Recent deals suggest more M&A is on the way – but focus on company quality first.
A recurring frustration this year has been a lack of corporate risk taking and deal doing. Boards, it seems, have been happier for companies to give more earnings back to shareholders as dividends or launch share buybacks. Could that be about to change?
Two announced mergers this week give cause for hope. Fund manager Henderson Group is merging with Janus Capital Group to form a US$6 billion wealth-management giant. And Japan’s Hitachi Construction made a $689 million bid for Bradken.
The Bradken bid is not surprising. The mining services group has been a perennial takeover target but a 34 per cent premium to the Bradken share price shows there is still good money to be made in picking takeovers.  More mining services takeovers seem likely.
Last week’s takeover $1 billion bid for SAI Global from Baring Private Equity Asian also came at a decent premium to the share price. But the bid gets SAI, which underperformed last year, back to prices it traded at two years ago. 
Investment bankers, of course, say this could be the start of a spike in deal flow before Christmas. Judging by the latest profit season, the market’s largest 100 companies have muted organic growth prospects. Growth by acquisition, at the right price, makes sense.
Strong corporate balance sheets and the low cost of debt build a case for greater M&A. As does reasonable equity market valuations and improving business confidence. 
Nevertheless, I am always wary of buying stocks based on their takeover prospects. Those who bought Bradken recently will be chuffed with recent gain. But long-term shareholders have watched Bradken fall from almost $15 in November 2008 to $2.43. 
Spotting potential takeover targets is hard enough. Getting the timing right so that portfolios are not loaded up with underperforming companies is the real battle. Stocks can be touted as takeover targets for years before a bid finally arrives. 
The best takeover targets are attractive investments with or without takeover. Investors must  feel confident that the company is trading below its intrinsic or fair value and be happy to hold it regardless of takeover. Buying on the basis of takeover alone is risky. 
Here are three stocks that have takeover appeal and are solid investments at the current price, regardless of M&A activity. Each suits investors comfortable with mid- and small-cap stocks.
1. CYBG Plc 
The National Australia Bank spin-off got off to a great start after its demerger in February 2016. CYBG’s CHESS Depositary Interests (CDI) rallied from $3.69 to $5.86, before easing to $4.55. 
Britain’s surprise decision in June to leave the European Union (Brexit) and CYBG’s move to temper the market’s growth expectations led to a mid-year slump in its shares. 
CYBG has rallied from those lows and the former problem child of NAB still looks a good acquisition for a larger European bank that wants a foothold in the United Kingdom banking sector. A lot of the expected operational turnaround appears to be priced into CYBG, but there’s scope for a predator to swoop and find further efficiency gains. 
Chart 1: CYBGSource: The Bull
2. Asaleo Care
The maker of personal-care and tissues products rallied to $2.33 from a $1.65 issue price after its $655 million June 2014 float. But a disappointing earnings guidance downgrade in July 2016 dragged Asaleo back to $1.50. 
Increased competition in its markets and higher pulp prices due to the weaker Australian dollar damaged its Fy16 result, which had been earlier flagged to the market. 
For all its problems, Asaleo has strong strategic value as the number one or two player in the personal-care and hygiene markets in Australia and New Zealand. Its well-known brands include Libra in female hygiene, Sorbent in tissues, and Handee in paper towels.
Asaleo would benefit from greater scale as part of a larger global consumer-products group, to offset declining pricing power in its main product categories. 
Sweden’s SCA Group Holding, a 34 per cent shareholder, is a potential suiter. With Asaleo back near its issue price, it might be time for SCA or a large consumer goods company to pounce on the slightly undervalued company. 
Chart 2: Asaleo CareSource: The Bull
3. Kathmandu Holdings 
The outdoor leisurewear group has had a volatile few years. Disappointing earnings guidance, management changes and a view that Kathmandu needs to improve its store layouts and product inventory crunched the share price in 2014 and early 2015. 
Kathmandu reported FY16 after-tax net profit of $33.5 million, up 64 per cent over the previous period. Higher profit margins and a reduction in store inventory helped it deliver better-than-expected cash generation and overcome sluggish top-line sales growth. 
New Zealand retailer Briscoe Group retains a 19.9 per cent stake in Kathmandu and made an takeover bid in in 2015. Briscoe eventually walked away from the bid, but it or other predators will surely keep a close watch on Kathmandu as its recovery unfolds. 
Chart 3: Kathmandu HoldingsSource: The Bull

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Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness and accuracy of the information, with regard to your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at Oct 5, 2016.