Earlier this week, the financial press was over the moon about a Citigroup equity research department report. The completely unironic title: "Addressing the Problem of Too Much Cash."
In the report, analysts Jim Suva and Asiya Merchant discuss the possibility that post-tax-reform Apple Inc. (Nasdaq: AAPL) brings home its $220 billion cash stockpile that is currently overseas and uses it for a takeover of other media or technology companies.
The two intrepid research analysts tell us, "the firm has too much cash - nearly $250 billion - growing at $50 billion a year. This is a good problem to have. Historically, Apple has avoided repatriating cash to the U.S. to avoid high taxation. As such, tax reform may allow Apple to put this cash to use. With over 90% of its cash sitting overseas, a one-time 10% repatriation tax would give Apple $220 billion for M&A or buybacks."
Oh, boy! Well, that is kind of the obvious answer, but this sounds like great news for shareholders. Right?
Let's hear some more bottled sunshine from Citi... before I blast a few ugly, jagged holes in its analysis and show you where the deals really are...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]
This Is Good... a Little Too Good
So, once the analysts tell us what Apple might do with its cash hoard, they then give us a list of takeover targets.
Naturally, they assess the probability that Apple would buy a particular company.
Here's the field:
At the top of the list is Netflix Inc. (Nasdaq: NFLX), sporting a "40% chance" of being snapped up by Apple.
They go on to opine that Walt Disney Co. (NYSE: DIS) has "a 25% chance" of being taken over by Apple, according to the report.
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Several other companies are listed with a "10% or less chance" of being acquired in an Apple spending binge in 2018.
The "probabilities" are fascinating.
Did our two intrepid analysts use some all-knowing database of historical data that determines "X%" of the time a company with "Y" characteristics and "Z" cash and equivalents on hand will buy "A" company with "B" particular traits?
Nope.
The Citi analysts "assessed and assigned the probabilities for each potential deal."
In polite terms, they guessed. Bluntly speaking, they made 'em up out of whole cloth.
Here's why that's significant for investors.
Like "Two-fer" Sales, Corporate Fortune-Telling Is Just Another Gimmick
This report represents the very pinnacle of "prediction as marketing tool."
They don't make commercials as good as this.
If Apple does buy Netflix, then our hero analysts can take credit for a successful prediction that would have made you a ton of money.
If the deal fails to materialize, they can just say, "Hey, we told you there was a less than 50% chance of a deal happening."
Deeper in the report, we see the pair has assigned a 5% probability to Apple buying Tesla Inc. (Nasdaq: TSLA).
If it goes down, they can boast they "correctly predicted there was a chance."
When it doesn't occur, they point out that they told us there was a low probability of a deal occurring.
See the trick? That's how prediction on Wall Street works.
If you're right, then you can turn on the marketing machine and collect tons of cash from folks who now think you are some sort of market-predicting savant, guaranteed to make them richer than they ever hoped to become.
If you are wrong... so what? So was everyone else... nothing to see here, move along. It's "marketing," not "investment advice."
So what if you got burned or lost money moving on their say-so?
I tend to have a lot of takeover activity in my portfolios every year.
In fact, a takeover is my favorite way to exit a position: unreasonably well paid!
When to sell is the hardest decision, and exiting via takeover relieves me of the responsibility of making the sale decision!
All I have to do is bank the cash.
So let me show you how I find these tempting morsels. Hint: I sure as hell don't rely on big bank analysts to do it.
How to "Find" a Likely Takeover Target
Here's the thing: I don't set out to find takeover targets.
I do what I usually do: look for good businesses that are available at unreasonably good prices that I can own for a long time.
But... the metrics I use to identify, value, and assess business and credit conditions just so happen to be the exact same metrics as strategic buyers looking to grab some growth, and financial buyers, like private equity firms, who are also looking to benefit from the growth in the business over time.
Even though the other two don't know it, of course, all of three of us are looking for the same thing.
The happy, lucrative result?
I end up with several takeovers a year in my portfolio... while analysts and lawyers I've never met do the really hard work.
I am not going to make a bunch of predictions about who might buy who in 2018 or assign some made-up probabilities to specific companies.
What I can do to help point you toward profits in 2018 is identify some segments of the market that appear very cheap based on the same metrics that buyout professionals and other companies are using to uncover potential bargains.
These companies may get bought out in 2018. They might just see their pricing improve as other investors realize they are cheap.
Either outcome ends up putting big money in my pocket as a shareholder, so I am comfortable with either outcome.
And if I'm wrong?
Well, the worst-case scenario is that you still own a rock solid company you pretty much never have to worry about. Oh, and you'll own it at an unreasonably good price.
Where to Find 2018's Most Promising Takeover Targets
Financial services remains my absolute favorite target area right now.
Community banks will continue to consolidate as regulatory and technology costs make it difficult to compete. They either have to grow to obtain needed scale or sell to a larger competitor.
Larger banks can't grow earnings organically, so they need to buy growth to keep shareholders happy.
It is a perfect storm of those who need to buy and those who want to sell. Those banks who choose not to sell will need to grow assets and earnings pretty quickly, and that is going to lead to higher share prices, so own banks in this sector, and you win either way.
Owning a collection of small banks with sound balance sheets purchased when the shares trade below book value is a consistently profitable endeavor, and that trend will continue through 2018.
We should see some consolidation among brokerage firms and investment managers as well. Many of them are trading at bargain prices based on their asset value.
As investors, particularly the large institutions who control trillions of dollars, have become more cost-conscious, fees have begun to shrink. That's not going to change in the foreseeable future.
Smaller firms will be looking for a larger partner to help absorb costs. Much like the small banks, smaller brokers and asset managers face a "grow or sell" choice... and either growing or selling means stock prices are higher tomorrow than they are today.
There are other places to look, too.
You need to be very selective and patient, but healthcare will continue to be an M&A hotbed in 2018.
Focusing on those healthcare and health services companies when they can be purchased at low multiples of cash flow or below their net asset value should continue to be a very profitable endeavor.
Healthcare is in a state of flux as the GOP continues to work on a viable alternative to Obamacare, and that's going to create the opportunity to buy good companies at great prices in 2018.
I don't pretend to have any idea what healthcare reform will look like by the time it's all said and done. But I do know that the population continues to age, and discoveries that extend and improve life are being made every day. Healthcare should continue to be a pretty good business.
Another thing I don't know and won't pretend to: I have no idea who will buy who this year. I can only focus on buying good business at unreasonably great prices based on cash flow and asset value.
It's a can't-fail strategy because, unlike prediction-as-marketing-exercises done by giant Wall Street banks, the approach is logical and fundamentally sound. And it can be unreasonably profitable, too.
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About the Author
Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.