Small Caps Benefiting From M&A Activity

by: Alan Brochstein, CFA

Nothing makes my day like a 30% premium acquisition bid. Earlier this year, I suggested that the environment was ripe for mergers and acquisitions for smaller companies, citing record high cash balances and a challenging top-line environment. It's one of the reasons why the Russell 2000 is up 6% more than the S&P 500 so far this year. Activity has been torrid lately, and investors in the Top 20 Model Porfolio have seen lightning strike twice in recent months ():

Smts cybs

First, 6 days before Cybersource (CYBS) received a bid in April from Visa (NYSE:V), we established an initial position. This week, Somanetics (SMTS-OLD) received a bid from Covidien (COV), almost a year after we established our initial position (though we added some as recently as April). CYBS happened too fast for me to share the idea with my followers on Seeking Alpha, but I profiled SMTS last year in depth and followed up in October by highlighting it as a candidate for potential acquisition.

Maybe I actually have a talent at this, as I often chuckle about my first Seeking Alpha article in February 2007 on Color Kinetics, an LED company. In that article, I ended with a suggestion that they might be acquired, and they were four months later. A day before that acquisition, I profiled Healthcare company Optioncare, and Walgreens (WAG) bought them just three weeks later. Am I a magician? Hardly. I never invest with acquisition as the primary investment thesis, but I do spend a lot of time thinking about strategic fit. I like to invest in good companies that can grow without being stomped by bigger companies. In the case of CYBS, it was clear to me that they dominated an adjacent space in the e-commerce transaction enabling industry. In the case of SMTS, it was clear to me that they had essentially a monopoly. The case for COV to buy that monopoly was obvious, as it was adjacent to other things that they do with the same hospital customers. It didn't hurt that they were the European distributor too.

For those of you who follow my work, you know that I am very process oriented, using my screens, checking my technicals, constantly revising my targets, etc. Unfortunately, trying to pick companies that might be acquired is more of an art than a science. With that said, I recommend focusing on Healthcare, Technology and Industrials as the areas most likely to generate opportunities. Cash balances are very high in each of those areas - the currency is there. Each of them has challenges in top-line growth that can be addressed through strategic acquisition. On the target side, it's not always about being so extremely cheap. Both CYBS and SMTS traded at a premium PE to the market, but they were both growing very strongly and were cheap to where they should trade. Clearly, though, the buyers weren't looking at the bargain racks - they were interested in finding unique franchises at a reasonable price.

So, of our current 20 holdings, which ones do I think have the highest likelihood of being acquired? First, I would go with Synovis Life Technologies (NASDAQ:SYNO). I profiled it late last year, and I continue to like the story. The underlying business is very strong, and they have a toe-hold into an area that doubles their addressable market. Unfortunately, their success is masked by the cost of their new OWC division (formerly Pegasus). Second, I would go with Haynes International (NASDAQ:HAYN), which I mentioned in a portfolio strategy piece earlier this year. I believe that they have unique assets and that they are potentially interesting to several companies that are in the same general business but not directly competing (at least not on all products), including Allegheny Technology (NYSE:ATI), Carpenter Technologies (NYSE:CRS) and Titanium Metals (TIE). They have a contractual relationship already with TIE. Finally, I will throw out Ceradyne (CRDN), where I believe that the company has strategic fit with several larger global ceramics companies who could better employ their leading technology and innovation.

Disclosure: Long CRDN, HAYN and SYNO in the Top 20 Model Portfolio