Profit by Being Ahead of This Cycle

In a recent interview with Barron’s, Roger Vogel of Silvercrest Asset Management described one of his strategies as “catching lightning” – a strategy that is compelling him to add names to his small-cap portfolios. You may well be thinking, who is Roger Vogel? A fair question – I’d never heard of him myself until I read the interview. Instead of trotting out credentials, though, let’s focus on the rationale for his strategy; the logic is impeccable, and it highlights the opportunity investors are overlooking in this segment of the market.

Back to basics
Let’s start with some basics: What does the stock market reward? Earnings growth. How does a company achieve earnings growth? Broadly speaking, there are two ways:

• Option 1: Build it. The firm expands its activity by investing in growth internally.

The rub here is that, at an aggregate level, internal growth depends on growth in the economy. Unless the firm expects to take market share from its competitors, the ability to add capacity is capped by growth in the company’s market, which depends, in turn, on advances in overall economic activity. That’s a big drawback in an economy that is still reeling from the worst financial crisis since the Great Depression. Ruling out organic growth leaves companies with:

• Option 2: Buy it. The firm expands its activity through acquisitions.

When companies buy growth by acquiring companies in their sector (“strategic M&A” in banker’s lingo), there is no requirement for a booming economy: The idea is simply to buy market share (if the sector is growing, all the better, but it isn’t necessary).

Earning a 30% to 40% premium
Let’s recap: Companies are struggling to produce organic growth in a sluggish economy. Factor in healthy corporate balance sheets and you have the catalysts for what Vogel expects will be “a very big merger-and-acquisition cycle, mostly focused on small-cap companies.” In order to profit from that trend, Vogel has increased the number of stocks in his small-cap portfolios, “to give us a greater chance of maybe catching lightning for one of these transactions, which typically get a 30% or 40% premium.”

He’s quite right concerning the premium. I gathered data on 666 strategic acquisitions of small-cap companies – an ominous number, admittedly -- and found that the value-weighted average premium with respect to the target company’s stock price one week prior to the announcement is 33.8%. In some individual deals, the premium was quite a bit larger than that:

Source: Capital IQ, a division of Standard & Poor’s.

Does this mean that investors can make money by “owning” the small-cap sector indiscriminately, i.e. by investing in an index fund such as iShares Russell 2000 Index ETF (NYSE: IWM)? My answer to that is, emphatically, no! A small-cap indexing strategy isn’t a good choice right now. Asset allocation expert GMO expects small caps as a group to produce after-inflation annualized returns of just 1 percent a year over the next seven years, less than large-cap stocks and barely ahead of inflation.

Indexing -- no, individual stocks -- yes
But not all small-cap stocks will earn the average return, and selecting those that will earn premium returns depends crucially on the ability to spot undervaluation. Certainly, there are a good number of small caps currently trading at a lower multiple than the median multiple of 13.4 for the set of acquisitions I referred to earlier. They include:

Source: Capital IQ, a division of Standard & Poor’s. *Enterprise Value-to-EBITDA multiple compares the firm’s equity value plus net debt to EBITDA, a measure of cash flow; it’s a commonly used valuation measure in the context of acquisitions.

All other things being equal, investors are at an advantage when they look at small caps, as opposed to mid- and large-cap stocks, because the former are relatively underfollowed; the small-cap segment is less efficient and individual stocks more likely to be undervalued. However, in order to compound, rather than squander, that advantage, you need to focus on identifying individual small caps that offer the greatest upside: high-quality companies that are on sale at attractive prices.

Helping you "catch lightning"
That is exactly what the analysts at Motley Fool Hidden Gems spend nearly all of their time on, along with monitoring the stocks they already own in the real-money Hidden Gems portfolio. If you’d like to start building a portfolio of high-quality small-cap names, there is no better place to start than Hidden Gems’ 10 Buy First stocks; to get access to those stocks (and all other picks), sign up for a 30-day free trial today and get a head start on corporate acquirers.

Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. The Motley Fool has a disclosure policy. Try any of our Foolish newsletters today, free for 30 days.