It’s official: Mergers & acquisitions are back.

There was a malaise during the pandemic as corporate buyers hunkered down and went into cash preservation mode. But takeover activity rebounded in a big way in 2021, with global dealmaking volume reaching a record high of $5.1 trillion.

There were 358 deals in the telecom sector alone last year. Media companies were involved in 2,038. And the tech space saw 5,958. Combined, that’s 8,354 transactions in these fields, an increase of nearly 50%. Other groups such as healthcare and real estate have been busy as well.

Activity is expected to remain brisk in 2022, fueled by buoyant corporate earnings, historically low costs of capital, and rising cash stockpiles. Private equity groups and special purpose acquisition companies (SPACs) continue to have a hungry appetite. Strong equity valuations (shares are typically used as currency to close deals) have also played a role.

Whatever the reason, a recent survey from accounting firm KPMG found that two-thirds of business executives expect 2022 takeover activity to surpass what we saw in 2021. And as we know, whenever a large fish swallows a smaller one, shareholders in the target company often walk away with quick gains of 30%, 40%, or more.

4 Signs Of A Potential Takeover

This begs an interesting question… What would happen if we could “reverse engineer” the process to pinpoint a target before they were taken out by a larger acquirer?

I’ve examined countless takeovers in recent years looking for commonalities. I’ve also been in on more than my fair share of these deals over the years. And while there is no such thing as a crystal ball in the investment world, I have noticed a few things. Just as meteorologists are trained to spot wind shear and other telltale signs of an imminent tornado, there is a specific set of conditions that often precede a takeover announcement.

Without getting bogged down in the details, I can tell you that these four criteria have the most predictive power.

1. Visible Growth Prospects
It takes growth to placate investors. Companies that don’t deliver often see their shares languish. Unfortunately, finding new growth avenues isn’t always easy, particularly for mature businesses.

Acquisitions can be the surest growth catalyst – and there are a lot of larger, older companies out there in need of propulsion.

2. Achievable Synergies
You won’t ever see a merger press release where the word “synergy” isn’t mentioned at least once, if not multiple times. In fact, synergy is what justifies the sometimes exorbitant price tag to make these deals happen. That’s how they sell it to voting shareholders.

When two businesses get married, they no longer need two separate marketing departments and two separate headquarters buildings. Combining into one organization provides an opportunity to eliminate or downsize overlapping administrative functions, sell off redundant assets and take other steps to streamline expenses.

Those cost savings are called synergies. And the bigger the scale, the more they add up. In most cases, the two companies joining will become more profitable together than they were apart. It’s a classic case of 2 + 2 = 5.

Mergers can bring about other benefits, such as supply chain efficiencies or debt refinancing. All can help expand margins and allow the combined organization to squeeze more profit from every dollar of sales. But the most impactful mergers can do more than just cut expenses. They can boost sales as well, delivering both top and bottom-line synergies.

When an innovative company with great ideas joins forces with a more established player with global distribution capabilities, it can be a beautiful thing. Just remember, the greater the potential synergies, the more accretive a takeover can be to cash flows – and thus the more attractive to acquirers.

3. Enhanced Pricing Power
Every business wants to increase product prices and boost their profit margins. But it’s a calculated trade-off. Doing so can scare away customers, shrinking market share, and biting into volume. The grocery business, for example, is known for being cut-throat. Kroger has a net operating margin of just 1.8% — pocketing less than two pennies for every dollar of sales. By contrast, there is Microsoft, which boasts an operating margin of 40%, or 40 cents per dollar of revenue.

Of course, these are two starkly different industries, so we’re comparing apples to oranges. But it’s much easier for Microsoft to raise prices for its software and services without suffering a sharp dent in demand. Economists refer to such sensitivity as elasticity. That begs the question: why do some businesses have more pricing power than others? Well, brand name recognition is often a factor, particularly when it’s associated with quality. There’s a reason why shoppers are willing to pay more for Dr. Pepper… or John Deere lawnmowers.

But pricing power is also a function of the competitive intensity of the industry. Monopolies can charge whatever they want. Gas stations not so much. This is an important concept for us. By its nature, buyouts lead to industry consolidation, concentrating market share into a smaller number of dominant players – who then can wield more pricing power.

4. Eliminating Competition
If you’re a Star Trek fan, then you might be familiar with the Borg, a fearsome race of cybernetic creatures that take over entire races. With every assimilation, the Borg not only remove a potential enemy, but they also absorb the unique strengths and assets of that conquered race – making it their own. Over time, they become increasingly formidable. As they say, resistance is futile. The business world is no different.

Microsoft didn’t reach $140 billion in annual sales all on its own. PowerPoint, for instance, came from the purchase of a company called Forethought back in the 1980s. Over the years, it has gobbled up more than 200 smaller competitors, absorbing their assets (and their customers). More recently, it has hunted down Nuance for $20 billion and ZeniMax for $7.6 billion.

You could say the same thing about other tech juggernauts such as Apple, and Google parent Alphabet.

Of course, there are regulatory bodies and antitrust frameworks in place to make sure that mergers don’t completely quash competition within a given space. But it always pays to be on the lookout for situations where deep-pocketed companies can turn dangerous potential enemies into valuable allies.

Closing Thoughts

This market is dominated by headlines of war, inflation, the pandemic, and soaring government debt levels…

But in this uncertain market, I can tell you one thing that is certain: Larger companies are on the hunt for smaller targets. Flush with cash and eager to make a deal to fuel growth, I expect a wave of deals to happen in the coming months.

Even the whisper of a “mega-merger” can hand investors enormous returns. And over at Takeover Trader, I’ve just pinpointed a potential takeover deal that could dwarf them all.

Want to get in on my next big trade? Click here for details.