I’ve found that Mergers & Acquisitions (M&A) are among the best indicators for the micro and small-cap segment of the market. Dealmaking is at the core of the stock market, from IPO activity to capital raising and all the way to M&A activity, which includes takeovers between public companies, mergers among peers, and private equity acquiring public companies to take them private.

In my experience with small-cap investing, I have noticed that a significant number of stocks in this space are acquired. This typically results in a positive reaction, often causing the share price to skyrocket, especially when bids come in well above the current market price. While takeover investing isn’t a standalone strategy, it can yield excellent returns. Identifying healthy smaller companies that are prime candidates for acquisition is an effective way to select strong investments.

When activity in M&A declines, it often leads to a decrease in IPO listings and capital raising. Indicating that the market conditions aren’t favourable. Companies are unlikely to pursue IPOs or raise capital in an environment where they might not receive a fair price for their shares.

In flat markets, firms prefer to delay such actions, waiting for a time when they can achieve better valuations through equity dilution or public offerings.

Mergers & Acquisitions are a great proxy for value…

A slowdown in M&A also suggests a lack of attractive deals and indicates that the opportunity cost doesn’t support aggressive searching in the small-cap market. Currently, I observe a surge in M&A and takeovers of well-run small-cap companies. This environment is particularly advantageous, with the strength of the US dollar allowing large private equity firms to acquire companies in regions like Australia at potentially lower multiples (typically EV/EBITDA) than they could in the US or other developed markets.

This trend highlights the inherent value in the small-cap markets today. Additionally, I’m seeing cash flow-positive, dividend-paying small-cap companies with increasing revenue, large addressable markets, and favourable business conditions, yet they are trading at single-digit or early teen P/E ratios compared to their global counterparts.

Since COVID, small-caps, especially those outside of tech, AI, or precious metals—essentially normal, traditional businesses—have been undervalued. When investors recognise value, private equity activity tends to rise, as reflected in the recent influx of takeovers and buyouts across the ASX.

Monitoring private equity activity is essential because a significant portion of the small-caps I follow ends up being acquired at higher prices than the market price, leading to price spikes. It can be frustrating when a great company you select is taken over as it means it couldn’t compound longer. However, I am willing to accept the premium offered, sell during the spike, and reinvest the capital into new opportunities.

This frequent occurrence means that over time, half of my portfolio changes due to takeovers and M&A activity.

Rates and Small-Caps

Mergers and acquisitions (M&A) activity in small-cap stocks has seen a decline since April 1, 2022, with a nearly 56% drop globally through August 31, 2024. This downturn is partly attributed to macroeconomic uncertainty, which has led investors to prefer larger-cap stocks that are generally less volatile. However, historical trends suggest that small-cap stocks may warrant closer attention as interest rates begin to decrease, potentially narrowing the performance gap between large-cap and small-cap companies.

Interest rates significantly affect small-cap companies because they often rely on variable-rate debt, which is more responsive to interest rate fluctuations than the fixed-rate debt typically used by large-cap companies. During periods of ultra-low interest rates, small-cap companies benefit from these low variable rates; however, as rates rise, this advantage diminishes.

2025 looks to the year of Mergers & Acquisitions…

Looking ahead, as interest rates come down in 2025, it is likely to become even more attractive for companies to increase their M&A activity due to cheaper and more favourable capital. Takeovers can serve as a significant catalyst for a revaluation of share prices. Typically, acquisitions come at a premium to the current market price, with premiums ranging from 30% to 90%.

So, if you are a microcap or small-cap investor, always think about what the catalyst could be beyond the underlying business activity.

As part of a thesis on selecting potential takeover candidates, focusing on compelling reasons beyond just acquisitions can help you build a portfolio of high-quality smaller companies. If these companies are not taken over, you can still hold them long-term with confidence. On the other hand, if they are acquired sooner than expected, it allows you to realise their valuation, book profits, and seek out the next opportunity.

Overall, while M&A activity in small-cap stocks has been subdued, there are signs that conditions could be favourable for a rebound. This is especially true if interest rates continue to trend lower and regulatory changes encourage more M&A activity.

Where to hunt for takeover candidates?

This year, I am finding that developed markets and companies in New Zealand, Australia, Singapore, and Japan will be attractive investments. The reason for this is the recent surge of the US dollar against these currencies. Additionally, companies from Europe are also looking to invest in these regions. I have already observed several takeovers this year, predominantly on the Australian Securities Exchange (ASX).

The ASX features many great companies that are undervalued yet possess high-quality assets and products. Companies with operations in the US are particularly appealing, as they can be acquired at more favorable currency valuations while earning in US dollars, making them more attractive to US firms.

Ideal candidates for investment are companies with hard-to-replicate asset bases, whether those are property, mining rights, intellectual property, or strong networks and supply chains.

The current trend we are seeing is “buy over build.”

Whilst investing based on Takeovers is not a complete strategy it can be a way to curate a list of ideal companies or at least provide a top-down way to find quality small caps.

Just food for thought.