How to pick a company ripe for takeover
Targets are often market leaders with established businesses and substantial sales
If you’ve ever been to a British seaside town, the chances are that you’ve succumbed to the “penny falls”. The idea is to send coins down metal chutes on to money-laden shelves that rhythmically move back and forth.
The skill lies in directing your coin towards the most precarious piles in the hope of nudging them over the precipice and collecting a bonanza.
I suspect many investors are now playing a similar game with UK smaller company stocks — hunting down those ripe for takeover in the hope of a share price boost after they are snapped up.
According to Charles Hall at broker Peel Hunt, 45 UK companies with a market cap of more than £100mn were acquired last year, and a further 33 have been acquired already this year.
We have seen three deals recently in funds I run. Pawnbroker H&T accepted a cash offer from US peer FirstCash. Industrial chain-maker Renold and high-tech instrument manufacturer Spectris have reached agreements with private equity houses.
The deals were at a premium to the pre-announcement share prices of between 40 and 96 per cent. So these takeovers can be lucrative and trying to target the next one may seem like a smart strategy. But can it work?
You might try a couple of approaches. The first is buying on rumours — but be warned, you may end up paying a “bid premium” for deals that don’t happen. Indeed, most of this year’s announced takeover bids appear to have surprised the market.
This may be because bids are being made public earlier, giving little time for leaks and chatter. Companies receiving bids may have a vested interest in going public quickly to flush out other potential buyers. Compliance requirements also tend to encourage earlier announcements.
This can mean more prospective deals failing to complete. If you own a company engaged in takeover talks it may be sensible to sell at least part of your holding if prices have risen sharply on the news in case the bid stumbles.
A more reliable tactic might be to focus on companies with the characteristics of a good takeover target. So what might they be?
First, think scale and scope for expansion. Often, targets are businesses with substantial sales and leading positions in their market. Buying an established business and either managing it better or using it as a base from which to expand beats investing the time and cost of building something from scratch.
Take Dowlais, a global autos supplier, which this year agreed a merger at a modest premium with US peer, American Axle. Dowlais was among the world leaders in producing sideshafts for car manufacturers such as Stellantis.
A metric we use to identify this kind of business is enterprise value compared with a company’s sales. In the case of Dowlais, in 2024 it generated over £4bn of sales, but its market cap at the end of the year was less than £1bn.
Even including just over £1bn of debt, you could buy the shares on an EV/sales of approximately 0.4 times. American Axle was drawn in by the scale that Dowlais could bring in an industry where the end customer — car manufacturers — are notoriously tough negotiators.
The next tactic is to follow the cash. Private equity has been a big buyer of UK smaller companies. Often the purchase is made using debt. So companies with modest levels of debt and lots of assets that would be expensive to replace make obvious contenders. Of course, these businesses should be very profitable and have strong cash flows, because the private equity buyers will need that income to repay the debt they take on for the purchase.
It almost goes without saying that the companies should be undervalued. In my view, that’s still a large part of the UK market, but there are some areas that look particularly inexpensive. Many of the businesses we’ve owned that have later been captured by private equity buyers are high-margin people companies, such as corporate adviser K3 Capital or specialist consultant Alpha FMC. The public markets seemed to put much lower valuations on these businesses’ impressive margins and scope for future growth than private equity did.
Finally, look for under-appreciated divisions — sometimes a takeover may not be of a whole business. In May, Johnson Matthey sold its catalyst technologies division to US firm Honeywell. This generated roughly 20 per cent of the business’s earnings, but at the time the £1.8bn sale price represented roughly 80 per cent of Johnson Matthey’s market capitalisation. The result was an immediate 29 per cent surge in the share price. Companies with such unlocked value look very tempting.
With all that said, I have mixed views on the takeover trend. It’s difficult not to feel uneasy as the initial sugar rush subsides following an announcement. The bid prices often don’t reflect the medium-term prospects of these companies. You need to find equally good replacements afterwards — and, though this has been doable so far, it could change if this level of takeover activity persists.
As for trying to guess the timing of the next takeover, in my experience that’s a mug’s game — just like the penny falls arcade machines. Those piles of coins can hang teasingly for a very long time.
A company ripe for a takeover is usually one worth owning yourself. So try thinking of businesses you would like to take over. Ultimately, this approach is more likely to enrich you over the long term — regardless of whether those companies are bought or remain listed.