Even though the private equity craze has settled down recently, there has still been more than $3.5 trillion worth of merger activity this year.
Despite the drying up of the cheap credit that private equity firms largely used to purchase companies over the past few years, analysts expect good ol' stock-swap mergers to set the buyout trend going forward.
C'mon, big money!
If stock-swap mergers do indeed become popular on the Street, you'll undoubtedly see a lot of industry consolidation activity, like we're seeing in MetroPCS's
Shareholders of the acquired company typically receive some nice premiums, and this has been particularly true of this year's buyouts. For instance, Wild Oats shareholders received a 20% premium on their shares from the Whole Foods
Sounds great, right?
Hey, no one's going to complain about a quick double-digit 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 Frontier Oil
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 13% 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 Royce's three precepts:
- Focus on small companies.
- Employ a fundamentally driven, business-buyer's approach to small-cap investing.
- Plan on holding for five to 10 years, if not longer.
And mix those with three teachings from Motley Fool Hidden Gems, where Tom Gardner and Bill Mann have had eight companies from their scorecard acquired:
- Hunt for cash-rich balance sheets.
- Look for top-flight managers (who preferably have an ownership stake in the company).
- Buy businesses with a wide market opportunity or a valuable product roster.
We employ these principles at Motley Fool Hidden Gems with good results thus far: Our picks are beating the market by 32 percentage points since our inception four years ago. If you'd like to see the companies we've selected for subscribers, a trial is free for 30 days. Simply follow this link to get started.
This article was originally published on June 12, 2007. It has been updated.
Fool contributor Todd Wenning is firmly convinced that Guitar Hero is the greatest video game ever made. He does not own shares of any company mentioned. Royce Premier is a Champion Funds selection. Whole Foods is a Stock Advisor recommendation. Johnson & Johnson is an Income Investor pick. The Fool's disclosure policy is never for sale.