It’s been a busy few months in the stock market, with bids emerging for Morrisons and others mooted for companies such as easyJet and Stagecoach. A takeover bid can be profitable in the short-term for holders of UK shares. But longer-term holders can suffer by being forced to sell their shares below their purchase price rather than waiting for a possible share price recovery.
For example, if I had bought Morrisons shares in May, before the bids emerged, I would be sitting on a 63% share price increase to date. But if I had been holding the shares since December 2011, even after the takeover news, my holding would show a 7% decline in share price.
It can be helpful to assess which UK shares could become takeover targets. Here’s how I do that.
Considering a company’s financial and strategic valuation
There are two sorts of logic for most takeovers.
The first is that a company’s market price falls below its possible financial valuation. That could be based on the business as it is run today. It might also reflect the prospect of a new owner changing its cost structure. So, for example, private equity bidders for Morrisons likely reckon that they could make cost savings at the company.
A second type of logic is on display in a strategic takeover. A strategic takeover is a combination within an industry or market which adds size to an existing player. That can improve its bargaining position or pricing power, or achieve economies of scale. The Wizz approach to easyJet and National Express bid for Stagecoach are examples among UK shares. In such bids, the target company doesn’t need to be obviously undervalued, as the bidder perceives the opportunity to unlock value from strategic synergies.
Spotting UK shares that could be takeover targets
Based on that, I think it can be fairly simple to identify UK shares that are possible takeover targets. What is much harder is knowing the timing of any such possible bid. I think Morrisons looked attractively valued for many years – but no bid emerged until this year. Tying my money up in underperforming shares for many years in the hope of a takeover approach has an opportunity cost.
Despite that, I still think it’s worthwhile looking for possible takeover targets. An undervalued company could offer a good investment opportunity for me regardless of any takeover. Sometimes due to market conditions or a poor trading statement, a company’s shares will fall dramatically. That means that sometimes, quality shares are available at an attractive price. Over time hopefully the stock market will rebalance the company’s share price with its fundamental value.
Why I focus on business quality
But there are risks in such an approach. Consider Centrica as an example of such risks. Its persistently cheap looking valuation could suggest a fundamental undervaluation. That might attract a takeover approach. But a low share price could signal investor worries of falling future customer demand. Centrica’s share price may reflect worries domestic gas supply will plummet as environmental regulations bite.
A share that looks undervalued sometimes just keeps falling. So, while I hunt for value, as an investor I also look for long-term business prospects. I wouldn’t buy UK shares for my portfolio just because I think they could become takeover targets.
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Christopher Ruane owns shares in Centrica and Stagecoach. The Motley Fool UK has recommended Morrisons and Wizz Air Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.