In his Ahead of the Tape column [subscription] in the Wall Street Journal, Justin Lahart raises an interesting possible explanation for the outperformance of small-cap stocks:
The surge in leveraged buyouts has spawned a cottage industry aimed at figuring out which company might be the next big takeout candidate. Wall Street has been screening for low debt levels, hefty cash flows and the like to come up with lists of would-be LBO candidates. One reason shares of companies with smaller market capitalizations have done so well in recent years is that they're considered the most likely targets. Many LBO screens cut off companies whose market value is thought to be too high to make them buyout fodder.
He then warns investors that a slow-down in private equity could hurt the performance of these stocks, which have been bid up on buyout speculation. The way for investors to avoid this is to remember this mantra: A possible buyout is not a reason to buy a stock. But, by focusing on buying good companies at a large discount to their value, you will probably stumble into quite a few buyouts. For that reason, many of the criteria used to find probable buyout candidates are good criteria for selecting good long-term investments. In my post Finding Smaller Buyout Candidates, I made a list of some of the criteria I use to find cheap stocks that are potential fodder for the buyout industry:
- A stock trading around its liquidation value (this can be calculated by subtracting the a company's total liabilities from its current assets, which Benjamin Graham called a net-net).
- A company with a strong brand that would be a good strategic fit for a larger company.
- A stock trading at a low price/earnings multiple.
- A company without strong anti-takeover provisions.
Interests rates may rise and fall, and leveraged buyouts may wane in popularity and then come back again. But I believe that these criteria will always be helpful for finding undervalued stocks, and undervalued stocks usually outperform.
