Small-cap stocks: As U.S. economy improves, M&A activity could rise

One of the factors that investment strategists often focus on when discussing small-cap investing is the role that mergers and acquisitions (M&A) can play in generating investment returns. Historically1, an increased level of M&A activity has been considered bullish for small-cap returns.

The basic premise supporting the relationships between M&A and small-cap investing is this: equities on the lower end of market capitalization can provide attractive opportunities for acquirers to essentially buy potential growth (or buy synergies) at the early stages of a target company’s life cycle. Throw in a favorable financing environment, with capital available in all forms, and it is reasonable to assume that recent years have offered a reasonably fertile M&A environment.

Total companies purchased per calendar year
Companies are using less than 100% of resources
Total dollars spent on dividends and share buybacks

M&A volume trending below expectations

Despite today’s favorable market conditions, 2013 can thus far be described as a generously below-average year when it comes to the overall level of M&A activity in small-cap stocks.

Throughout much of 2012, our position on potential M&A activity could have been classified as hopeful but by no means certain. It was our opinion — most of the time — that too much uncertainty existed for companies to strike new deals. Uncertainties included anemic growth in the United States, uneven European markets, slowing economic growth across emerging markets, continued political wrangling over the U.S. debt ceiling, and the many implications of U. S. healthcare legislation. However, as we entered 2013 we believed that the vast majority of the structural impediments had been cleared (or at least answered) and we were anticipating an improved year for M&A activity.

Fast-forward to today, and the question remains in our minds as to why M&A has not accelerated, particularly considering that corporate balance sheets and cost structures are clean for the most part. In some cases, potential acquisition targets have amassed high cash positions, which is a strong positive. Financing costs continue to remain attractive, with the markets open to raise capital in all forms.

So why the low number of transactions? We believe the following two factors have contributed to the weakness:

  • U.S. economic growth, while improving, remains below expected trends.
  • Generally speaking, companies have taken to instituting or raising dividends and/or repurchasing shares instead of engaging in M&A activity.

In our opinion, the two points above are interrelated in that companies have spent the past five years rationalizing cost structures (and in some cases reliquefying balance sheets), and many of them believe that today’s environment is still not ripe for acquisitions. In the minds of many chief financial officers, dividends and buybacks have become safe and efficient uses of capital, putting them on equal footing with M&A.

M&A activity within our portfolios

Despite the disappointing year-to-date figures, we continue to believe that as economic activity improves, so will M&A volume. In contrast to the overall trends in the marketplace, the Small-Cap Core Fund portfolio that we oversee has experienced a number of M&A transactions this year (see chart below).

M&A transactions within Delaware Investments Small-Cap Core Fund portfolio (2013 YTD)

Stock Sector Acquirer
Premium to prior day's close
Berry Petroleum Energy LinnCo 28%
Lufkin Industries Capital goods General Electric 35%
Buckeye Technologies Basic materials Georgia-Pacific 27%
ExactTarget  Technology Salesforce.com 50%
Cooper Tire & Rubber Credit cyclicals Apollo Tyres 39%
SHFL Entertainment Consumer services Bally Technologies 24%
Boise Paper Basic materials Packaging Corp of America 26%
Greenway Medical Healthcare Vista Equity Partners 19%

Data: Delaware Investments internal reports, using Bloomberg applications

While we never invest based solely on a company’s takeout potential, we view the volume of takeout activity within our portfolios as substantiation of the research process conducted by our investment team. Our focus remains on finding companies with, in our view, competitive market advantages and strong financial metrics that are attractively priced relative to their intrinsic value.

1Based on analysis conducted internally by Delaware Investments

The views expressed represent the Manager’s assessment of the market environment as of October 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager’s views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.

Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.

Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies, representing approximately 98% of the investable U.S. equity market.

Diversification may not protect against market risk.

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