With the share markets trading on a one year forward multiple of around 11 times – its lowest level since mid-2010 – and earnings growth looking flat within many sectors, the climate for heightened M&A activity over the next 12 months is likely to gather momentum.

A strong Australian dollar, and access to cheap debt funding having improved, domestic stocks are also expected to be eyeballing acquisitions offshore.

Even despite the high Aussie dollar, current valuations are expected to remain compelling enough to continue attracting offshore acquirers. If global brewer SABMiller’s $9.5 billion bid for Foster’s Group is any indicator, currency is not a show-stopper when it comes to big-end global players doing deals locally.

Investors with shares in companies targeted for takeover may find themselves sitting on handsome unrealised capital gains. According to Goldman Sachs research, once a takeover announcement is made, shares in the target firm rally between 10 to 20 percent within the first three months.

As a case in point, the share price of the world's second-largest winemaker, Treasury Wine Estates (TWE) surged by 10 percent following a report that China-based Bright Food Group was considering a bid, equivalent to 9.1 times to 10.7 times the 2012 financial year EBIT. Back in April shares in Woodside Petroleum (WPL) also jumped by around 10 percent following rumours that BHP Billiton (BHP) was preparing to make a $46 billion bid for it.

There are potential takeover targets to be found across all sectors, the latest being Echo Entertainment Group (EGP) which only listed on the Australian bourse in early June. Comprising the former casino assets of Tabcorp – including Sydney's Star City casino and three casinos in Queensland - Echo is regarded as a potential takeover target for James Packer’s Crown Ltd (CWN) which currently has a 4.9 percent stake. Echo's biggest shareholder, Perpetual Investments - which owns seven percent - expects any takeover to follow a $960 million renovation at Star City. Meantime, having spun off its casino assets to Echo, Tabcorp (TAH) is now seen as ripe for a merger with rival Tatts Group (TTS).  

Industrial Stocks

Given the amount of macroeconomic uncertainty and weaker market conditions, M&A deals are probably least likely to be found in the industrials sector. But Goldman's has done some modelling and thinks that the industrial stocks most likely to become takeover targets are the following: Leighton holdings (LEI), Downer EDI (DOW), Perpetual (PPT), Myer (MYR), and Treasury Wine Estates (TWE), and small-caps industrials including Elders (ELD), Nufarm (NUF) and Ten Network (TEN). This modelling takes into consideration current valuations and internal rates of return (IRR).

Miners

On the mining front, large companies offering the highest IRR include: Aquarius Platinum (AQP), Iluka Resources (ILU), BlueScope Steel (BSL), Macarthur Coal (MCC), and PanAust (PNA), while small-cap miners with the highest IRRs include Kingsgate Consolidated (KCN), Mount Gibson (MGX), and Kagara (KZL).

According to Peter O’Connor resources analyst with Merrill Lynch, mid-tier and third-tier miners with strategically important assets - particularly those whose share prices have recently declined alongside  commodity prices – are likely to attract big-end mining stocks that have exceptionally deep pockets.

He suspects Atlas Iron (AGO), Extract Resources (EXT), and especially Paladin Energy (PDN) – which has shed 50 per cent of its share price since March - will be attractive to local suitors, as well as China and India-based bidders wanting to get a foot-hold on future supply.

James Wilson senior resources analyst with RBS Morgans believes M&A activity in 2011 will centre around iron ore, copper and gold. “The domino effect of big fish being eaten by even bigger rivals means the M&A deals are likely to increase on both frequency and magnitude,” says Wilson.

Gold stocks

Wilson notes that the premium applied to gold explorers has come off by around 20-25 per cent; the gold  sector now is back into buying territory. Two stand out stocks that are trading at 50 per cent discounts to their former highs, are Ampella Mining (AMX) and Gryphon Minerals (GRY). Adding to the attraction for acquirers is the fact that both stocks are 18-24 months away from production.

Wilson also thinks that Regis Resources (RRL) a serious takeover target by big players, due to its recent confirmation that the company has 1.57 million ounces of gold at its Garden Well project  Similarly, Wilson believes that Alacer Gold’s (AQG) production profile make it attractive to big-end miners.

Junior Iron Ore Stocks

There are thin-pickings left in the WA-based junior iron ore space, says Wilson. The remaining standout target stocks include Brockman Resources (BRM), Iron Ore Holdings (IOH) and Atlas Iron (AGO). “The likes of BHP or FMG may regard the real estate, infrastructure, and port capacity of these stocks as attractive ‘bolt-ons’ to their existing operations,” he says.

Copper Stocks

In the copper space, the closer Sandfire Resources (SFR) gets to production at its various projects, the more interest Wilson expects Oz Minerals - which currently owns 19 percent – to take in the stock. He also expects the profitable diversified metal mines of Independence Group (IGO) to be similarly attractive to large-cap acquirers.

Mining Services

Acquirers are less interested in paying goodwill for labour-intensive mining services stocks where people can and are poached within the current hot labour market. There can be management blocking stakes that make taking over these companies difficult. However, Tamara Stretch analyst with RBS Morgans says companies with unique hard assets in high demand – like Toxfree Solutions (TOX), Mermaid Marine (MRM) and Imdex (IMD) - are most likely to be takeover targets in WA.

REITs

Based on substantial discounts to underlying net tangible asset base (NTA), plus a myriad of attractive metrics - including stable/secure yields, more contentious management, and better constructed balance sheets - David Curtis director with Reliance Investment management says many REITs now look like prime contenders for takeover. Charter Hall Office (CQO) is now regarded as the next REIT destined for privatisation following the 20 per cent stake taken by three US hedge funds that are now calling for the current manager to be dumped.

Thematics are currently against residential assets, but Curtis says FKP Property Group’s (FKP) 43 percent discount to NTA could still make it attractive to existing shareholder Stockland (SGP) which has first rights to its retirement assets. Given that it typically trades at a premium to its NTA, Curtis says Stockland - currently discounted by around eight percent - could also make for a potential takeover target.

He says the current pricing mismatch between GPT Group (GPT) - currently discounted by 13.3 percent to NTA - and the unlisted GPT wholesale fund also presents a buying opportunity.

Other potential takeover targets identified by Curtis further across the REITs sector include: Aspen Group (APZ), Challenger Diversified Property group (CDI), and one-asset REIT Carindale Property Trust (CDP) which are currently trading at 34, 20 and 23 percent discount to NTA respectively.

Curtis also questions how long high quality stable REITs like CFS Retail Property Trust (CFX) and Commonwealth Property Office Fund (CPA) can continue trading at discounts of 14 and 11 percent respectively before they too are either taken out or consolidated by current owners. “I suspect there is sufficient M&A activity in store to provide a much needed re-rating to the sector at large,” says Curtis.

Timing Your Buy Into Takeover Targets

When it comes to capitalising on M&A activity, rumours clearly are the lifeblood of share markets, and the smart money typically moves ahead of the announcement. There’s no better example of this than the market leak late last year over Rio Tinto’s (RIO) interests in acquiring Riversdale (RIV). By the time Rio’s interests were officially announced a few weeks later the stock was trading at a discount, meaning that only those who ‘bought the rumour’ made the profit.

So how can investors capitalise on share price gains surrounding M&A rumours? If you already own the stock, Colin Campbell private client adviser with Wilson HTM suggests locking-in the profit following a share price movement and retaining a core holding. “If it’s a highly sought after asset, you might want to sell a third to half, and hang into the rest or if it’s highly conditional - sell up to two thirds of your holding,” says Campbell.

For investors who don’t already own the stock, Campbell recommends firstly A) determining how far the price has run up prior to the announcement, and B) how much the price could drop away once a bid falls over. He says this will help to determine how much pressure the stock will come under after the event.

One way to capture a return without the capital investment of actually buying the stock, says Campbell is to buy call options. One way to do this, adds Campbell is to sell long-term puts on potential targets to fund short-term calls – while also generating additional upfront income. “The question is - does the risk/reward, construction, and constant monitoring warrant taking these positions,” says Campbell. “Similarly, would you still be happy owing the underlying stock if you got likelihood of M&A activity wrong?”

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