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Breathe Right nasal-strip manufacturer CNS (Nasdaq: CNXS  ) announced that it had agreed to be acquired by GlaxoSmithKline (NYSE: GSK  ) for $37.50 a share in cash (or $566 million) -- 31% higher than Friday's closing price. CNS closed yesterday well below $37, leaving some room to shoot even higher before the deal closes early next year.

The power of small caps
We write often about the incredible power of small caps. Indeed, the 10 best-performing stocks of the past decade all started out as small caps. This makes sense, of course -- small companies have more room to run than larger companies. But that list fails to include a whole different kind of successful investment: the promising little company that gets swallowed up, either by a larger competitor (as in this case) or by private investors.

As my former Fool colleague and current hedge-fund manager Zeke Ashton wrote, "This is one of the great advantages of small-cap investing. If Mr. Market is unwilling to recognize the intrinsic value of a small company for some reason, other companies may be willing to step up to the plate and purchase it."

He's right. But it's not just other companies that are willing to step up to the plate. Sometimes it's private investors, and sometimes it's the management itself. If you know how to find companies whose elements would make them attractive to outside buyers, you can generate massive gains.

Big fish, small pond
CNS is a perfect example. It was recommended in our Motley Fool Hidden Gems service back in September 2003, when it was capitalized at just $170 million. Even then, our analyst recognized that this small company was a likely target for a larger suitor. From the buy report:

[Fool co-founder] Tom Gardner: Do you expect CNS to be acquired in the next few years?

[Guest analyst] Matt Richey: I like the odds. CNS is a great franchise at a great price. A larger consumer health-care company could quickly turn Breathe Right into a much more prominent national brand. As for potential acquirers, one candidate is Church & Dwight (NYSE: CHD  ) , maker of Arm & Hammer baking soda, Arrid deodorant, and Trojan condoms. The company has a history of acquisitions and is the right size at a market cap of $1.3 billion. All that said, CNS appears content to go it alone. The important thing is, with or without a takeover premium, CNS investors stand to do well.

Matt was right, even if he didn't get the right company. Interestingly, Church & Dwight has been acquisitive of products and companies like CNS, as has another personal products company, Chattem (Nasdaq: CHTT  ) . Since its recommendation, CNS has returned 230%-plus for Motley Fool Hidden Gems subscribers, so we'll forgive Matt for not predicting the correct buyer. The important things to note are that (1) he got the thesis right, and (2) the stock performed extremely well even before the buyout came to be.

Why was CNS a buyout candidate? There are many reasons, including its top-flight managers, its cash-rich balance sheet, and the long-term value of its product roster. A buyout candidate needn't have all three, of course, but it certainly helps.

Consider Fairmont Hotels, a Canadian hotelier that I recommended in Hidden Gems in June 2005 on the basis of its strong balance sheet and undervalued properties. By the end of last year, famed activist investor Carl Icahn had taken a run at the company, and it eventually agreed to be bought out by a consortium.

I saw what these well-heeled investors came to see, that Fairmont's gold-plated facilities were being undervalued by the market, which was focused on short-term struggles. CNS was no different. CNS has a product that dominates its market, but its management, capable though it is, struggled to diversify its product offerings.

Before the buyout agreement, we had a huge gain on our scorecard, but I chose not to sell. Why? Because either CNS was going to continue to return excellent cash results to investors, or it was going to combine with another company in one way or another. We didn't know about this merger, but we were prepared for it.

Think small
Mergers don't always take place on great terms for shareholders. I was extremely displeased that our gains on Fairmont were limited to 40% by the takeover, and we similarly feel that the Shire (Nasdaq: SHPGY  ) acquisition of Transkaryotic Therapies and the Morgan Stanley (NYSE: MS  ) takeover of TransMontaigne deprived outside shareholders of a great deal of future value. Nonetheless, we continue to seek out these kinds of situations. It's all part of the power of small-cap companies -- often, they're the minnows that big fish seek out to make themselves grow.

Bill Mann is the co-advisor of Motley Fool Hidden Gems. A free trial gives you access to the lineup of small-cap companies that are outperforming the broader market by more than 19 percentage points. Click here to get started.

This article was originally published on October 10, 2006.

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At the time of publication, Bill owned none of the companies mentioned in this article. GlaxoSmithKline is an Income Investor recommendation. The Fool has a disclosure policy.

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