Our Top 3 Small-Cap Takeout Targets

As part of an ongoing series examining potential returns from Motley Fool Hidden Gems, I've already detailed our co-founder Tom Gardner's 5 Best Watchlist Stocks, as well as his five worst, and the top performing watchlist stocks from the rest of the team. This week, I turn my attention to the top takeout targets from our pool of official recommendations and real-money holdings.

This article runs a bit longer than the last few did, but please bear with me as I run through some of the dizzying action from the past few weeks and try to explain why we've been successful in finding companies that have ended up on the receiving end of big bids. At the end, I'll highlight a trio of small-cap stocks that I think offer prime buyout bait to prospective acquirers over the next few months.

More M&A than you can shake a stick at
It's been a heck of a couple of weeks for us. While deal-making in general is reported to be on the rise, lately, our Hidden Gems seem to be drawing bids at the rate of nearly one a week.

• On April 19, longtime Hidden Gem Blackboard (Nasdaq: BBBB) revealed that it had hired investment bankers to review unsolicited acquisition offers, driving the stock up almost 30%. (Little else is known about this potential deal.)
• On May 2, French brand conglomerate PPR announced it would be acquiring board-sports apparel maker Volcom for $24.50 in cash, moving that stock up almost 25%.
• On May 4, a small contract research organization that Hidden Gems holds, Kendle International, announced that it was being acquired by privately held INC Research for $15.25 per share in cash. The news resulted in a more than 55% one-day gain for the stock.
• This one doesn't officially count, because I removed the stock from our recommendation list a while ago, but throw it into the mix: Former Hidden Gem LoopNet agreed to be acquired by one-time hated rival CoStar Group on April 27, moving LoopNet stock up about 30%.

More than an active month
That's only the most recent acquisition activity. Since January 2010, at least nine active Hidden Gems companies have been acquired or (in the case of Blackboard) received offers still pending. The following table shows the potential returns from each of these recommendations. (Some stocks were recommended more than once.)

Returns calculated using dividend-adjusted closing prices from date of Hidden Gems issue until real-money sale or sell recommendation or (*not yet sold) recent pricing. Pricing information from Capital IQ, a division of Standard & Poor's.

Real-money returns
Prospective returns are nice, but cold, hard cash is even better. We've had the good fortune to make real money on many of these same deals, as detailed below:

Returns calculated using dividend-adjust closing prices from actual prices or (*not yet sold) recent pricing. Pricing information from Capital IQ, a division of Standard & Poor's.

Buying what Mr. Market won't
While the pace has been surprising, there's nothing outlandish about these offers, because many of the same characteristics that make a Hidden Gem company attractive to us make it doubly attractive to larger companies and private equity. When we're looking for Hidden Gems, we concentrate on finding companies with the following characteristics:

• Small: We're looking for market capitalizations roughly in the $200 million to $2.5 billion range. The small size tends to limit institutional ownership to a degree, and coincidentally, it means that deep-pocketed peers, competitors, or private-equity buyers have no trouble buying the entire business.
• Big insider ownership: When we can get them, we prefer companies with founders in key leadership roles, holding large equity stakes. That aligns their interests more directly with ours. It also means that acquirers clearing their offers with those big stakeholders have a higher chance of successfully convincing the rest of the shareholder base to sell.
• Enviable economic advantages: We generally try to find companies with strong brands or other competitive advantages, such as de facto monopolies. When we can't get those, we look for companies that can generate strong cash flows despite competitive pressures, even if they're not currently generating that cash. We're willing to pay for potential, just as acquirers are.
• Misunderstood, unloved, or otherwise unwanted: Our favorite stocks are those that the rest of the market actively dislikes or underestimates. That means we hold a mixture of dirty value stocks: something like turnaround candidate SUPERVALU (NYSE: SVU) before the more recent bullishness, or oft-shunned grower Atheros, which was spurned by the market for months, even though it was clear that it would benefit from a huge and growing long-term demand for wireless networking chips in everything from desktops to phones and tablet computers.
• Cheap: This gets back to the point directly above. We love what Wall Street hates, misunderstands, or merely ignores, because that is the situation most likely to result in good prices. Acquiring minds want the same thing. The bigger the discount to potential future value, the more attractive the takeout candidate.

Why does this work?
I don't want to belittle all the brain-straining work that claims markets are efficient. Finance professors need to eat, too, just like all those investors who continue to do what they shouldn't be able to do if theory mirrored reality. Let me just say that while markets tend toward efficiency, I think there are plenty of pockets of inefficiency for individual investors to mine for returns.

Markets tend to get things right eventually, but companies, like pop stars, fall out of favor and are written off. The "why" can be a real operation stumble, like SUPERVALU's overleveraged acquisition spree. Or, it can just be sloth, like the lazy conclusion we heard on Atheros for so many months, "PC sales aren't growing." Sometimes, these stocks are gone for good, Dexys Midnight Runners-style, but often, there's a big comeback a la Aerosmith.

When a company's stock price languishes long enough below the firm's intrinsic or potential value, eventually someone comes along looking to pick up the bargain. Nowadays, corporate balance sheets remain bloated with record cash hoards, and buyout-inclined firms are desperate for ways to make decent returns on capital in a time when yields on safe investments offer next to nothing.

Finally, remember that acquirers often have a couple of built-in advantages over the rest of us. They get something that outside shareholders don't: control and potential synergies. I cringe at that buzzword, too, and to be honest, a great many acquisitions never deliver the promised cost savings, accretive revenues, or other business enhancements that are used to justify the buyouts. However, many do, or at least have the potential to deliver, which is one of the big reasons a company can be worth a lot more to a big buyer than it is to the holders of the stand-alone company. It made sense to us when Qualcomm (Nasdaq: QCOM) bought Atheros out from under us, because it should allow this leader in cellphone technology to leverage the technology of a best-of-breed, up-and-coming wireless-networking chip maker.

Grim and grin-worthy realities
It's tempting to simply brag about the returns from successful buyouts of Hidden Gems stocks (Woo-hoo! Up 50% in a single day!). But I'm not wired to exaggerate that way, and an examination of nuances of our more mixed record yields some important investing lessons that can help us all get better returns in the long run.

The truth is, as the tables above show, some of these buyouts come at prices that are below our past cost bases, and some of them underbid what we believed to be the intrinsic value of the company. (Kendle International, for instance, I valued closer to $20 a share.) Let's take a more detailed look at a single example, Volcom, that provided us with successes, failures, and draws.

Wipeout, recovery, but overall an OK ride
In early May, Volcom announced an acquisition agreement under which French brand conglomerate PPR made a cash offer of $24.50 per share. The Volcom board, members of which held large positions in the stock, unanimously approved the offer, so this was about as done as a deal gets. The acquisition made sense for Volcom as a company, because PPR has a large global footprint, an efficient sourcing chain, distribution channel, and the experience and deep pockets to expand Volcom's markets. In contrast to other peer retailers who had experienced more robust post-recession recoveries, Volcom's results had been mixed, and it had not yet returned to the 20%-plus growth that investors had come to expect from the company a few years back. We may perhaps draw a conclusion about Volcom's potential future as a stand-alone company from the fact that there were reportedly no earn-out clauses for its management in the PPR deal.

While the $24.50 per share provided a nice boost over the then-current share price of $19 and change, this wasn't the best news for Hidden Gems members who bought shares of Volcom at $32 when Hidden Gems made its first Volcom recommendation in March 2006. That position finished up with a 23% loss.

Fortunately, our approach to small-cap investing has always been about more than a one-time buy. Hidden Gems founder Tom Gardner re-recommended Volcom twice when the stock was trading around $20, and by my math those scored 25%-ish gains. That's enough to beat the S&P 500's return over the period, but not enough to best the returns of the Russell 2000 index ETF.

We did better with our real-money buys, beating both indexes handily. Our blended real-money return on our Volcom buys stands at 72%, so depending on what your benchmark is for Volcom, we went 2.5-for-5 or 4-for-5.

*Real-money buys, returns calculated from dividend-adjusted prices. Classic recommendation returns calculated from dividend-adjusted, end-of-day pricing on date of issue release. ETF returns calculated from dividend-adjusted returns data, assuming equal-money purchase on same date as recommendation or real-money purchase. Pricing information from Capital IQ, a division of Standard & Poor's.

Win, lose, and draw? That's how just about any stock looks across time, and it's why we advocate continual, incremental investing in companies we know. When you only buy a company once, taking a single, bit swing, you greatly increase your odds of striking out. When you follow a company over a period of years, and you become better acquainted with its strengths, weaknesses, and its real value, you're in a much better position to profit, as our results from Volcom illustrate. I call this one a "draw" myself, but it could easily have ended up an overall loss had we not known enough about the company and had the conviction to make those better-performing, real-money buys.

What's next?
Sure, it's easy enough to look back and say "I knew it!" What do I have for future small-cap buyout candidates? When I'm handicapping the current crop of Hidden Gems with an eye to acquisition potential, the following companies rise to the top of my list.

• Bio-Reference Laboratories (Nasdaq: BRLI): This small medical testing company has been growing at a better-than-20% clip for years now, taking market share from entrenched competitors like LabCorp and Quest Diagnostics. Sooner or later, I think one of these two pays up to pick off the upstart.
• EnerNOC (Nasdaq: ENOC): This company is one of the leading providers of demand-curtailment services, which allows utilities and grid operators to buy "negawatts" instead of having to invest in expensive peak-power plants. A couple of recent regulatory rulings have made it clear that EnerNOC's on the right side of public policy, yet the market continues to treat the stock as if it's dead money forever. I think a deep-pocketed suitor would do well to see beyond the next couple of years and bet on the future potential.
• Blackboard: OK, maybe I'm cheating a little bit here, since we already know that Blackboard has received unsolicited buyout offers. However, I think the current market price of around $45 underbids what Blackboard would be worth to a company like Microsoft, Oracle (Nasdaq: ORCL), or (more likely, to my mind) salesforce.com (NYSE: CRM). I expect to see more activity here, and I want to see a better price before I give up my shares of this company that boasts retention rates of better than 90% for its software services.

Foolish final thoughts
As with all investing, it's not as easy to make money picking potential buyout candidates as a catchy headline might make it sound. Cash-producing companies can languish for years without finding suitors, and a white knight offer that sends your stock up 50% in a single day may also be locking in a loss forever. The best way I know to increase the odds of success is to practice investing the way we do at Hidden Gems, concentrating on stocks the market doesn't like or doesn't appreciate, and buying them more than once, at several, opportune times.

As The Motley Fool's only service dedicated to offering regular monthly investing ideas plus real-money backing of our favorites, Hidden Gems has been designed to get members the information they need in order to profit from our small-cap strategy. If you'd like to see our real-time buys, our stable of ideas, our weekly video updates, our real-time stock rankings, and the rest of what's on offer at Hidden Gems, a risk-free trial is on me.

If you're not ready for that, but you want to make sure you get personalized, up-to-date news on any of the stocks mentioned in this article, use the links below to add them to a personalized watchlist.

• Add Blackboard to My Watchlist.
• Add CoStar Group to My Watchlist.
• Add SUPERVALU to My Watchlist.
• Add Qualcomm to My Watchlist.
• Add Bio-Reference Laboratories to My Watchlist.
• Add LabCorp to My Watchlist.
• Add Quest Diagnostics to My Watchlist.
• Add EnerNOC to My Watchlist.
• Add Microsoft to My Watchlist.
• Add Google to My Watchlist.
• Add Oracle to My Watchlist.
• Add salesforce.com to My Watchlist.