Serious Money: Companies are flush with cash, the economic cycle is right and target companies are usually only too willing to be taken over, writes Chris Johns.

Mergers and acquisitions (M&A) are rarely out of the news these days. The deal putting together Procter & Gamble with Gillette has attracted the most headlines over the past few weeks.

Gillette's share price was trading around $44 just before the takeover proposal was announced, and is currently trading at $50. As recently as last October, you could have picked up Gillette shares for less than $40.

The year's other big US deal, the SBC takeover of AT&T, didn't see such a large jump in AT&T's share price on the day the deal was first made public, but you could have bought shares three months ago for around $14, compared with today's level of $20.

Closer to home, one of the year's biggest deals involved UK company Aggregate Industries being acquired by Swiss cement firm Holcim. At the turn of the year, Aggregate was trading at just over £1, today it stands at around £1.38.

M&A activity tends to follow a cycle not unlike the business cycle: when things are going well in the broader economy, companies seem to feel confident about their ability to acquire other businesses and manage them such that they make a lot more money than before. M&A deals always pick up once the economy has been growing for a while. Deal volume is also helped when companies have lots of cash and many industries are deemed to be super competitive.

Monopoly legislation ("anti-trust" in the US) was invented a century ago precisely as a result of another long wave of merger activity that put too much pricing power in the hands of producers rather than consumers. The history of M&A regulation is also one of cycles: regulators tend to keep up with industry developments, but only with a lag.

It is tempting to think that the EU Commission has completely missed the boat with its attempts to shackle Microsoft: there are bigger culprits out there. But the way things are shaping up, the regulators will have their work cut out this year. The main obstacle to deals would appear to be legal: all of the other drivers of the M&A cycle seem to be about to hit a sweet spot.

If the economic cycle is the driver of the animal spirits that give rise to the urge to merge there is still a small matter of finance. Right now, things couldn't be better from this perspective: companies are flush with cash.

Even where they don't have all the necessary funds from internal sources, the markets are only too happy to oblige with relatively cheap financing. The picture is made complete by the relative willingness of potential targets to be acquired.

Cynics might think that the chance of instant enrichment for the senior managers of target companies is the main driver here, but, whatever the reason, we observe relatively few hostile bids these days. The icing on the cake, this time around, is the flood of money into private equity: the presence of this pool of money focuses a lot of minds. For many companies, the means, motive and opportunity to do a deal, of one kind or another, are all present in spades.

From the investors' point of view it is generally reckoned that it is far more profitable to own shares in an acquired company, rather than in the acquirer. Our short list of examples of M&A activity seen so far this year would seem, in part at least, to bear this out: Procter & Gamble and SBC's share prices are either flat or down since the takeover announcements. Holcim, by contrast, has seen its share price rise strongly: this is the exception to the rule.

Many studies have appeared in recent years that purport to prove that mergers do not, on average, enhance shareholder value for the acquiring company. Think Vodafone (Mannesman) and Time Warner (America On-Line) for example.

For the boys in dark glasses (or merger arbitrage specialists as they are also known), the trick is to guess which companies are likely to be acquired and to buy the shares before anyone else. This is, of course, a highly specialised game: there is also the chance that you will go to jail if you don't play by the rules (in some jurisdictions at least).

The list of companies that could be involved in some sort of deal activity this year is a long one. The obvious place to start is with the sectors that have already been busy. Top of that list is telecommunications, particularly in the US. Telcos of all kinds are throwing off loads of cash but are seeing revenues under threat from competition and disruptive new technologies. The need for this sector to merge is obvious. In fact, this is about the only thing that this sector has going for it.

Banks are another obvious candidate for merger activity, particularly in Europe. ABN Amro's share price has risen quite strongly on merger rumours and, if consolidation finally gets under way after so many false starts, I would expect one or two French and German banks to figure prominently. Suggestions have already been made in some quarters that BNP Paribas could be a bidder for a large UK bank in the not too distant future, perhaps Lloyds TSB.

Another sector that could be tempted to get involved in deal activity, not least to cover up some of its current woes, is the pharmaceutical sector: here, unless they manage to find a particularly compelling deal, shareholders might be profoundly sceptical of the value enhancing qualities of any merger.

For the individual investor, trying to guess the next M&A deal is a high risk game - but also a potentially rewarding one, for those lucky enough to make the right calls. Those happy to stand on the sidelines can content themselves with the thought that a high level of deal activity is usually accompanied by buoyant markets.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.