Two trillion dollars worth of merger activity has been announced so far this year -- and it's June.

With all the mergers going on, investors are no doubt wondering if their stocks will soon be acquired for a nice premium.

C'mon, big money!
Recent merger mania seems to be focused on two major trends: industry consolidation, with larger firms like Microsoft (NASDAQ:MSFT) adding the smaller aQuantive (NASDAQ:AQNT), and private equity buyouts along the lines of Silver Lake Partners and TPG Capital's recent bid for Avaya (NYSE:AV).

Shareholders of the acquired company typically receive some nice premiums, particularly of late. In an extreme example, aQuantive shares shot up nearly 80% in one day when the Microsoft deal was announced. WebEx investors received a 22% premium from Cisco (NASDAQ:CSCO). Alliance Data Systems (NYSE:ADS) shares have jumped 23% since a buyout offer from Blackstone Group was announced in May.

Sounds great, right?
Hey, no one's going to complain about a quick 23% gain, but for small-cap investors there may be a dark cloud over many of these deals.

Because small caps have huge growth potential, a public or private buyout may cut off what could have been a portfolio- (and perhaps life-) changing stock.

Consider: What if Ultra Petroleum (AMEX:UPL) or Tesoro (NYSE:TSO) -- both of which were small caps in 2002 -- were plucked by private equity back in June 2002 for a small premium? What may have been a good deal at the time would have stripped investors of the subsequent 1,436% and 1,660% returns, respectively, that these companies have since posted.

Chuck Royce, manager of the Royce Premier Fund (RYPRX), summed up this sentiment nicely in a recent interview:

If a company is taken private at a 15% to 20% premium, it looks like a great short-term benefit. But it gives pause to small-cap investors like us, who employ a fundamentally driven, business-buyer's approach and often own companies for five to 10 years, if not longer.

Wise words from the man who has steered the Royce Premier Fund to 14% annualized returns over the past decade.

Between a rock and a hard place
Private equity buyouts and mergers are an integral part of small-cap investing, and let's face it, the next small-cap buyout is coming soon -- big money is finding a ton of value in small companies. But that doesn't mean you should go out and try to pick the next buyout. 

As a small-cap investor, all you can do is continue to look for financially stable, well-run companies. If you can find value in promising small caps, a buyout would just prove your thesis right. As for where to look, follow Chuck Royce's three precepts:

  1. Focus on small companies.
  2. Employ a fundamentally driven, business-buyer's approach to small-cap investing.
  3. Plan on holding for five to 10 years, if not longer.

And mix those with three learnings from Motley Fool Hidden Gems, where Tom Gardner and Bill Mann have had seven companies from their scorecard acquired (and two more in the process of being acquired):

  1. Hunt for cash-rich balance sheets.
  2. Look for top-flight managers (who preferably have an ownership stake in the company).
  3. Buy businesses with a wide market opportunity or a valuable product roster.

We employ these principles at Hidden Gems with good results thus far: Our picks are beating the market by 35 percentage points since our July 2003 inception. If you'd like to see the companies we've selected for subscribers, a trial is free for 30 days. Simply follow this link for more information.

Todd Wenning is firmly convinced that Guitar Hero is the greatest video game ever made. He does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value pick. aQuantive is a Rule Breakers choice. Royce Premier is a Champion Funds selection. The Fool's disclosure policy is never for sale.