The right way to play a takeover

(Money Magazine) -- The sharp jump in dealmaking lately -- mergers and acquisitions soared more than 20% in the first quarter -- may have you thinking about hunting for the next big takeover target.

On paper, this sounds like a pretty easy investment strategy: Find a promising company with big, cash-rich competitors on the prowl, buy the shares, wait for the buyout, and count your winnings. Rinse and repeat.

Unfortunately, it's not so simple. Anytime buyout activity heats up, shares of takeover targets also get bid up, leaving such stocks vulnerable to an unpleasant selloff if a buyer never materializes.

That's why it makes much more sense to go with shares of companies that are appealing to potential suitors but that will do just fine even if left at the altar.

Where can you find them? Well, health care has been an M&A hotbed lately, with drug companies frantically spending billions to prepare for an upcoming wave of patent expirations.

One attractive target is Genzyme (GENZ, Fortune 500), a $14 billion biotechnology firm that specializes in treatments for rare diseases, but which has recently been beset by manufacturing troubles that have hampered sales of two key drugs.

Activists like Carl Icahn have been putting pressure on management to right the ship, and though Genzyme has historically been an aggressive acquirer itself, potential suitors may take advantage of the current situation to run an offer up the flagpole.

A further twist: Two of Genzyme's most promising drugs should come on the market in 2012, right when patents will drop off dramatically in the industry. If Genzyme does not get bought, its shares are cheap enough that they should have plenty of upside. Morningstar analysts think Genzyme shares are about 30% below their fair value.

Dealmaking has also run rampant in the financial sector. Word on the street is that Barclays is on the prowl for a U.S. banking franchise to bolster its non-investment-banking businesses.

Various banks have been discussed as possible targets, but our research at Morningstar indicates that Barclays may be just as interested in buying a credit card company like Capital One (COF, Fortune 500) or Discover Financial Services (DFS, Fortune 500). Both would give Barclays -- the 11th-largest card issuer in the U.S. -- a great deal more scale in a business where scale really matters.

Of the two, Capital One would be a bigger deal, and it would bring strong retail and commercial banking operations in key regions to the table, courtesy of its acquisitions of Chevy Chase, Hibernia, and North Fork. Discover is significantly smaller than Capital One, but it has a global credit card network and key relationships with major card companies overseas such as China UnionPay and JCB in Japan.

Both stocks, though, are trading around a 40% discount to their fair value, according to Morningstar analysts. So there's plenty of cushion if neither is swiped by Barclays -- or any other suitor.