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This article appeared in the June 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

How to profit from the recent rise in mergers and acquisitions activity.

Photo of Geoff Wilson By Geoff Wilson, Wilson Asset Management

Australia is experiencing an increase in mergers and acquisitions (M&A) activity and several high-profile takeovers have been announced, including bids for Goodman Fielder, David Jones, Australand and SAI Global. This follows a surge in company floats in the later part of last year and we believe the increasing M&A trend will continue.

Our prediction is contingent on three important factors that are critical for creating an environment conducive to takeover activity. They are:

  1. Low interest rates
  2. Reasonable economic growth
  3. Strong confidence levels.

1. Low interest rates

Australia has had historically low interest rates for more than nine months. To illustrate the importance of this, assume an interest rate of 7 per cent. The after-tax cost of borrowing money (70 per cent of 7 per cent; the corporate tax rate is 30 per cent) is 4.9 per cent.

Therefore, if a company can borrow money at 7 per cent pre-tax or 4.9 per cent after-tax, then any takeover target that has an earnings yield above 4.9 per cent, delivers a positive earnings per share (EPS) outcome.

To turn an earnings yield into a price-to-earnings (PE) multiple, invert the earnings yield. Therefore, a 4.9 per cent earnings yield (4.9/100) becomes 100/4.9, which equates to a PE of 20.4 times.

So any target company that can be taken over on a PE of less than 20.4 times is EPS positive (that is, the takeover quickly increases the company's earnings). With the Australian sharemarket trading on an average PE of around 14.5 times and if a company can borrow at 7 per cent or less, the interest rate environment starts to become conducive for strong M&A activity.

2. Reasonable economic growth

The next two factors, reasonable economic growth and strong confidence, are highly interlinked. Company boards that make a decision to take over another company must be confident of the health of the economy. Over the past year, Australia's economy has been sluggish and the absence of any reasonable economic growth or forecast growth has been a stumbling block to M&A activity.

3. Strong confidence levels

Business confidence is the greatest variable in this M&A equation and, as I've mentioned, very dependent on the state of the economy. When considering takeovers, boards have not been confident of increasing their debt levels to finance acquisitions. After last year's Federal election, we saw some improvement in confidence levels. However, given the uncertainty created by the Federal Budget and even with record low interest rates, confidence levels have slumped.

How to make money from the M&A trend

A rise in M&A activity is a positive for investors over the short term and a negative over the longer term. This is because in the short term, the upside for a shareholder of the takeover target company is usually more than 25 per cent.

Over the long term, the evidence shows that acquisitions tend not to add value to the acquirer and, furthermore, the investor loses the opportunity to invest in the company that has been acquired.

Depending on your individual view, if an investor wants the opportunity to invest in as many companies as possible, then takeovers, in principle, are a negative for investors.

Takeover offers often lead to more offers

History shows that once a takeover bid for a company has been announced, there is a reasonable possibility that a higher offer or offers will come from the original bidder, or another company. Consider the bidding war for Warrnambool Cheese and Butter last year. Bega Cheese first made a cash and scrip offer, which at the time valued WCB at $5.78 a share.

This was followed by three offers by three different bidders, with WCB's board ultimately achieving an $8.40 a share all-cash offer from Canadian giant Saputo Inc. Based on the historical data, to play the takeover game investors might consider buying shares in a company after a takeover offer has been made, but this is a high-risk strategy.

Picking a target: common characteristics

Based on our experience, a number of characteristics are common among companies that become the target of corporate takeover activity. M&A candidates are often targets because the company is performing poorly.

However, buying shares in such a company is risky because the company may never receive a bid and, at best, you are left with a stake in an underperforming company or, at worst, the business fails and you lose your money.

When an industry is consolidating, this can also increase the possibility of takeovers. A pertinent example is the telco sector, which over the past couple of years has seen M2 Telecommunications buy Dodo, iiNet acquire various competitors including Internode, and TPG Limited's purchase of AAPT.

Similarly, when an industry is experiencing strong growth, companies are more likely to be subject to corporate actions. If an industry is deregulated, it is often a precursor to consolidation. Following the deregulation of Australia's single grain trading desk, AWB, ABB and Graincorp all received takeover offers from global competitors. If there is a known aggressor on a company's register, this can also signal a potential takeover.

Caveat emptor: risks of playing the takeover game

There are risks involved with trying to buy stocks purely because you think they might be the target of a takeover. If you buy shares in a company in anticipation of a takeover and no bid is forthcoming, the risk is that the share price drops significantly and the value of your investment falls.

It is also a high-risk strategy to buy shares in a company once a takeover offer has been announced, in the hope that a further, superior offer is made. There is a chance that no other offer is made or the takeover offer fails and the share price falls.

Wilson Asset Management looks to buy undervalued growth companies. We conduct in-depth research of companies and apply a rigorous rating process and, if the fundamentals of the business stack up, we consider investing. If an investee company is taken over and as shareholders we receive a takeover premium for our investment, we consider that an added benefit.

About the author

Geoff Wilson is the Chairman of Wilson Asset Management, a leading small-cap investor.

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