My Yahoo!Pro Forum: Satya Pradhuman, Small-Cap Analyst
NEW YORK - Small-cap stocks have outperformed large-caps so far this year, and the trend may continue, due in part to increased merger-and-acquisition activity. Merrill Lynch small-caps analyst Satya Pradhuman says M&A activity is boosting small-caps because they are temptingly cheap, relative to these firms' potential buyers. Investors who buy small stocks now may reap a premium later this year if these companies get snapped up.
Forbes.com: Why are small stocks still so undervalued as a group? Did the great bull run of the 1990s create an unusually wide valuation gap between large- and small-caps?
Pradhuman: What went on from 1994 to 1998 is that we were in a very large-cap-centric world. As a result, a lot of smaller firms saw their valuations shrink dramatically, their multiples collapse. And I think that's really what's created this opportunity, and that's why we're likely to see it (continue).
When did M&A activity among small caps begin to pick up?
If you look at the levels of consolidation we've been seeing in the U.S. over the last ten or so years, you're going to find the last two or three years to be abnormal. In 1999, over 200 small-cap firms were bought. In fact, if you look to micro-cap stocks, with market caps under roughly $200 million, I think we've had three years in a row where we've seen at least 300 companies being bought out. And if you go back a decade or so, the numbers were in the 40s or 50s. So we're seeing radically higher levels of consolidation, and it gets back to this idea of valuation discrepancy.
Why does the valuation gap boost M&A activity?
Large companies are always looking for good smaller businesses to bring in so they can grow their bottom line. Why I think it's timely is that the valuation gap that's been created over the last few years is severe. That means that larger firms are finding it much easier to acquire the smaller firms. If a large firm is looking to grow, and if you do the math in terms of building from scratch or buying, it basically says you buy today rather than build from scratch.
What about buyout firms? Will they get more attention from investors now that the IPO market is in the doldrums?
Yes. In the world of private equity, there really are two components--there's the classic venture-capital type of play and there's the buyout play. And until March of last year, the buyout funds did not get the shelf space. Everybody wanted to do venture capital. And our point is that if Nasdaq multiples slide the way they have, then the easy money for venture capital is behind. As a result, we think that the buyout firms may get a second look. So they are able to more easily raise capital and put it to work, because the math makes sense.
How do these buyout firms operate?
The classic sort of buyout activity is to look for good companies with free cash flow, low levels of leverage and just a solid franchise. You get those things and if the discount cash flows are much higher than the current equity value, you buy the company. To some extent, that's something that is likely to occur here, especially with the Fed easing.
Which small-cap sectors are benefiting most from the M&A boom?
What we have seen thus far is a fairly broad smattering of groups. We've had consumer cyclicals, some of the retailing issues and also a number of health care deals have been done. Up until March of last year, a lot of technology deals were being done, and energy and financials. It's a very broad smattering.
Do you see M&A activity continuing to pick up among small-caps as the year unfolds?
Our bet is that most of this continues because the value gap across these sectors is still quite compelling.
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