Bid targets will help your portfolio hit the bullseye

Stalkers are driving up the Footsie, so potential targets may be profitable

So much merger and acquisition (M&A) activity in one day is rare, but 2005 is turning out to be a boom year for deals. There were more than 700 takeovers and mergers in the first three quarters, according to the Office for National Statistics, ranging from the purchase of Allied Domecq by Pernod Ricard to Emap buying Scottish Radio. The increased level of deal-making is one factor in the strong performance of the stock market this year - Monday's frenzy helped to push the FTSE 100 Index of shares in leading companies 2 per cent higher on the day - and there is no reason to expect any let-up.

"We said that M&A activity would be a positive feature of the markets this year, and this has been proved correct," says Anthony Nutt, investment manager of the Jupiter Income Trust. "Many companies have plenty of cash on their balance sheets and this, combined with the low cost of debt, has encouraged a number of listed companies and private equity firms to launch takeover bids."

Investors holding shares in a company that is the subject of a bid can make money very quickly. O2 shares rose from 165p to 205p as news of the Telefonica deal broke, an instant gain of 22 per cent. But to cash in, you need to own the shares in advance; the market moves too quickly for small investors to make a turn once news of a deal is public.

The bad news is that picking takeover targets in advance isn't easy - the fact that a company appears vulnerable doesn't mean a bidder will emerge. "If you had asked me last week to suggest a company likely to be taken over, O2 would have been an obvious candidate," says Hilary Cook, a director of Barclays Stockbrokers. "But for some time I've also been a fan of Boots for the same reason, and I'm still waiting."

Richard Hunter, head of UK equities at Hargreaves Lansdown, also urges investors to be cautious. "As a rule of thumb, the potential for takeover action should be low on your list of priorities when picking shares, " he says. "Instead, look for stocks you would want to hold in any case, where a bid would then be an additional bonus."

That said, takeovers generally reflect certain themes, which investors can use to identify possible future bid situations. "If a company seems to have gone as far as it can without further significant investment, it may be a target," Hunter says. "Within this generalisation, smaller - perhaps even largely family-held - companies with good balance sheets and profits may be suitable."

Bidders often look for particular characteristics when acquiring companies. Allied Domecq was attractive to Pernod Ricard for the huge economies of scale it offered as a company in the same business sector. Last year, Philip Green was keen to buy Marks & Spencer because it was a strong business perceived to have lost its way.

"The real key is a unique selling point: does a company have something that is strategically valuable but unavailable elsewhere?" says Cook. "O2, for example, will give Telefonica 25 million customers in the UK, something it could never achieve by starting its own business here."

One feature of the M&A boom this year has been the number of bids by foreign companies for UK businesses. Partly, this reflects the fact that large British companies now find it difficult to buy each other, because in many sectors, market share is concentrated in so few hands that deals would be frowned on by the competition authorities.

Justin Urquhart-Stewart, a director of Seven Investment Management, says more acquisitions from international companies are likely to follow. " Look for sectors where there are direct competitors that could come in from overseas. The hotel groups, for example, are obvious targets," he says.

In particular, sectors such as banking and utilities are interesting to overseas acquirers because the barriers to entry are too high for them to consider launching rivals. However, international bidders are usually looking for strong businesses that they can bolt on to their existing operations. The purchase of struggling Abbey by the Spanish bank Santander last year was the exception rather than the rule.

Finally, Hunter says, a weakening in the share price of a possible bid target can trigger a bid. "Any weakness can render a company vulnerable on the simple basis that it is cheaper than before," he says, " particularly if an acquirer has already done some groundwork on the target."

For this reason, it's worth putting certain companies on a watching brief. Rumours of a deal are worth listening to, even if it takes several months for a formal approach to emerge.

O2 has been linked to bid speculation for much of the year, for example, and its shares have steadily moved up since January. However, this progress faltered in line with a weakening in the stock market as a whole in late October - just before the Telefonica bid.

Six takeover targets that have yet to fall

Alliance & Leicester: "The premium valuation of A&L shares does reflect some existing bid speculation," says Hilary Cook of Barclays. "However, A&L is clearly a very good company, and the shares will not fall out of bed while we wait for a bidder."

Centrica: "If a bid materialises, we think £3 to £3.25 is not unrealistic [it's about £2.40 now]," says Cook. "Even if a bid does not emerge, we think Centrica is undervalued - it has unique assets, strong cash flows and good dividend growth."

Lloyds TSB: "Barclays has not been immune to speculation, which means all the UK's banks are in play," says Richard Hunter of Hargreaves Lansdown. "The attraction at Lloyds is the yield of 7 per cent on the shares - even in the absence of a bid, investors have that comfort."

Northern Rock: " Consolidation in banking is a continuing investment theme," says Justin Urquhart-Stewart of Seven. "Northern Rock should be attractive as a well-run mortgage bank."

United Utilities: Several major UK utilities have been bid targets this year, says Hunter. "United would require a large acquirer, but several big German utilities, notably Eon, have been looking around," he says. "Plus, United offers a yield above 7 per cent."

Whitbread: "This company has an interesting range of brands," says Urquhart-Stewart. "There is real value, but Whitbread doesn't seem able to exploit it; buyers may feel they can do better."

Should you sell or hold?

Investors with shares in a company where a takeover is agreed can face a dilemma. Soon after news of the deal breaks, their shares' price may rise significantly above the price offered by the bidder; the market may think another bidder might emerge, say. Should you sell at this higher price?

Hilary Cook of Barclays Stockbrokers says selling out early can be a mistake. "For private investors, the cost of dealing can wipe out the premium. As a rule, hang on for the cash from the acquirer."

There are two advantages to waiting. First, it's always possible that rival bids will emerge, boosting your gains further. Second, even if no new bid arises, investors have the floor price of the existing offer to fall back on, with no dealing costs to cover.

However, Cook warns investors to tread carefully with takeovers of British companies by overseas predators offering their own shares rather than cash. If an overseas acquirer fails to offer a free dealing service in their own stock for small investors, you could be left with foreign shares that will prove even more expensive to sell.