007. And that turned into a record year, with the value of deals reaching $1.6 trillion.

Those looking to profit on deals by picking companies before they're taken over should know it's not easy. But there are guidelines for choosing possible M&A targets. One is a reasonably valued stock, not so high that it's likely to scare off buyers.

Other signs are low debt and a history of generating lots of cash. Those are key for buyers who borrow heavily to finance deals, says Hottovy, the Morningstar analyst. Their debt can be repaid with the money coming out of target companies.

Among the picks in a Morningstar report co-authored by Hottovy last month:
  • Kohl's (KSS): The department store chain has strong cash flow and its stock trades at 10.7 times per share earnings in the previous 12 months, which Morningstar considers attractive. The average for S&P 500 companies is 17 times.
  • Chesapeake Energy (CHK): The second-biggest U.S. gas producer is a target of investors looking to get the share price up. Embattled CEO Aubrey McClendon was pushed out last month. The stock is down 12% in the past 12 months.
  • City National (CYN): Morningstar likes that the Los Angeles-based bank courts wealthy business owners as customers and has increased earnings per share by 63% in two years. The stock is up 17% in the past 12 months.
Conditions seem ripe for plenty more deals.

Borrowing money to buy has rarely been cheaper since interest rates are near record lows. And many companies can pay for M&A out of their own pocket. Companies in the Standard & Poor's 500 index have more than $1 trillion in cash on their books, up 66% in five years.

If the means are plenty, so are the motives.

Before the Great Recession, buyout firms raised hundreds of billions of dollars from investors. They promised to use the money to buy companies within a set time or return it. Some of those deadlines are fast approaching. As of September, buyout firms had $193 billion left to spend by the end of 2013, according to Triago, which helps raise money for the industry.

About a quarter of the money spent to buy U.S. companies this year has come from leveraged buyout firms. That is about the same as before the recession, according to Dealogic.
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