Why should the Big Boys on Wall Street get all the benefits from corporate mega-deals? Average investors can profit from mergers & acquisitions (M&A), but you need to know what to look for.

Case in point: A blockbuster deal was closed in April, merging Raytheon with United Technologies to form Raytheon Technologies (NYSE: RTX). The merger resulted in a giant aerospace and defense company that will generate about $70 billion in annual revenue.

Billed as “a merger of equals,” the corporate marriage is largely about getting bigger and reaping diversification. Both companies operate in aerospace/defense, with Raytheon providing a greater footprint in the civilian sector.

There is little overlap between the companies’ operations and there aren’t significant operational synergies. In fact, each company’s operating units will remain separate. Most cost savings will come on the corporate side in terms of procurement and administrative expenses. The larger size could give the combined company better bargaining power and more sway with clients and supplies alike.

Muted Reaction

The market reaction to this mega deal was essentially a shrug. The trading volume in the two stocks did jump, but the share prices barely budged. Basically, some investors liked the deal and wanted in, others didn’t like it and wanted out.

You see, the market isn’t automatically impressed when two big companies join together. It cares whether the corporate marriage generates value.

In this particular case, the two companies didn’t have clear synergies and it was an all-stock transaction purposely structured to have no premium built in. As a result, the merger announcement did not move the stock price much one way or another.

But when it comes to M&A, a “marriage of equals” is rare. Usually a larger company buys and takes over the smaller fish.

The More Interesting Type of M&A

For a big company with lots of cash and looking new ways to grow, rather than develop certain new products and services from scratch, often it’s easier to just buy out a smaller company to take over its attractive lines of business and intellectual properties or to simply to remove a competitor. The acquirer typically wants to see ways to create synergies (higher revenues and lower costs) by absorbing the acquiree.

From the smaller company’s point of view, it makes sense to sell part or all of itself if it receives an offer it can’t refuse. Sometimes, smaller companies can struggle to make a profit and they could run into liquidity problems. In this scenario, finding a buyer is one way out. Other times, the execs might just want to move onto bigger things.

For example, Elon Musk made his early fortunes when he founded and then sold Zip2 and X.com (which then merged with the company that launched Paypal). He used the money from selling his early companies to found Tesla (NSDQ: TSLA), which is now worth billions of dollars more than his earlier companies.

A Yummy Premium

When one corporation takes over another, the buyer’s stock usually falls while the seller’s stock rises. This is because the acquiring company typically pays a nice premium to sweeten the deal. According to a Boston Consulting Group analysis of more than 12,000 M&A deals that occurred globally between 1999 and 2019, the average premium paid was 30%.

In the last six years or so, the premium has been generally below that average (in the 20’s), but if you are an investor in the company being bought out, a quick 20%+ increase in your stock’s value overnight is not too shabby.

This is why whenever there is a rumor that a company may be bought out, that company’s stock will jump.

Still, you’ll want to invest in a quality company that has other things going for it other than being a potential takeover target. You don’t want to invest in a company in bad shape just hoping for a buyout. A company desperate to sell probably won’t get a great premium anyway. And if a buyout never happens, you are stuck with a lousy stock.

A Few Helpful Signs

It’s impossible to accurately predict who will be taken over and who won’t, but there are many signs to look for. I will mention a few here.

If a company has a popular niche product or service, it could become a takeover target. Even if the smaller company hasn’t been able to convert the popularity into consistent profits yet, a larger company, which has access to much more resources, could see ways to add value to the niche product/service and to its own existing operations through integration.

A company with a strong balance sheet and no complicated capital structure or overhanging legal or accounting issues is especially attractive. After all, the buyer wants the transaction to go smoothly. Nobody wants to buy something that will cause headaches, no matter how cheap it is.

A good sign is if the small company already partners with one or more larger companies in certain project(s) and joint ventures. Working together lets the big company get a good look at the other company’s characteristics and helps the execs know each other. If the big company likes what it sees, it could decide to just take over.

But maybe the M&A scene is too risky for you. During the coronavirus crisis, you should also consider safe havens, such as stable dividend paying stocks.

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