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Laggards to lift off

A mid-sized speciality chemicals company little known outside its native USA has sent a big message to UK investors. By making a putative bid for Elementis (ELM), another chemicals specialist, New York-based Minerals Technologies (US:MTX) signalled a likely lift-off in takeover bids for special sorts of stock market laggards as economic life looks to revive.

That prospect should excite retail investors, especially those whose portfolios are groaning with what we might label ‘value’ stocks. But as they seek to identify possible bid targets, it is vital investors pose a different set of questions to the ones they ask when they say ‘are the shares cheap?’

And even before they begin searching for candidates, they should sort their existing holdings into potential predators and likely prey. That’s a sensible starting point because, where takeovers are concerned, it is usually smart to sell the predators and buy the prey.

Buying shares in would-be victims seems common sense; less so the notion of selling shares in predators. After all, such companies are meant to be the business jungle’s big beasts, the alpha males who get what they want and lay the rest to waste. Metaphors aside, investors should sell the predators because growth by acquisition – however tempting for the bosses – is often a mug’s game for investors.

The problem is that, as a breed, company bosses are longer on confidence than they are on ability. As a result, as has been well documented, they serially overpay for acquisitions. Rarely short on animal spirits, bosses are too optimistic about the markets their acquisitions will take their companies into; they exaggerate their ability to extract synergies and their integration plans usually fail to meet expectations.

As to that different set of questions investors must ask, they should aim to see the thing through the mind’s eye of a corporate predator; although one whose thinking is straight. Smart predators do lots of screening upfront. That’s logical since every acquisitive company has an ideal size of takeover candidate, operating in the right location, offering the right products and services, generating revenues where they are most wanted and more besides. Outside investors cannot second guess such factors since they will be unique to each and every acquirer.

However, what can sometimes be spied from the outside is the special factor that lifts a run-of-the-mill piece of corporate road kill into a valued prize; the factor that makes the acquisitive boss say, “Wow, would I like to have that within the group”.

Elementis seems a good example of the wow factor hidden inside an ordinary corporate wrapping. Actually, that should probably be ‘factors’ plural because the group has two big things in its favour that would be really difficult to replicate. It is the world’s leading supplier of hectorite, a clay much used in the cosmetics and oil-mining industries, and is a near-monopoly supplier of chromium in the US. Onto these strengths, it has bolted the comparatively recent addition of industrial talc via a £380m deal. It is not yet clear whether this deal has compromised – or complemented – the merits of hectorite and chromium. Conflicting signals from management and poor trading has only added to the confusion. So much so that, following the first Covid shock, Elementis’s share price dropped to 18p in April. But even at 73p, just before news of the US company’s approach leaked into the market, the share price was still 74 per cent below its five-year high.

Elementis’s bosses say the 107p a share all-cash approach significantly undervalues their group. Certainly it does in relation to the 285p five-year high; much less so, however, using conventional analysis of the group’s financial statements to estimate a value. Whether focusing on Elementis’s ability to generate free cash or – especially – its accounting profits, 107p looks like a sensible opener.

But the point is that conventional number crunching is out of place in situations such as this. At stake may be assets that are really difficult to value from the outside because they won’t be identified as separate revenue streams in a group’s accounts. Often it is sufficient to identify the asset – whether tangible or intangible – and leave it at that.

What lifts Elementis in the big eyes of predators is its commanding positions in markets that are unlikely to disappear, especially if – as seems the case with Minerals Technologies – the attractive operating assets can be aligned with existing interests, thus presenting the chance that two plus two will equal five. And it won’t matter – apropos the earlier comment – if the US company’s bosses acquire Elementis then fail to hit their targets. Why should Elementis’s shareholders care about that?

There are Elementis lookalikes – under the cosh and undervalued – in almost every portfolio. The Bearbull Income Fund had a clear-out of candidates – including Elementis – in the summer because they looked unlikely to pay dividends any time soon. Even so, a couple of possibilities remain. There is Vesuvius (VSVS), a world-leading supplier of consumables to foundries and which might be a suitable target for Minerals Technologies except that, with an equity value of almost £1.3bn, it is probably too big. Then there is aircraft charter services provider Air Partner (AIR), which has traded far better through the pandemic than its share price suggests – at 80p it is 44 per cent below its five-year high – and which has a niche that bigger travel brokers covet but would struggle to replicate. Which are yours? Identify them and stick with them.