All the attention has gone to the most conservative investments lately. Think Treasury bonds and gold bullion. People are even wishing their savings accounts earned a little more. But this is exactly the wrong focus to have.
Thanks to M&A activity and corporate stock buybacks fueled by cheap debt, I think an epic bull market is coming (see last week's column here). And if my prediction for a bull driven by corporate deleveraging and a resurgent economy is right, the riskiest and most aggressive equities will fare best.
So forget gold. Forget bonds. Here's why it's time to take a look at small-capitalization stocks -- along with three stocks worth considering. (Hint: They're in the health care and technology sectors.)
Time to buy
The motivation is simple: Corporations are earning record profits while CEOs are armed with record cash hoards. And they aren't being paid to do nothing; shareholders expect results. (This was the subject of my May 5 column, "Takeover artists get back to work.")Of the available options for excess cash, executives prefer to pursue mergers and acquisitions rather than increase dividends or pay down debt. According to a recent Credit Suisse survey of European CEOs, 50% expect to increase M&A spending. Only 29% said they would pay down debt, the next-most-popular option.
Also, as I discussed last week, corporations have plenty of room on their balance sheets to take on cheap financing, while overall M&A activity is well below previous peaks. Currently, M&A activity is down to just 0.5% of GDP, compared with a peak of 3.5% during the tech boom in early 2000.
All of this means many small-cap companies will become buyout targets as CEOs look to expand their empires and increase returns to shareholders, pushing prices higher as deal premiums get factored into the valuation of the entire asset class.
All about margins
According to UBS strategist Jonathan Golub, there are a number of reasons to expect a strong M&A cycle. The most important are the potential for earnings growth and the ability of large-company CEOs to unlock value through the process.On the first point, with many believing we've entered a "lower-growth world," there will be a desire to buy small, growing companies rather than to try creating growth in-house. Small caps are the perfect vehicle for this. Golub notes that analysts expect the group to produce twice the earnings growth of large caps over the next year, with companies in the S&P 600 Small Cap Index ($SML) growing earnings by 24.2%, compared with 12.8% growth for the larger companies in the S&P 500 ($INX).
For the second point, Golub notes the high potential for deal synergies, the value unlocked by M&A transactions when revenue and earnings of the combined entity are greater than the sum of the parts. Think cost-cutting initiatives and cross-selling product to existing customers.On the revenue side, small-cap sales growth outpaced that of large caps in the second quarter. This comes after smaller stocks lagged during the first phase of the economic recovery, with large-cap companies posting revenue growth during the last three months of 2009 while small caps suffered a contraction. Analysts, who have significantly underestimated small-cap revenue growth recently, expect the recent reversal of this trend to continue over the next several quarters as small-cap revenue growth picks up steam.
As for margins, small caps are poised for a boost here, too. Profitability fluctuates across the business cycle as so-called "fixed costs," items like the mortgage on a factory or the payment on a piece of machinery, are spread over higher or lower production volumes. When production increases, businesses benefit from a concept known as "operating leverage" as the cost of producing each additional unit of sales declines. Cost-cutting initiatives can expedite this process.
Because of their economies of scale, large-cap profit margins have bounced back much faster over the past year. In fact, the difference between large-cap and small-cap margins has blown out to 7%, up from a low of around 4.3% in 2001. S&P 500 operating margins now stand at 14.3%, compared with a historical peak of 14.8%, while S&P 600 margins stand at just 7.3%, compared with a previous peak of 9.6%.
A slower recovery among small caps is to be expected: During the last cycle, it took them five years to recoup losses in profitability, which means small-cap profit margins have plenty of room to run -- making them lucrative targets for acquirers.
