Growth Through Acquisitions in Uncertain Times

Growth Through Acquisitions in Uncertain Times

"The global economy is entering into a new phase of uncertainty and danger...The risks of a global freezing up of capital markets as well as a global crisis similar to what happened in September 2008 are real."

- Justin Yifu Lin, Chief Economist at The World Bank, January 18, 2012

As measured by the Volatility Index (VIX), stock-market volatility was down dramatically over the past few months, even in the face of continued uncertainty surrounding the state of the global economy. January's European sovereign debt downgrades and a statement from The World Bank, which warned of a possible slump in global economic growth, were seemingly ignored by the equity markets as the small-cap Russell 2000 Index advanced 7.1% in the year's first month. From the most recent market low on October 3, 2011 through the end of January 2012, the small-cap index quietly gained 30.7%. Record excess corporate cash levels are perhaps the most telling sign of the uncertainty present in the current economic environment. However, we are continually struck by the way smaller companies continue to grow and operate in this ambiguous and anemic economic environment.

To be sure, a focus on strong capital allocation is vital. Properly understanding a company's capital allocation decisions is a key element in our investment process. This is especially true today, a period in which corporate balance sheets are generally in excellent condition and, in many cases, flush with cash. Yet with the economy gradually improving, the need for companies to hoard cash would seem to have passed. We continue to believe that the coming merger and acquisition cycle is going to be significant because corporations are likely to continue striving to find top-line growth. Strong firms are now in a position to buy, which makes small, well-managed companies look that much more enticing as targets.

Mergers and strategic acquisitions are part of the normal smaller company landscape, as larger companies acquire smaller companies to fuel future growth. This is especially true coming out of recessionary periods, and it is our contention that this time will be no different. Although the credit markets have eased considerably over the past year, credit is still not readily available, which suggests that, at least in the near-term, all-cash deals will be the norm. This should be supportive of small-cap valuations.

In a recent research report from Bank of America-Merrill Lynch, Steven DeSanctis points out that "last year we saw 99 deals in small caps for a total amount of $84 billion…almost 75% of the deals were all-cash transactions last year, which continues a recent trend, but this remains well above the long-term average of 42%. We also saw that 33% of the small-cap deals were privatizations, which is the highest percentage we have seen in our data."

It should also be noted that small-cap companies are joining their large-cap and mid-cap counterparts in making strategic acquisitions to bolster growth, as organic growth continues to be elusive. We expect this trend to continue and have often viewed the strategic consolidation of a particular industry or sector as a positive. To us, it is generally a good time to invest when the people closest to these businesses are investing.

Our goal as investors is to buy quality businesses that we believe represent unrecognized value. Understanding a company's capital allocation process and their ability to use the strength of their balance sheet to grow in these uncertain times is paramount to our process. Although we have always recognized the return potential of M&A and related activities, we are not in the business of buying companies because they look like potential acquisition targets. However, as long-term investors with a business buyer's approach, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when they are purchased at an attractively low price.

Stay tuned…
FDG