Small Caps Have a Target on Their Back
As the week draws to a close, there's palpable relief among market watchers. Through Thursday, all the major indexes are up over 1%. Small-caps stocks continue to lead the broader market, supported in large part by an expected pick up in acquisitions. As deals are expected to play such a large role in the small-cap space, I thought now might be a good time to talk about Mergers and Acquisitions (M&A).
I know that for many, the term M&A conjures up images of corporate raiders and liquidation sales. From movies like Wall Street to Tommy Boy, Hollywood is rife with examples of M&A evildoers and the plucky, independent businessmen who foil them.
If we take a step back from the silver-screen and one towards reality, M&A plays an extremely important role in the life cycle of corporations. At its best, M&A allows strong companies to grow more quickly than they could organically, incentivizes good management, and allows for cost-saving synergies. At its worst, M&A creates profits for bankers and problems for shareholders since share prices often fall upon news that a company has become an acquirer.
Lehman's collapse and the frozen credit markets threw a bucket of cold water on a red-hot mergers and acquisitions market of 2007. But the economic recovery and an increased number of publicly-traded companies signals a near-term return to the days of brisk M&A business.
And in a heavy M&A transaction environment, small-cap stocks are easy targets.
A few days ago I discussed how firms have loaded up on cash and shunned heavy debt loads. For those readers who missed the article, you can find it here. This cash on hand certainly makes them potential acquirers, but it also makes these small cap companies very attractive targets for acquisition.
When a company acquires another firm, it buys up the equity, but also takes on the acquired company's debt. So a small-cap firm with no debt goes from being a bargain to a steal.
***So where's the profit opportunity?
The great thing about playing the M&A market is that small-cap companies who get acquired are usually terrific firms. There are reasons they are targets, such as great revenue streams, cutting-edge proprietary technology or just an all around strong competitive market position. Investors that pick a well-run company with good fundamentals, in a sector known for consolidation, can yield short-term gains - and long term upside.
I recently added a small-cap Chinese coal mining outfit to my Small Cap Investor PRO portfolio. It benefits from China's insatiable demand for cheap energy, as well as the rapid consolidation of China's coal industry. For more information about this potential acquisition target, click here.
***I've said before that I'm bullish on tech. Well, I'm also bullish on tech mergers and acquisitions. The technology sector M&A play out a bit differently than in other sectors. In the tech space, fresh companies are always popping up with new devices, software and ways of doing business. It's the innovation center of our economy, and for companies to succeed, they need to keep innovating. Or buy up a company that is innovating.
In May I discussed a couple Israeli tech stocks. These companies are still on my radar, and I hope that they're on yours. Big hitters like Juniper and Cisco are increasingly feeling like outsiders as these new software companies' client lists grow. The large-caps want in on the game, and they'll pay big to make it happen. Buyers are sure to be enticed by these firms' small-market cap and low debt capital structure.
***I understand that there are a host of problems that accompany M&A. The revenue synergies touted by management rarely materialize, and cost synergies are usually only realized through lay-offs. Acquiring companies can see their share prices sink, as mergers inject a measure of uncertainty into the stock. Often, mergers merely result in CEO's and investment bankers becoming a few bucks richer.
But in the small-cap space, mergers can have some pretty sizable benefits. I mentioned the semiconductor testing company LTX-Credence (NASDAQ: LTXC) last Wednesday - and shares are up around 13 percent since.
LTX-Credence was formed by the merger of two smaller semiconductor testing firms, LTX and Credence. The name was a bit of a no-brainer. Management of the two companies realized that the players in their industry were consolidating, and survival meant joining forces. This has resulted in a sum greater than the parts scenario, as LTX-Credence is rapidly gaining market share in a competitive and growing industry.
***Whether you're investing in small-caps stocks on merger speculation or not, small-caps have a target on their backs. If you find a strong small company that is flush with cash, you can almost be sure it's already in some big player's crosshairs. That can be an added bonus for investors who are already have a position in the company if and when news of an acquisition hits the wires.
