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Small is big: Dealmakers focus on profitability and deleveraging as small caps gain investor attention

The S&P 500 has outperformed the Russell 2000 in the last decade, as free money and low inflation meant investors chased fast-growing mega caps. Over the next year and beyond, a reversal is expected.

That is because small cap stocks – typically those with market caps of USD 3bn or less — currently trade at cheaper multiples than large caps, outperform them on profitability, and already have a lot of bad news priced in, said Art Hogan, chief market strategist at B Riley Wealth, at B Riley’s institutional investor conference in Beverly Hills last week.

Under-owned and under-valued compared to their bigger brethren, small-cap stocks tend to outperform large caps during inflationary environments, as they did in 1975-1982 and are expected to do so again in the coming years, according to James Furey, of Furey Research Partners, speaking in March.

How did we get here? Driven by free money, surging valuations, and a confidence borne out of the disinflationary environment created by globalization, many loss-making firms had the currency to make accretive acquisitions over the last decade. That era has now ended, argued Furey. Now, soaring inflation and interest rates combined with crumbling stock prices have impacted the psychology of dealmakers.

Going forward M&A should be much more balanced with a greater focus on profitability than growth, Furey says.

“There will be a very healthy M&A market over the next decade but … we’re going to see more competition for cash-flow positive companies.”

Diamonds in the rough

M&A volumes tend to peak at market tops and trough at market bottoms. Average deal size also tends to rise and fall accordingly. Deal volume fell to a record low USD 21bn in April 2020, near the market bottom, before peaking in early 2021, several months ahead of the Russell 2000’s and S&P 500’s tops. Monthly volumes dropped to USD 51bn last July before ticking up and then to USD 58bn in January before another small rebound, in line with the S&P 500’s relief rallies.

Most economists now expect some form of recession – even if only mild – late this year.

“When it’s a more difficult market you search for opportunity and hidden gems,” said Furey. For Hogan, consumer staples are overpriced, while the energy sector remains underpriced.

Three examples

Three small cap stocks are emblematic of the way M&A could play out.

Funeral home company Carriage Services [NYSE:CSV] has hit pause on its acquisition strategy to focus on deleveraging until the end of 2024, after making acquisitions that added 20% of its revenue in the last couple of years, executives told this news service. Part of that deleveraging plan will see it divest USD 10m or more in funeral homes located in mature markets.

Redwire [NYSE:RDW], a space infrastructure company built from seven acquisitions that went public in 2021, intends to slow down its M&A pace given the cost of capital has gone up, its CFO Jonathan Baliff said at last week’s B Riley event.

Alarm.com Holdings [NASDAQ:ALRM], a provider of security products and services, has been making smaller acquisitions, as it focuses on profitable growth, its CFO said at a recent investor conference. Its deals have dropped from about USD 65m for Open Eye in October 2019 to USD 35m for Noonlight last October, and even less for Shooter Detection in December 2020.

In the last 15 years, money poured into private equity, venture capital and riskier companies, but not traditional small cap, noted Furey. Asset allocators are over-weighted on those riskier assets and are looking for new areas that will benefit from the new inflationary, high interest-rate environment. Small caps are set to benefit.