Stella and Bud would make a great couple. Or so the Belgium-based brewer InBev, maker of lager Stella Artois, believed in making its recent takeover bid for American brewer Anheuser-Busch, producer of Budweiser, the self-proclaimed King of Beers.

The $52-billion InBev/Anheuser-Busch combination demonstrates that even amid a major economic slowdown and a sharp decline in mergers and acquisitions in 2008, beautiful deals are still gleaming in the eyes of companies that have fortified balance sheets and are on the prowl for acquisitions. Why? Because in their eyes, combinations like InBev/Anheuser above all represent one thing: opportunity.

Specifically, struggling smaller competitors with strong fundamentals are now available at relatively discounted stock prices. And value investors in the right place at the right time can reap the benefits -- namely, the typical "pop" in a to-be-acquired company’s stock when a takeover is announced or the bargain share prices that result when a company is left at the M&A altar. By evaluating businesses the way acquirers do, according to three key criteria -- strong free cash flow, a reasonably healthy balance sheet, and a position in lucrative niche markets -- you can identify potential M&A targets that may prove winning investments.

As for the first criterion, a company’s free cash flow can be likened to the "fun money" that consumers have at the end of the month after paying all their bills; it allows for discretionary purchases like a new car, a home improvement, or a vacation. For companies, a lot of free cash flow means they can at their discretion pay down debt, increase dividends, make capital expenditures to grow the company, and buy back stock -- actions that enhance shareholder value. That’s why billionaire investor Warren Buffett calls free cash flow "owner’s cash."  And we call it the best standard by which to measure a company’s profitability.

Second, a clean balance sheet is an acquirer’s (and a value investor’s) best friend, in our view. A balance sheet containing a decent amount of cash and cash equivalents and low long-term debt is particularly appealing in a potential acquisition. Together, high cash levels and low debt help a company to weather tough markets and remain more competitive than companies that are highly leveraged, in our view.

New markets, new customers

Third, companies that compete in good market niches are extremely attractive to acquirers seeking to expand their menu of products or services without having to invest the time and money to create those products and services from scratch. For acquirers, new niche markets serve to open the door to new customers and new sources of revenue and profits.

Consider how these three criteria apply to a couple of current M&A ventures:

Video-game maker Electronic Arts (market capitalization: about $15 billion) is seeking to buy smaller rival Take-Two Interactive (market capitalization: about $2 billion). Electronic Arts initiated a $2 billion cash offer in February to capitalize on the potential of Take-Two’s library of games -- most notably its hugely popular Grand Theft Auto series, whose latest installment shattered industry records by generating more than $500 million in sales.

Since Electronic Arts is known mostly for its sports games, this acquisition could help the company reach fans of the urban, gritty action games that Take-Two has pioneered. What’s more, Take-Two boasts a clean balance sheet, with only $16 million in long-term debt -- peanuts in comparison to its market capitalization.  And the company’s free-cash-flow yield is 8%, one of the highest in the industry. Armed with that knowledge, Electronic Arts made its offer, and Take-Two’s stock price shot up from about $15 per share to more than $23, where it remains to date.

A "meeting of the mines"

International mining company Cleveland-Cliffs (market capitalization: about $10 billion) and coal company Alpha Natural Resources (about $7 billion) announced a definitive merger agreement in mid-July. Cleveland-Cliffs, North America’s largest producer of iron-ore pellets, saw obvious synergies in hitching up with Alpha, North America’s largest producer of metallurgical coal. Both iron ore and metallurgical coal are vital to steel manufacturing and in tight supply, which has driven their prices dramatically higher over the past year.

This strategic "meeting of the mines" will create one of the largest U.S. mining companies and a major supplier to the global steel industry. You can be sure that Cleveland-Cliffs liked Alpha’s balance sheet, bearing only $249 million in long-term debt, which is low in comparison to Alpha’s market capitalization. Alpha’s free cash flow yield is also compelling. If you do the math based on the company’s own 2008 earnings estimates, it would equate to a 6% free-cash-flow yield (which is very good in its own right).  However, if you use 2009 earnings estimates, the yield rises to a whopping 20%. As we see it, that huge jump in yield is one reason why Cleveland-Cliffs wants to align itself with Alpha. When the merger offer was announced, Alpha’s stock price climbed from about $92 per share to more than $106.

At the time of this writing, both the Electronic Arts/Take-Two Interactive and Cleveland-Cliffs/Alpha Natural Resources deals were still awaiting final approval from shareholders. Should the deals collapse, both Take-Two’s and Alpha’s stock prices are likely to drop, as often happens in such cases. In our experience, that may lead to additional investment opportunities, as the companies’ shares could end up trading at discounts to their intrinsic value. After all, Take-Two and Alpha had all the Right Stuff to attract suitors in the first place.  And if their share valuations are beaten down in the aftermath of an unconsummated deal, their strong fundamentals still remain intact.

Barring any significant changes to the current economic environment, we expect in the coming months to continue to see fewer multi-billion-dollar private equity buyouts and more strategic mergers and acquisitions like Electronic Arts/Take-Two Interactive and Cleveland-Cliffs/Alpha Natural Resources. We think U.S. acquisition targets should look especially good to foreign companies in light of the weak U.S. dollar. In our judgment, companies most likely to be acquisition targets include smaller oil and chemical companies, insurance companies, retailers, and restaurant chains.

In sum, the current market conditions are ripe for mergers and acquisitions, launched by companies with the means and the desire to grow. By evaluating potential buyout targets the way acquirers do -- by looking at free cash flow, the balance sheet, and market niches -- you’re more likely to find yourself in the front row at the next Stella and Bud wedding.