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How To Play The Coming Acquisitions Boom

In many companies, the biggest portion of the CEO's compensation is tied to its stock price. When the Federal Reserve reduced interest rates close to zero, it had an unintended consequence of a booming stock market which has resulted in multi-million dollar payouts to those lucky enough to be CEO during the past 8 years. Going forward, CEOs need to grow their businesses if they want to earn big bonuses. For many CEOs the easiest way to create growth is through acquisitions. Here are two ways to play the coming acquisitions boom.

Invest In The Acquirers

Even though interest rates are rising, they are still very low. Companies that have access to credit can still borrow the money at historically low rates to make acquisitions.

However, in my experience most acquisitions don't work out for the acquirer. The promised synergies don't appear despite the assurances of the investment bankers for both the buyer and the seller. Don't depend on the opinion of an investment bank that stands to earn large fees from the transaction. Instead, look for companies that have an excellent track record of growth through acquisitions.

Broadcom (AVGO), for example, has gone from $36 to $244 in the last 5 years and much of the growth has come from making smart acquisitions. Current market conditions should play well to Broadcom's strengths.

An acquisition that doesn't go as planned can be devastating for shareholders. AT&T (T), for example, was at $36, 5 years ago, and is still trading at about $36, eventhough it paid $49 billion in 2014 to acquire DirecTV. With that kind of track record, shareholders should think twice about whether AT&Ts proposed $108 billion acquisition of Time Warner is in their best interests.

I would bet on Broadcom, but not AT&T.

Invest In The Acquisition Targets

In the healthcare sector, there are many pharmaceutical companies with lots of cash flow, but nothing in the pipeline to replace the drugs that are coming off patent. They have the salesforce and staff to deal with doctors, insurers, and regulators that biotech companies need to take their drugs from clinical trials to commercial success.

Gilead (GILD), Celgene (CELG) and Sanofi (SNY), have made multi-billion dollar acquisitions in the past 6 months. Novo Nordisk (NVO) and Eli Lilly (LLY) face similar challenges which I expect they will try to solve the same way.

Todd Hagopian, who runs a biotech fund for us, has done a great job of anticipating the likely acquisition targets in the biotech space.

I first wrote about his strategy in September 2016, just after Pfizer beat out Gilead to buy Medivation. I asked him who would Gilead go after next? We discussed 4 potential targets, Puma Biotechnology (PBYI) at $68, Incyte Corporation (INCY) at $89, Kite Pharma (KITE) at $55, and Portola Pharmaceutical (PTLA) at $23.

Gilead bought Kite for $180 a little more than a year later. Correctly anticipating Gilead's acquisition of Kite contributed a lot to Todd's 30.46% return in 2017. But it also helped that the other 3 stocks did not crash as so many biotech stocks do. Today, Puma, Incyte, and Portola are at $71, $85, $32 respectively.

The lesson is that if you want to invest in acquisition targets, it is important to make sure that the companies you select have enough going for them that they can survive, and perhaps prosper, even if they do not get bought out.

Of the 3 companies that Gilead did not buy, Todd still thinks Incyte is candidate for a buy out. That's why it is currently the third largest holding in his biotech fund.

My Take: Many CEOs get big bonuses if their company's stock appreciates during their tenure. In the last 8 years, these CEOs enjoyed a windfall as falling interest rates caused a stock market boom. Now that interest rates are rising, the windfall is over. CEOs who have never started a business are going to be highly motivated to grow through acquisitions.

This strategy counts on CEOs to take full advantage of their compensation plans. I think that's a good bet.

The manager with the best track record for this strategy is Todd HagopianTodd does not run a mutual fund. His fund is an investment option for clients of our separately managed account program. For information about investing with him, click here.

If you would like to be notified when I write about stocks you are following, click here.

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