The story in the technology sector during 2012 was all about M&As. Mergers and acquisition activity in the sector surged as many larger tech firms - flush with cash - sought to buy growth. Their targets? Small- and mid-sized firms across the social media, cloud computing and software sectors.
For investors in the acquired firms, the buy-outs have certainly been quite lucrative as many companies have been taken out at share prices much higher than current market prices. For example, travel site Priceline (Nasdaq:PCLN) offered to buy rival Kayak (Nasdaq:KYAK) for a 26% premium to its closing share price.
Given the potential to profit from future M&A activity, the question remains whether or not investors should tilt a portion of their tech portfolios towards future buyout candidates.
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More M&As on the Way
While technology deal volume technically trended lower in 2012, the dollar amounts of those deals well exceeded 2011's numbers, and 2013 is predicted to be another banner year. According to PricewaterhouseCoopers (PwC), large-cap tech companies will once again open their wallets after re-analyzing their business models. Analysts at PwC believe the New Year will feature plenty of drivers that will spur M&A activity in the tech.
Factors such as changes in customers' attitudes towards cloud services, the continued high growth in social media and smartphone/tablet adoption will be the main catalysts for M&A demand. At the same time, technology-oriented private equity funds are expected to demand slower-growing firms that produce cash flow assets, such as software firms, which have lucrative licensing fees. Likewise, patents - as shown by the recent battles between Apple (Nasdaq:AAPL) and Samsung - will be a driving force in creating more buyouts in the sector.
Should You Bet on the Targets?
With another bullish tech M&A forecast on the horizon, should regular retail investors bet on the potential targets? The answer is not so simple. Buying a firm's shares simply on the basis of a potential buyout can be a risky business. If that takeover does not come to fruition, investors and their portfolios can be left holding the bag and can reap big losses. Picking just the right firm can be tricky, as investors have to gauge a multitude of moving parts.
On the flipside, pick the right winner and you can be rewarded with plenty of upside and profit. Investors can also gain access to the acquiring company's shares - assuming the deal is structured that way - which may prove to be a better "investment" in the longer term. So the appeal of betting on tech M&A is certainly there.
For investors wanting to cash in on the growing M&A fever, skipping the firms that are often talked about as buyout targets could be the best strategy as they already trade at premiums. The most prudent approach to playing acquisitions is to focus on small/midsized companies that are undervalued and have attractive fundamentals. Businesses that have dominant shares of niche markets and strong management represent the most logical acquisition candidates. Overall, the tech sector is just full of them - many of which are former dotcom darlings that have grown in their maturity, but which haven't grown too large.
Finding those leaders is easier than you think. The midcap sweet spot seems to be where most of the deals are being made: market caps between $2 billion and $10 billion. Companies such as enterprise software purveyor CA Technologies (Nasdaq:CA), network storage firm NetApp (Nasdaq:NTAP) and data security firm Check Point Software (Nasdaq:CHKP) are just the right size and are leaders in their respective fields. At the same time, their market caps are just small enough to be swallowed by the big boys.
Another potential way to play increased tech M&A, a small cap tech fund. While the PowerShares S&P SmallCap Info Tech (Nasdaq:PSCT) won't experience the same kind of pop that owning an individual buyout target will see, the fund is chock-full of smaller firms that could be great acquisition targets in the sector.
The Bottom Line
Merger and buyout activity in the tech sector continues to rise as larger firms spend their cash hoards on growth. For investors, buying potential acquisition targets could be a risky, yet lucrative bet on the tech sector. The key is to focus your portfolio's attention on the midcap firms with leadership in their fields.
At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.