Small Companies Ripe for the Pickin'

In last week's article, we looked at Business Week's annual Hot 100 feature on small, fast-growing companies. Reviewing the 1999 list, we discovered that only 11 of the companies featured managed to repeat as Hot 100 companies in the current issue. An equally weighted investment in all 11 of those companies would have produced a 54.8% return through June 15, 2001, versus a loss of 6.2% (excluding dividends) for the S&P 500 and a loss of 16% for the Nasdaq.

This week, I'll continue to share with you lessons from the Hot 100. While the 11 companies that repeated on the list two years later produced the best return, investors would have gotten a very good return from another sub-group of the 1999 Hot 100: those companies that were acquired. 

Interestingly, 17 of the 100 companies on the 1999 Hot 100 were acquired between May 31, 1999 and today. Let's think about that for a minute: It means that if you are primarily engaged in investing in small-cap growth stocks, you stand almost a one in five chance of having your company bought out within two years! 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.

In the case of these 17 companies, if you had put $1,000 dollars in each of them at the price quoted in the Hot 100 article (that's $17,000 total), and then gone to Madagascar or some other place and just returned on June 15, 2001, you'd find that your investment would have ballooned into $21,176.70. That's a 24.6% pre-tax return, once again well ahead of the Naz and the S&P 500 indexes. Actually, for most of those deals, investors would have received cash, which would have provided opportunity for additional interest income if it had been sitting in a money market account. So an investor would have done slightly better than the 24.6% mark noted above. Of course, capital gains taxes would have reduced the true profit, but you get the idea (I'll stop now).

Of the 17 acquisitions, 11 were purchased with cash. In the other six deals, investors would have received stock in the acquiring company. Which leads to an interesting question: When your company is acquired, should you sell and take the profit, or should you keep the shares of the acquiring company?  

The worst outcome among the acquisitions was for shareholders of International Network Services, which was acquired by Lucent Technologies (NYSE: LU) in August of 1999. INS shareholders received shares of Lucent in this transaction, which at the date of issuance were worth $63.58 per INS share. At the time, the deal represented a 63% return for investors who bought at the price of $39 quoted in the BW Hot 100 article -- and in only two months! If investors had sold right then, their $1,000 investment would have fetched $1,630, minus any capital gains taxes. Unfortunately, the poor souls who held on to the Lucent shares issued to them in the deal would have seen their investment lose about 86% of its value to $137.18 as of June 15, 2001.

On the other side of the coin, investors in Medco Research would have received 0.6757 shares of King Pharmaceuticals (NYSE: KG) when King bought Medco in February of 2000. Since the acquisition, King has been a worldbeater, up 60% since acquiring Medco. Medco Research investors would be sitting on $1,653 as of June 15, and would have saved themselves the capital gains taxes since they didn't sell their shares. 

Of course, as they say, hindsight is always 20/20. Here are my personal guidelines regarding what to do when your company gets acquired and you face the prospects of receiving stock in the acquiring company.

• Ask yourself this question: Would you have paid what the acquiring company did for your shares? If the answer is no, think about selling. Unless there are some real synergies that materialize from the deal, if you think the acquiring company overpaid, that's good for you and bad for the acquirer. 
• If you have no interest in learning about or following the new company's business, sell your shares.
• If, while researching the acquiring business, you find that you wouldn't buy their shares at the current market price, that's probably a good reason for selling.

In all the above cases, it's probably easier to sell after the deal is announced but before it's completed. It just makes things more complicated to wait to receive the new shares only to sell them. In most cases, the price of the acquired company's stock will have moved upward towards the acquisition price, although in many cases not all the way to the value specified in the acquisition. By selling, investors get most of the premium and don't have to worry what happens to the acquiring company's stock, or whether the deal will go through or not. 

As you can see, my bias is towards selling when one of my companies gets taken out. Getting shares in a company that I wouldn't buy of my own accord is like being on the receiving end of a random share generating machine that takes shares of companies I've researched and believe in and replaces them with shares of a company that I may not know and probably would not have purchased otherwise. It just seems intuitive to me that most of the time, I'd rather take my money off the table (preferably at a profit) and start again on my own terms.

That said, I'd consider keeping the shares in the acquiring business if:

• the company is interesting to me and is one that I wouldn't mind keeping up with
• the company meets my investing criteria and appears to be attractively priced
• the company paid a fair but not inflated price for the company that it's acquiring
• the acquisition is one that makes sense for both companies

That's about it for today! For those who wrote in to ask, let me give a final tally for the 1999 Business Week Hot 100 list. Best as I can figure, if you'd invested $1,000 in each of the 100 companies on June 1, 1999 (or at the "recent price" published in the article for those companies that I couldn't get historical data for), your investment would have turned into $112,530.70 by June 15, 2001. This doesn't include any dividends, assumes that you would have kept any shares issued to you in a buyout, and doesn't consider any reinvestment of the cash that you would have received in cash acquisitions.

That's a return of about 12.5% in two years, beats both the Nasdaq and S&P 500 indexes quite handily, and validates to some extent the approach of looking for small companies with above-average growth for investment. That being the case, I'll continue to make my annual purchase of Business Week's Hot 100 issue. Of course, we'll still be scanning the Foolish 8 list for great investment ideas -- one of which we profile every month in our new investing publication, The Motley Fool Select.