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12.2. Investor Behaviour

In an ideal world, predator firms prefer to take advantage of low share prices in a depressed bear market to acquire businesses on the cheap that are ripe for takeover. This may be good news for existing shareholders and potential investors, if share price rises when a company is targeted.

However, irrespective of the state of the market (bear, bull or stable) individual investors must tread carefully. If a company is an obvious takeover target, any likely bid may already be reflected in its share price. If the bid fails, the price may fall. Companies can also be "virtual bid" targets where predators express an interest but never make a formal offer, a practice that has increased significantly over the past decade.

So, how do we identify a potential takeover target?

Companies grow organically, or through acquisition. Once they have reached saturation point in terms of their products or services but remain profitable and cash rich, they may need to diversify to maintain growth. Conversely, once a company has gone as far as it can without further investment, it may become a target.

In general terms, one of the best "buy" strategies for investors is to ride on the back of predator firms, particularly venture capitalists who seek out companies with valuable assets (including cash) whose share price is low. These can always be sold off, if the takeover goes wrong.

One method of spotting a potential target is to calculate the current net asset value per share (NAV) based on the asset backing (cover) and valuation ratios, which we discussed in Chapter Eleven. This measures the assets owned by the target company, less its liabilities. If the NAV per share is higher than the current share price (i.e. the ratio is greater than one) then asset strippers may be ready to pounce.

It is also worth tracking erratic share price movements, changes in shareholdings and executive management. If a company or consortium increases their stake, or acquires a seat on the board, it may signal a potential takeover.

Of course, you also need to consider when to sell shares. It may be necessary to get out quickly, particularly if the price is peaking. One profitable strategy may be to sell soon after a bid. However, you should always analyse any factors that could push the price further, such as the predator's intention to turn the business around, or a bidding war.

Overall, trying to spot a takeover and buying in is high risk. So, it is only advisable for the most active private investor who is not prepared to hold speculative shares for too long because:

- Very few takeovers go through, even if a bid is made.

- If there is a merger, the share price often takes time to recuperate.

- As mentioned earlier, history is also littered with takeovers that have failed to produce long term gains.

12.3. The "Golden Rules" of Investment

Activity 1

Whether investors wish to acquire a small number of shares for inclusion in their market portfolio, or the entire market capitalisation of equity to gain control of the company, a number of "golden rules" outlined in Chapter Five should underpin their decision.

Can you summarise them?

- The P/E ratio (earnings yield reciprocal) shows how a company's value is rated by the market in relation to the profit it earns. The higher the P/E, the greater the confidence that profits should rise. The lower the P/E, the greater the concern that profits are unsustainable.

- Alternatively, a low P/E ratio could reflect that a company's shares are undervalued by the market relative to its profit performance and be attractive to speculative investors.

- Shares in companies expected to produce rapid growth in profits and hence capital gains may offer low dividend yields. Higher dividend yields are usually offered by relatively mature, stable businesses with little prospects of increasing profits and dividend.

- Conversely, part of stock market law is "the higher the yield, the higher the risk". This applies particularly to shares where a higher dividend yield usually signals greater uncertainty over whether the dividend can be maintained in future, particularly if dividend cover is low.

As a general rule, if any investment offers a higher dividend yield or earnings yield (a low P/E ratio) with lower cover than similar investments, it is advisable to be cautious.

According to the legendary UK investor Jim Slater (who you also encountered in Chapter Five) it also pays to specialize in growth shares for long-term reward. In his text Beyond the Zulu Principle published in 1996 and still in print, the following investment criteria are specified.

(I) Mandatory criteria

a) A prospective P/E ratio no larger than 20 (an earnings yield of 5 percent).

b) For large investments, a prospective P/E ratio that is less than a company's future EPS growth. For smaller investments, a maximum P/E ratio that is 75 percent of growth rate.

c) Avoid speculative shares, namely those with the highest P/E growth factor (PEG), calculated by dividing the prospective P/E ratio by the estimated future growth rate in earnings per share (EPS). These are the ones to sell to improve the average safety margin of an investment portfolio.

d) Strong cash flow in terms of cash per share in excess of EPS for the last reported year and the average of the previous five years.

e) Low gearing (the proportion of debt in the firm's financial structure) preferably below 50 percent or, better still, positive cash balances.

f) High strength relative to the market in the previous twelve months coupled with strength in the preceding month or three months. Avoid shares that are flagging.

g) A strong competitive advantage.

h) No active selling of a company's shares by its directors.

(II) Highly desirable criteria

a) Accelerating EPS preferably linked to a company's ability to replicate its successful activities.

b) A number of directors buying shares.

c) A market capitalisation in excess of £30 million.

(III) Bonus criteria

a) A low price-to-sales ratio (PSR).

b) Something innovative.

c) A low price-to-research ratio (PRR).

d) A reasonable asset position (cover)

According to Slater:

"These criteria may be looked on as an investor's quiver full of arrows. They need not all be fired and some may miss their targets, but you do need to score a substantial number of bull's-eyes."

They may also be refined and extended by experience and new ideas.

Applied to takeover activity, the lesson to be learned from Slater's approach to investment confirms our earlier point. The likely rewards from an acquisition are determined by the analysis which precedes it. A company that selects another for the purpose of long-term growth by utilizing a rigorous disciplined approach with in-built safety margins, such as asset backing, supported by strong financial criteria has little to fear. If the composite entity continues to grow profitably, patient investment will eventually be rewarded by an efficient stock market, which reflects its progress.

Conversely, our earlier discussion of the motives for acquisition drew attention to the dangers associated with company takeovers for short-term gain, merely because the target's shares were priced low by the stock market. Even though the predator may be purchasing at less than book value (negative goodwill) the acquisition may be worth more "dead than alive" since the realizable assets are worth less than this figure.

You will also recall that subjective reasons for takeovers, based on managerial growth, prestige and security, may be supported by an elaborate rationale without an objective analysis of the commercial factors involved. However, like any other investment:

An acquisition strategy is the art of the specific, where preparation meets opportunity. In the absence of luck, let alone judgment, the likely consequence of takeovers motivated by factors which exclude the growth of shareholders' earnings from the equation is that equity prices may collapse after the acquisition.

 
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