Earlier this week, I looked at a range of commodity stocks that look quite attractive in relation to the value of their assets.

I focused on Freeport McMoran (NYSE: FCX) as a clear example of a stock that looks quite appealing in the context of its balance sheet, if not its income statement.

Yet other investors are focusing on Freeport McMoran for an entirely different reason. A recent article on Bloomberg.com suggested that a major mining firm such as Rio Tinto (NYSE: RIO) could take advantage of share-price weakness and make a move to acquire the copper and gold miner.

The article quickly reminded me of a lesson I learned from a mentor nearly 20 years ago: “Never ever pursue a stock simply on the basis of a buyout rumor.” He correctly noted that few rumored deals actually come to pass.

Since then, I’ve added my own addendum to his dictum: If a stock is reasonably-priced or downright inexpensive — even after buyout rumors have circulated — then you could look at the potential deal as another catalyst for the stock.

In that context, Freeport McMoran is already quite attractive on its own merits, and a bid from Rio or BHP Billiton (NYSE: BHP) would just get you to your eventual target price that much more quickly. The fact that Freeport McMoran’s stock has risen only modestly since the story ran only reinforces the notion that you are not chasing someone else’s “pump-and-dump” scheme.

Of course, there are many examples where investors foolishly chase a stock ever higher on buyout rumors, only to get burned when those rumors die down. This happened recently with drugstore chain Rite-Aid (NYSE: RAD). Shares moved up from a $1 to $1.50 this past winter on improving results. To most analysts, $1.50 looked like fair value. So when the stock shot past $2 on buyout rumors, the stock suddenly became very risky. Indeed, that kind of move often means it’s a good time to sell.

 
Right now, the rumor mill is churning with talk of a merger between Kroger (NYSE: KR) and Safeway (NYSE: SWY). Analysts at BMO took a deep look at the logic behind such rumors, and came away impressed. Their key conclusion: the combined entity would reap considerable synergies, so a deal could be priced that provides 30% to 40% upside for shareholders of both grocers. (Kroger would likely be the surviving entity, so Safeway’s upside would come sooner and Kroger’s would come later.) The buying power that a combined platform could muster with suppliers would finally match up with the purchasing strength that has propelled Wal-Mart (NYSE: WMT) to overpower the grocery space.

More to the point, if the merger doesn’t happen, then both of these stocks still look reasonably valued on a standalone basis. Each stock trades for less than 10 times projected 2013 profits. This isn’t an endorsement of these stocks, but a framework through which you can look at them.

Yet investors should note that Safeway reports earnings on Thursday, April 26, and the results are likely to be mediocre at best due to some near-term headwinds. It may pay to wait until after the news is digested to play the merger and acquisition (M&A) angle on this stock.

All that cash — looking for a home
Frankly, it’s fairly surprising how little buyout activity we’ve seen in recent quarters. The ever-rising cash balances at many companies, the low cost of borrowing and the need to find growth opportunities in this tepid economy should be fueling a furious bout of deal-making. Private-equity firms, with more than $400 billion in cash could also be looking at breaking out their checkbooks, according to Goldman Sachs. Though it hasn’t been much in evidence yet, I remain convinced that robust M&A activity will turn out to be one of the key investing themes when 2012 comes to a close.

So what other companies could be in play? Well, the key is to focus on companies that are already so cheap based on their current cash flow, that they would both appeal to potential acquirers and have solid downside support in terms of valuation — in case a deal never happened.

In play yet again — but this time, with downside support
Unfortunately, this means companies that are deeply out of favor should be the focus. Take Radio Shack (NYSE: RSH) as an example. Its stock has slumped from $20 in late 2010 to a recent $6 on a string of weak quarterly results. Indeed, you can probably assume that the electronics retailer will disappoint investors yet again when quarterly results are released this Tuesday, April 24.

But here’s the rub: this stock has fallen so sharp, that a financial or strategic buyer could offer a 50% premium and still pay a low price for this company. RadioShack has generated an average of $150 million in annual free cash flow — on average — during the past eight years. The company is now valued at just $600 million, and its fairly strong balance sheet (with $592 million in gross cash) is precisely the kind of weapon that private-equity firms like to target.

RadioShack was the subject of buyout rumors when its stock was at $20 — and investors got burned. Now, with shares off 70%, those rumors are back, though this time the downside risk in the stock seems much lower. Again, it’s foolish to own a stock like this in hopes of a buyout, but the dowdy valuation means it’s already a bargain on the fundamentals.

Could this be the next big energy deal?
Investors may also seek continued M&A in the energy sector, especially as natural gas-focused firms are short of funds to exploit their assets. As an example, Chesapeake Energy (NYSE: CHK) is scrambling to raise cash to meet its 2012 capital spending plans, and fears of balance sheet troubles have pushed this stock below $20 for the first time since 2009. (Behind-the-scenes dealings by CEO Aubrey McClendon that have raised conflict-of-interest concerns have also pressured shares.)

Chesapeake is now worth less than $12 billion. Note that Exxon Mobil (NYSE: XOM) paid more than $40 billion to acquire XTO Energy in 2010, and Chesapeake’s current energy assets are even more extensive than XTO’s were. To be sure, natural gas prices are now much lower, but strategic investors such as ExxonMobil know this won’t last and may well conclude that Chesapeake is too much of a bargain to pass up.

Risks to Consider: Companies such as RadioShack, Chesapeake Energy, Best Buy (NYSE: BBY), Nokia (NYSE: NOK) and many others have made a series of missteps to find themselves in the bargain bin, and further missteps can’t be ruled out. That’s why you must stress-test a company in terms of its downside support.

Action to Take –> It’s wisest to focus on quality companies that are simply out of favor such as Freeport McMoran, Kroger or RadioShack. If you hear of buyout rumors, go straight to the financial statements to be sure that these companies have the assets or the cash flow to support the stock, even if buyout rumors evaporate.