The stock rally we were able to take advantage of in 2009 is all but over. But that doesn’t mean you can’t make money on stocks in 2010.

In fact, there’s a simple way you can cash in overnight gains that could make your recent ones look pathetic. Today, I’m showing you exactly what to do…

The S&P 500 is extremely overpriced. If you look at the index’s trailing price-to-earnings ratio, you’ll see investors have pushed share prices past their fair value with no regard for historical precedent:

Based on the chart above, investors have lately been willing to pay upwards of 100 times earnings for a stock, which hasn’t happened in the last 80 years. This level of stock pumping can’t hold.

There are a number of triggers that could cause a second collapse, many of which I’ve articulated in recent articles. Today, however, I’m not going to continue bashing stocks. Instead I’m going to fill you in on how smart investors are going long this treacherous market…

Why M&A Activity Is the No. 1 Indicator for 2010

If you want to make serious overnight gains, there’s only one indicator you need to be watching: merger and acquisition activity.

You see, when M&A activity is up, there’s a better chance your small caps will be bought out. But when it’s down, finding overnight gains can be tough. In 2009, we saw 28% less M&A activity than the previous year. But that’s starting to change…

Last week, oil-giant Exxon Mobil Corp (NYSE: XOM) announced an agreement to buy XTO Energy Inc (NYSE: XTO), the leading U.S. natural gas producer. The $41 billion deal helped boost Q4 M&A activity to $636 billion, which is the highest level since the third quarter of 2008.

We also saw Enterprise Products Partners (NYSE: EPD) buy three liquefied natural gas pipeline systems from Chevron Corp (NYSE: CVX) early last week. (My Lifetime Income Report readers have been holding EPD since February, and are sitting on a 41.2% gain as I write.)

These are huge deals, but they point to a trend that’ll be important for small investors as well. Already, we’re seeing many small-caps participating in this M&A market…

Take MPS Group (NYSE: MPS), for instance. On October 19, after the bell, employment consulting group, Adecco SA (PINK: AHEXY), announced a deal to buy MPS for a significant premium. The next day, investors were able to bank 21.3% overnight.

Another recent small-cap deal was inked just last week that could have made you some serious overnight cash: Apollo Global Management announced a deal to buy Cedar Fair (NYSE: FUN) for a 26.7% premium to its share price.

If you’re thinking these overnight gains are too small to care about, I’ve got just the example for you. In fact, the Penny Sleuth even highlighted it as it was breaking a few weeks back.

La Jolla Pharmaceutical Co (NASDAQ: LJPC) penned a deal to sell to Adamis Pharmaceuticals Corp (OTCBB: ADMP) in early December. Take a look at how that worked out for LJPC shareholders and Sleuth readers who caught it on the Monday Watchlist:

From Friday, Dec. 4 to Tuesday Dec. 8, La Jolla’s Stock jumped from just 6 cents per share to 24 cents. That’s a four-day quadruple!

You can see similar results if you know where to look. And that’s exactly what I’m going to show you…

4 Buyout Candidates Ready to Explode

First, you need to find an industry susceptible to takeover deals. Today, we’re looking at two: pharmaceuticals and oil & gas producers.

Pharmaceutical companies have a history of buying up small biotechs for their product pipelines.

You see, it costs millions upon millions of dollars to develop a new drug. It also takes years to go through clinical trials and FDA approvals. That’s why Big Pharma companies, which have to answer to large investors demanding instant share appreciation, typically leave it in the hands of tiny biotechs.

To find buyout candidates, look to those with drugs in stage three clinical trials. Also, look at the specific drugs. If they are unique enough, and appeal to a massive population of patients, there’s a good chance a giant like Pfizer Inc (NYSE: PFE) or Merck & Co Inc (NYSE: MRK) is waiting in the wings.

Here are a couple you should check out before Big Pharma gets its hands on them:

• NeurogesX Inc (NASDAQ: NGSX) – somewhat mature biotech in the pain management industry. Its lead product, Qutenza, eases neuropathic pain. It already has two market approved products and another sitting in Phase 3 of clinical trials.

• Repligen Corp (NASDAQ: RGEN) – develops novel therapeutic products for neurological disorders. Like NeurogesX, Repligen has receives income from products already on the market. The buyout potential comes from its pipeline, which has one product in Phase 3, and another in Phase 2 clinical trials.

Along with biotechs, oil & gas producers offer significant buyout potential. Specifically, natural gas producers are in position to benefit from the recent M&A activity. I already highlighted the Exxon-XTO deal, which was centered on XTO’s massive natural gas resources in the U.S.

These are a couple small-caps that could do even better:

• Gulfport Energy Corp (NASDAQ: GPOR) – a major leaseholder and producer of Canadian Oil Sands and Bakken Shale natural gas. With Exxon’s purchase of “unconventional” gas resources recently, Gulfport is in a prime position for a takeover bid.

• Approach Resources Inc (NASDAQ: AREX) – another North American oil & gas producer, with over 211 billion cubic feet equivalent. This one also has some tight shale gas reserves that should attract big players like Exxon and Royal Dutch Shell plc (NYSE: RDS.A).

Of course, when you are looking into buyout candidates, you are truly speculating. These are never sure bets. But if M&A activity continues on the trend it’s on, these four are among the few worth looking into.

Sincerely,
Jim Nelson

December 23, 2009

Jim Nelson

Jim Nelson began his investing career during the tech boom at age 14 – with purchases of Starbucks and AOL. Early inspiration came from an old Tweedy Brown whitepaper: “What Works in the Market.” He graduated with a degree in Political Science from Pittsburgh University, Nelson focuses on income investing, including dividends, covered calls, and fixed-income. Additionally, he covers MLPs, ADRs, utilities, consumer staples and tobacco. Nelson is the managing editor of Lifetime Income Report.

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