Supply and Demand . . . and That’s It

This book is partly about how to know something others don’t—by processing information others find unfathomable and creating capital markets technology to do that. If information can’t be processed well by our brains one way, reframe it in another more useful way, like our P/E-to-E/P flip. Or cut it in half and look at it anew. Or ask: “What does it correlate to?”

The news is full of useful information, if you can use Question Two to connect the dots. Just be creative and ask, “I wonder if that could mean anything? Wouldn’t that be nuts?” One phenomenon that pops up occasionally is increased merger and acquisition activity. It’s normal for mergers and acquisitions to increase in an economic expansion. Firms with improved balance sheets awash with cash look to acquire additional valuable market share, parallel product lines, vertical integration, new core competencies, new product categories or just simply diversify. In one way, this is unremarkable and mundane.

But can it mean anything for the stock market? Conventionally, market lore says merger manias lead to poor stock market results. Partly that is because mergers happen after the economy has been improving for a while—and after that, at some time, comes another recession. So it’s easy to see why folks see merger manias leading to bad times. Look at the late-1990s mergers coinciding with the Tech IPO craze. After a wave of deals like the Time Warner takeover of AOL, we were rewarded with a severe bear market and recession.

It makes sense takeovers should backfire often. After all, sellers (knowing the business inside out) usually know more about what they sell than buyers (being outsiders) know about what they buy. So shouldn’t it be true buyers fare less well than sellers—arguing for lower prices later when reality sets in and the buyer and its shareholders realize they’ve been fleeced?

I made this point in my second book, The Wall Street Waltz. And I was wrong. Historically, there is some validity to the argument, but I put too much emphasis on some time periods and not enough on others. My conclusions were too dependent on takeovers of the 1920s and late 1960s. There was a lot of unintentional data-mining and confirmation bias in what I said then. Now I’d say I was wrong then, and the whole thing is very 50/50. It depends on the nature of the deals involved, and half are this way and half that way—and it varies with time.

Cash, Stock or Hybrid?

There was a crucial difference in how most of those 1990s mergers as well as the 1920s and late 1960s deals were structured compared to the post-2002 deals. The bulk of corporate mergers taking place in 2003, 2004, 2005 and 2006 were mostly transacted in cash, whereas those done in those three earlier periods were transacted mainly in stock. In the one, an acquirer pays earnest money for the shares of the acquiree; in the other, the acquirer simply issues newly created shares to fund the takeover. Question Two: Is there a difference between the two and their potential impact on the stock market? What can you see differently about this situation others don’t see? What can you fathom that is unfathomable to most?

When Company A buys Company B for cash, it exchanges the cash for Company B’s shares and then simply destroys those shares. After the deal, there are the same number of Company A’s shares as before the deal and no shares of Company B. Company A now has its earnings and Company B’s earnings, so Company A’s earnings per share rise. Very simple!

This assumes on an annual basis Company B is profitable and its earnings exceed the interest payments Company A must pay to borrow the money to buy Company B. But otherwise, the acquisition is immediately accretive to earnings—shares are destroyed and, all else being equal, the acquirer’s earnings per share rise immediately. The supply of equity outstanding in this case is reduced as the acquired company’s stock is destroyed. Let me say that again. Cash-based acquisitions reduce the supply of equity outstanding. If demand remains constant and supply shrinks, prices should rise. Cash-based acquisitions tend to be bullish.

Takeovers transacted wholly in stock are different. Afterward, usually the acquirer’s earnings per share fall because more shares are dumped on the market, diluting value. See it this way: Firm A is worth X. Firm B is worth Y. To acquire Firm B, Firm A must bid up B’s price. Perhaps Firm A bids Firm B up by 25% to 1.25Y. That extra 25% is paid for by increasing the supply of stock of Firm A—newly created, never-before-existing shares. Firm A issues enough new shares to cover all of the prior value of Firm B plus enough newly created shares to cover the 25% markup. So, there are more real share equivalents after the deal than before.

Now, if Firm B has a higher P/E than Firm A at 1.25Y, Firm A’s earnings per share fall when the deal is done. This is most of the deals in the 1920s, late 1960s and 1990s. It is the AOL-Time Warner deal. These increase supply of equity, are dilutive and make earnings per share fall.

There is a third type of deal—Firm A buys Firm B partly for cash and partly for newly created shares. Hybrids deals are common, having some of the qualities of both, but usually are more cash-like than a pure equity deal. Why? In these deals, usually the acquirer can’t borrow enough cash to take over all of Company B, so it borrows what it can and issues shares to make up the difference. Usually these are bigger deals.

Suppose Firm A is worth $10 billion and B is worth $20 billion. A buys B. The smaller A swallowing the bigger B may frighten lenders. Maybe lenders will lend Firm A only $14 billion to buy B—exactly why doesn’t matter for this example. Before the deal there were $30 billion of equities outstanding representing A and B together ($10+$20=$30). To buy Firm B, Firm A bids B up 20% to be worth $24 billion. It uses the $14 billion it borrowed and issues another $10 billion of its own newly created shares to total the $24 billion it needs. At the end of the deal, there are $20 billion of equities—down from $30 billion before the deal. The supply of equity shrank by $10 billion—not by as much as if it had financed the whole thing with debt—but the equity supply shrank nonetheless. Almost always, a stock and cash deal reduces the supply of equity and should be accretive to earnings—just not as much as pure cash deals.

These aren’t radically new ideas. Anyone who took accounting or perhaps Economics 101 in college (meaning lots of folks) should know the difference between accretive and dilutive. What’s more, you can easily monitor which firms are doing takeovers and which ones are dilutive or accretive. In our über-regulated business world, we get plenty of notice when a company launches a merger, acquisition, IPO, new stock issue, a global plot to steal oil—you name it. We know when the mergers are taking place, for how much and in what form.

Merger manias financed by newly created shares increase the supply of equity and are, all else being equal, a bearish factor. Merger manias transacted for cash destroy stock supply—reduced supply is a bullish factor. But few people see the difference.

What Really Makes Stock Prices Move

Before tackling what you can know about the impact of cash mergers on the stock market, we must delve into what really drives stock prices. This combines Question One and Question Two. There are countless myths regarding what people think causes price movements you can debunk with Question One. But Question Two—What can you fathom about what causes stock prices to move that others cannot fathom?—is easy. Way too easy for humans to want to fathom.

There are just two factors in this whole, wide, wonderful and whacky world driving stock prices. Always and everywhere, stock prices are derived by shifts in supply and demand. I’ve said so throughout the book, but sometimes the easiest concepts are the toughest for human minds to accept. Supply and demand are commonly known concepts, but few investors make the cognitive leap to securities pricing. Most folks who took college economics forgot about supply and demand as fast as possible after finishing finals and never thought about securities prices in terms of supply and demand. Folks with PhDs in economics were trained, but usually not in securities prices and decades later don’t think in terms of supply and demand for securities.

Myriad research reports, newsletters and media reporting tell you where the author(s) sees the market going but almost never based on analysis of supply and demand shifts. Your news anchor, poli-tic, stockbroker or tennis partner may tell you it’s any number of economic or technical indicators, pop-culture concerns, political conspiracies or self-fulfilling prophecies driving stock prices. Go to your favorite finance website and you’ll see:

You never hear a talking head say, “Supply of stocks remained relatively stable today, but demand increased for reasons we can only guess about, causing stock prices to rise.” It’s boring! Supply and demand of stocks as a storyline doesn’t sell advertising or influence you to a particular side in a political, social or economic feud. There is no reason media would be so understated.

These two dueling pressures set prices of all we buy. Seeming pressures, such as increased regulation or an alien space invasion, are just more forces on supply and demand—an alien invasion likely decreases demand for equities, and increased securities regulation likely decreases supply of equities. Myriad things can impact both supply and demand pressures—but, ultimately, it always comes back to supply and demand.

Supply and demand shifts explain why people eagerly pay extraordinary amounts for an original Beatles vinyl, an original Le Corbusier chair or a limited edition Star Wars poster—if those things float your boat. However, no one pays up for plain old paper clips. First, there are billions of paper clips floating neglected in office desk trays everywhere. Second, if you run short and don’t feel like running to your local Office Depot, you can use a binder clip or even a rubber band. That’s called substitution. Things with easy substitutes never command premium pricing like those that can’t be replaced. Third, paper clips are easy to make. Unless Andy Warhol bent a particular paper clip into a reasonable rendering of Marilyn Monroe, a paper clip won’t fetch a premium.

In college economics, you probably learned supply and demand are both about eagerness. Eagerness is emotional. Demand describes how emotionally eager consumers are to buy something at varying prices. Typically, but not always, at higher prices, consumers want less of something than at lower prices. Makes sense! Alternatively, supply is a concept depicting how eager suppliers are to generate output of some good or service at varying prices. Generally, but not always, suppliers want to produce more of something at higher prices than at lower prices. If the price is low enough, they won’t want to produce at all.

It starts getting interesting when either producers or consumers become more eager to supply or consume at the same prices. If producers become more eager to supply—meaning supply increases—but consumers aren’t any more eager to consume, the market floods with supply and prices drop. You may say, “Why would suppliers ever do that?” Maybe new technology cuts their costs and prods their eagerness—sort of like Moore’s Law pushed the semiconductor learning curve to lower prices for decades, making electronics firms ever more eager to make more at lower prices. On the flip side, if consumers become more eager—meaning demand rises—but producers don’t step up supply to match increased demand, prices rise. Straightforward.

Eagerness to buy or eagerness to supply can shift for psychological reasons deriving from any number of factors. After all, eagerness is an emotion, and emotion is psychological. And markets are psychological. All this you would have heard in any economics class—nothing remotely controversial here.

But supply and demand are a little different when it comes to securities in several ways. Unless you did very unusual work in graduate school, you probably never saw any college study of supply and demand for equities. Demand for equities is about the eagerness to own or not own existing securities. Do we want to own GE stock more than we want to own a bond or an Andy Warhol Marilyn Monroe paper clip? Has that changed for some reason? How do we feel about owning GE stock versus Pfizer?

The aggregate emotion of demand for equities can shift within the bandwidth of our human emotion very quickly and freely, in just the same way tempers can flare or a movie can suddenly make you cry or laugh. Witness this by watching the volume of daily shares traded. In our super-connected world, people can become worked up and decide to buy or sell and, within moments, complete a transaction. If their eagerness waxes or wanes, they can nearly instantaneously act in massive volume. They can completely reverse course hours, days or months later if they are so emotionally inclined.

Demand can shift fast, but only as far as people can become emotionally eager or uneager. See it like this—you can only be as angry as you get or as happy as you get, and you can quickly swing from one extreme to the other in the right circumstances but, at the extreme, only as far as you go personally. Someone else might get a lot angrier than you do or a lot more giddy. Maybe you suffer depression. Some people do. Others don’t—ever. Maybe you’re very steady-rolling—maybe too much so, and your spouse complains about that. We vary a lot individually, but overall, as a group, we’re average. For people as a whole, total demand shifts only within the average bandwidth of our aggregate emotion, although it can do that quickly—nearly instantaneously. Think how much emotion shifted in the hours after 9/11. Hence, demand has a tremendously powerful effect on pricing in the short term because it can shift so fast. It has less power in the long term because it can shift only within our overall average emotional bandwidth and not farther. It can only go so far.

Think of this differently. It’s hard for you to keep your emotions at extreme levels for long. This is why most folks can’t stay extremely angry or giddy very long. It’s just like that super party when you were 23 on a warm summer night with the right friends—it was just perfect—and you felt perfect. But the next day you felt tired. Things scar some of us sometimes, and as individuals, we never get over them. As we live life, those things change us. But newly changed—for good or bad—we only get so high or low. Altogether, when we get very angry or very ecstatic, we tend not to stay that way too long because there is too much energy exerted in staying away from our emotional norm.

So shifts in demand tend to be forceful, fast, not too far and then revert to the mean with time. This is part of why demand shifts impact short-term pricing so much more than long-term pricing.

Shifts in supply are different. In the short run, the actual supply of securities is almost completely fixed as it takes time and effort and a cooperative multiplicity of players to create new shares or destroy existing ones. Think about how long it takes for IPOs or mergers—or even just a debt offering—to evolve and the amount of advance notice the companies are legally required to give the public. An increase in supply technically means increased eagerness to supply equities. But initial eagerness is dampened early on because no one is actually sure if the deal can be pulled off. There is no assurance all the necessary pieces will come together for that offering—a process that will take many months if it happens at all. You can’t be overly eager about something you know may not happen. Eagerness on a deal grows over the time period in which the deal is successfully pursued.

Take a new stock or debt offering. When a company decides to issue stock or debt, it first must find an investment banker to manage the process. That alone takes time, particularly if it creates a competition among several investment banking firms, which is common. At this point, the potential issuer doesn’t know what the deal might look like, if it will go through with it, if it can go through with it or even when it can happen should it be willing and able to do it. The investment banker will require freshly audited financials from a major auditing firm—typically, one of the “Big Four”—also taking time. Then, in an equally uncertain process in a debt offering, the investment banker works with the issuer to secure an adequate rating from the three main rating agencies: Moody’s, Standard & Poor’s and Fitch. Also in parallel, it starts the filing process with regulators who must approve the offering—from the Securities and Exchange Commission (SEC) federally down to the state regulators in every state where the issue is to be sold (or the appropriate regulator overseas, such as the Financial Services Authority [FSA] in Britain). Then it markets the deal, which takes another few months. It’s only toward the end of that process the issuer has any real sense of how eager it can be to offer the securities or not.

Maybe by the time all this is done, the market has faded. Maybe it’s fading throughout the marketing process. Maybe a similar competitor got to market two months ahead of you, beating you to the punch and sapping demand in your category of offering. Plenty of deals get pulled at the last minute. Think how depressing that can be.

Under the best of circumstances, when the stars align, offerings are never a speedy, painless process—allowing you to assume supply is pretty well fixed in the short term. Conversely, no matter what anyone would have you believe, no one has any way to predict supply in the far-distant future. (Read more on this in Chapter 6 of my 2011 book, Markets Never Forget.) This is among the reasons why long-term mechanical forecasting notions are usually way, way wide of the mark. No one knows what whacky things may happen to the creation or destruction of equity supply 5 to 20 years from now. If you hear someone forecasting stocks to be a good or bad investment over the next 10 or 20 years, you’re dealing with someone who is telling you more about what they don’t know about how capital markets work than what they do know.

Stock prices 10 years out will be determined more by what happens to supply seven, eight and nine years from now than anything else. As I write, no one has any capital markets technology or know-how allowing them to predict such a thing. In general, stocks are more positive than negative. Beyond that generality, no one should make a forecast for more than 12 to 24 months ahead. Said alternatively, shifts in demand are often more powerful in the short term, and shifts in supply are regularly more powerful in the long term. Sometimes you can foresee shifts in demand others don’t see—justifying a 12- to 24-month forecast. But longer than that, you’re just peering into fog. In the very long term, demand will bounce from very low to very high many times, but supply, subject to fundamental forces, can be almost infinitely bullish or bearish if the right conditions exist to increase new supply or destroy it.

The Three Drivers of Stock Demand

Because supply of securities is relatively fixed over the short term, your focus in most times should be measuring demand. Figure out the direction of demand, and you’ve figured out how to make a short-term forecast. (Usually—sometimes you must account for supply; we get to that later.) That’s something your fellow investors probably aren’t seeing clearly and something you can know they typically don’t. And they won’t just because I wrote this book. Set aside everything else—what you hear in the media, what you hear from friends, what so-called experts tell you about technical or fundamental investing—and focus on what impacts demand. For this, the Three Questions are handy. There are three broad forces at play impacting investor demand—economic, political and sentiment.

Economic Drivers

Phenomena like GDP growth, corporate earnings, technological innovations, budget deficits, monetary conditions and the like are economic drivers. For example, if GDP is growing at a fast clip and corporate earnings are beating expectations, people usually feel more positive about the economic future and more inclined to take on equity risk (unless they think everything is too good, so it must get worse—which happens sometimes). If the economy is in recession and CEOs are being perp-walked to the curb, investors will likely be overall less keen on the stock market.

Investors get in trouble here because either they or their information source misinterprets economic news. What’s more, investors focus on known information. If a surprisingly good GDP report comes out, it’s too late for you to act on it. The market moves ahead of or simultaneously to news—good and bad—but not after it’s widely disseminated. What economic releases can do is help you paint a more accurate picture of current (or just past) economic conditions. From there, you must make your own forward-looking estimate about how these drivers may shift and how that is likely to impact demand, for better or worse.

Political Drivers

Elections, shifts in political control implying new future legislation impacting the tax code and the like are examples of political drivers. Recall from Chapter 2, the threat of material new legislation, particularly any threatening property rights, may cause loss aversion and fear of political muggings. Poli-tics have more impact on market risk aversion than even their narcissistic little brains can fathom.

Generally, capital markets fear change, which is why the presidential-term-cycle capital markets technology works. The market is never sure if a poli-tic is a zealot, a phony, a genuine phony or just a moron. Usually the best thing, politically, is gridlock, as we saw in the mid- to late 1990s, because it implies little change. The markets doing so well from the November 1994 election into 2000 with perfect gridlock isn’t coincidence. The market wasn’t worried about much legislation getting passed by a Republican Congress with a tiny majority and a Democratic president embroiled in multiple scandals and obsessed by polling numbers.

A Question One political myth you already know you can make a market bet on is the belief (by many) tax cuts lead to budget deficits, which are bad for the economy. The op-ed pages and media commentaries are full of otherwise rational people advancing their political agenda by making you believe tax cut-based deficits rob the government of desperately needed capital to run the government correctly, which leads to recession, bear markets, high unemployment and dashed hopes. Nonsense. Those folks don’t understand what we covered in Chapter 6—deficits have generally and measurably resulted in zippier GDP growth and strong stock market returns. Most important, the government doesn’t run anything very correctly—regardless of whether you have a Democratic or Republican Congress or administration. Or as President Ford once said, “If the government made beer, it would be 50 bucks a six-pack and taste bad.”

Investor Sentiment

The third driver, investor sentiment, is pure emotion. Sentiment is constantly moving—weekly, daily, even second to second. It’s everything else that impacts investors’ feelings. In many ways, it isn’t any more complicated than that party we mentioned earlier. It got you feeling great. The next morning you didn’t feel great. The day after that you’ll likely feel better. It is partly that we can’t sustain our emotions at extremes for long, as mentioned earlier. But we can artificially push them there temporarily.

That Wall of Worry

When headlines are most dour and your friends and colleagues are bemoaning how terrible things are, you can be confident they will feel better later and sentiment will improve at some point. Those who were most worried and sold their stocks low with hindsight bias gradually regain confidence and begin buying again. An initial reaction to higher prices is glee. You get pulled back to the middle of your emotional bandwidth by fear of heights. New, higher prices scare people. Since they didn’t expect stocks to rise as much as they did, they now fear they may fall. Since investors fear losses more than they enjoy prospects of gains, this creates rising anxiety. This is the proverbial “wall of worry” bull markets climb. The higher it goes, the more angst those who didn’t predict it feel. Since they didn’t see why it should go up, they can’t see why it shouldn’t go down. Since they hate losses much more than they like gains, the fear of downside dominates.

A good illustration of this is the first-year returns following a bear market. When people assume they face the most market risk, they miss out on a remarkably low-risk period. First-year returns following true bear markets are super above average, as shown in Table 7.1

Table 7.1 Stock Market Returns Following Bear Markets

Source: Global Financial Data, Inc., S&P 500 price returns.

The reason the bell curves in Chapter 4 worked for equities is they were a good measure of sentiment. The bell curves showed where sentiment was at a point in time, not where it was going. If you know and accept that, you can game the future direction. For example, in the late 1990s, the forecasting consensus wasn’t bullish enough. Markets came in high because demand was too low and had to move higher. The bell curves were a good capital markets technology innovation for measuring investor sentiment.

Supply: How It Works

Supply is like an unending accordion that can be expanded or contracted continuously. Other than what the market can bear, there is no limit to how many shares may be issued in IPOs or reissues or how much debt can be raised if underlying economics justify it. Or how many shares can be bought back and destroyed through stock buy-backs or cash-based takeovers.

When there is sufficient incentive to flood the market with new supply, prices will eventually drop, overpowering any demand. This is how it works. Take a hot sector, like Tech in the late 1990s. As prices appreciate rapidly, everyone wants in on the action. Suppose Firm A makes a novel product and has a total private market value of $1 billion. It floats a hot offering at a high price, raising lots of money while giving up very little control of the company—it raises $250 million but gives up only 20% of the company. The prior existing 80% of shares remain privately held. Effectively, that values Firm A before the money at $1 billion. With the money, the deal is completed at $1.25 billion. The founders and other shareholders who initially had private stock of questionable liquidity now have a public security with a daily price making them multimillionaires. They’re happy. The investment bankers are thrilled with their 7% of the $250 million—$17.5 million in fees!

Eager observers watch the post-offering price rise and hope the market can handle an offering from another similar outfit. So they find an entrepreneur and venture capital and create privately held Firm B, which is a Firm A look-alike. They get their investment banker to take Firm B public to get in on the cheap money. Maybe they have just a plan and no revenue, like many of the 1990s dot-coms. If B’s offering goes well, someone else will attempt it with Firms C, D, E, F and so on.

Firm A now realizes, as the high-quality, granddaddy of this product line, it can raise more capital with more newly created shares. It senses it can garner premium valuations over the group of inexperienced newbies. This time, it raises another $350 million but gives up only 17.5% of Firm A in newly created shares. Now Firm A is valued at $2 billion.

Now Company X, a mature, boring firm worth $100 billion, decides it can’t take the risk of not being in on the hot new product category. It initiates a hostile takeover bid to acquire Company A for $3 billion, paid for with new Company X stock. Company A shares disappear and are replaced with new Company X shares worth $1 billion more than the $2 billion Company A previously had been selling for. Again, Company A shareholders get rewarded, but, suddenly, there are a lot more newly created shares. Earnings are the same as before. This, like most stock mergers, was dilutive to earnings. It’s the same amount of earnings but many more shares. All the IPOs and new issues start flooding the market with shares in the hot category. Eventually, supply drowns demand and prices roll over. If demand drops, prices implode.

Just as they did when the Tech market crashed close on the heels of the Tech-IPO craze in March 2000.1 Demand fell all the way to the market’s ultimate global double bottom in 2002 and 2003.2 The scapegoats were many for the Tech bubble. People blamed Tech companies for being overvalued. (A term that is often over-abused—companies are worth what people pay for them at a point in time.) Greedy CEOs got their share of blame, too. Corporate accounting rules were deemed too lax or not expansive enough.

The reality was the Tech bubble burst because the market was inundated with supply, and demand couldn’t keep pace and then fell. That is the most apt explanation. Some would blame investment bankers, but that isn’t fair or appropriate—no matter how you feel about them. Investment bankers simply respond to investor eagerness for more supply (demand). The real culprits were investors’ overconfident brains, letting them run rampant and over-allocate to a sector. Investors were too eager—demand was too high. Absent their demand, investment bankers and issuers can’t flood the market with supply.

You should pretty much always be wary about excessive euphoria regarding IPOs in the latest “hot sector.” Every time we see a hot sector—throughout the entire history of investing—investors claim, “It’s different this time.” It’s never really different this time—just the niggly details. There is never anything different about an inundation of supply surpassing demand and causing prices to drop. (For more evidence of how it’s never different this time, see the reprint in Appendix G of my March 6, 2000, Forbes column, “1980 Revisited,” calling the top of the Tech bubble because of parallels to the 1980 Energy bubble.)

Merger Mania

Supply of stock can increase infinitely (which wouldn’t be so good for stock prices in the long term) but may also be reduced when a company, thinking its stock is too cheap, uses cash to repurchase its own shares. Through stock buybacks, as discussed in Chapter 6, and cash-based takeovers, as discussed earlier, supply can be destroyed nearly infinitely. Using Question Two, we know cash-based merger manias can be followed by good stock market returns. If demand remains the same (or even greater) but supply is reduced, prices should rise, all else being equal.

How does knowing this Question Two truth help you? Simply keep in mind the difference between equity-based (dilutive) and cash (accretive) mergers. Are there a lot of IPOs hitting the market and on average more equity-based mergers taking place? That’s a potentially bearish concern. Not the only factor to consider—but one among others that should shape your forward-looking assessment. Conversely, lots of cash mergers probably present a little-noticed bullish surprise—news most investors don’t process correctly because they don’t know how.

Knowing increased cash-takeover activity is a positive factor can help you shape better forward-looking expectations. But does that provide additional insight into which sectors you should overweight and which individual stocks you may want to buy? Absolutely! Look at the sectors where the mergers are occurring and work your way, top down, to a good buy-out target. If you’re right on a few of your buy-out targets, you get a nice price bump if (and when) the merger is announced. It’s easy, free money.

Riding the M&A Wave

You can ride the M&A wave by finding stocks ripe to be taken over. Acquisition premiums paid to shareholders of buy-outs often yield large increases in share prices. Good buy-out targets are likely to have some or all of the following characteristics:

• Low valuations
• High free cash flow
• Strong balance sheets
• Quality brand names
• Regional strength
• High relative market share
• Smaller in size
• Strong distribution networks
• No concentrated controlling shareholders

The good news is you can check for those attributes by reading shareholder reports—available for free on corporate websites. Here are just two examples (stocks I identified as buy-out targets in Forbes) showing how to look for and apply these attributes.

I wrote about MBNA in my May 9, 2005, Forbes column.3 MBNA was the world’s largest credit card company, issuing familiar cards like Visa, MasterCard and American Express, with a successful strategy of focusing on affinity groups like associations and financial institutions. If you had one of those cards, it was probably issued by MBNA, whether you knew it or not. Besides credit cards, it had strong business in consumer and home equity loans. It had all the qualities of a perfect takeover target—strong brand name, healthy balance sheets—plus, valued at 12 times trailing earnings, it looked darned cheap. Bank of America thought so, too. It announced its intention to buy MBNA on June 30, 2005, and MBNA ended the day up 24%.4 Had you bought on the day I recommended it, you would have been up a very nice 30%.5

CP Ships was a great takeover candidate I wrote about in my April 18, 2005, Forbes column.6 Though this container shipper was domiciled in Britain, 80% of its business activity focused on North America. With a fleet of 80 ships, it was the leader in most of its routes. In 2005, this little British stock was overlooked because shipping is a cyclical business. But it’s also a growth business, and this stock looked cheap at 13 times 2005 earnings and $3.7 billion in very real revenue. The Germans at TUI AG—a massive, well-diversified tourism and shipping company—expanded their shipping business quickly and cheaply by announcing a merger with CP Ships on August 22, 2005. CP Ships shareholders got a nice 8% 7 boost that day. However, had you bought when I recommended it, you would have been up 56%.8

Categorically, you know the bulk of cash-based deals will occur with stocks that are cheap in terms of having a high earnings yield compared to the acquirer’s pretax cost of long-term borrowing. Suppose the average company borrowing rate (the BBB 10-year bond rate) is 6% and the average corporate tax rate is 33%. The after-tax average cost of borrowing is therefore 4%. Takeover targets will tend to have earnings yields greater than 4% after they’ve been marked up with a maybe 25% pricing premium. Hence, most takeover targets will have an earnings yield above 5% before the deal is announced, translating to a P/E below 20. To get the acquirer’s earnings per share to rise the most from the deal, the higher the earnings yield, the better. Most cash-based takeovers will tend to be value stocks with lower P/Es (high earnings yields). Seek those kinds of stocks to capitalize on cash-merger mania.

No One Stock Style Is Always Better—Period!

Supply and demand being the only determinants of stock pricing—and the potential to create or destroy new shares being nearly infinite—is why no correctly calculated index, size, style, country or category is better for all time. (Remember our graphs in Chapter 4?) While collectors of a particular category type (small-cap value, large-cap growth, Japan, biotech) believe the category they like is permanently better, it isn’t and can’t be.

But when an equity category collector tells you his or her category is permanently better—and many believe this—you’re being told what the teller doesn’t understand about markets. Supply creation is infinitely elastic if given enough time in the right circumstances. And demand bounces constantly in the short to intermediate term. There is no evidence supply of any equity category is capped, can’t be bought back and destroyed or is in anyway predictable in the long term. Consider this: If there is demand for a category, the investment bankers will meet it—they don’t care about investor perception about a particular category needing to be superior over time.

For example, plenty of folks are diehard adherents to small-cap value. I’ll give you a simple tip. Whenever big-cap growth does lousy, small-cap value does well—they are polar style opposites. Saying one does well is the same as saying the other does badly. You can always find investors firmly convinced small-cap value is permanently better.

I started doing small-cap value stocks three decades ago, long before the word small-cap value existed. My first book, Super Stocks (published in 1984), was about price-to-sales ratios—specifically how to use PSRs to find small-cap value stocks others couldn’t find. Even then the term small-cap value didn’t exist. The term evolved in the mid-1980s on the heels of that earlier period as small-cap value stocks did well. A period much like the past six years.

In 1989, when Callan Associates, a major consulting firm to institutions (primarily defined benefit pension plans), introduced the very first small-cap value peer group for institutional investors to use in calibrating how well or badly a given manager did, only 12 of us were included in that initial group. They couldn’t find any other pure-play small-cap value managers. That was how primitive this category was not quite 20 years ago.

Today, my firm still manages money in the category for large defined benefit pension plans, endowments and foundations. It’s a perfectly valid part of the market to include in a much broader portfolio (which all these institutional investors have). But the category has times when it shines and times it doesn’t. Folks forget that—including many who should know better.

I’m not arguing against owning small-cap value or for owning big-cap or the market as a whole. I’m saying there are painfully long stretches when things seeming to work in the very long term don’t actually work. And these times are too long to not drive everyone, including you, nuts. For periods of 5, 10 or 20 years, it will be shifts in supply determining most of the return of the market and of the market’s subsets. In the very long term (and lots of subsets thereof), all major categories, correctly calculated, should have very similar returns. Falling in perpetual perma-love with some category won’t guarantee you perma-superior future return.