Given this financial reality for many companies, an acquisition is among the few options left to bolster growth in an environment where roughly 2 percent gross domestic product growth is the best that can be hoped for.
"The only way companies have a shot at meeting growth expectations is by buying," said Uri Landesman, president of hedge fund Platinum Partners. He expects this secular trend to help small-caps outperform, but is negative on the overall market, calling for an overall correction of as much as 15 percent.
A Lot to Like About Small Caps
Small-caps look attractive to both investors and potential acquirers because of their strong balance sheets and good earnings momentum. Unlike large caps, smaller companies have more room to cut costs to boost margins. "Profit margins have exceeded the old highs for the S&P 500 but have yet to exceed the old highs for the Russell 2000," said Veru of Palisade Capital Management.
Small caps are also attractively valued. While the Russell 2000 is sitting at all-time highs, small caps trade on just 15.4-times expected earnings, according to DeSanctis. At previous peaks, they traded at 17-times — suggesting room for more gains.
After investors flocked to yield and safety amid ongoing global economic uncertainty, small-caps have split into two camps — dividend payers and non-dividend payers, said Seth Reicher, president of Snyder Capital Management.
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"Companies that pay out dividends are expensive," said Reicher, whose firm manages $2 billion. "Companies that have high free-cash-flow yields and don't pay out dividends are inexpensive. That's where the opportunity is."
Reicher, a value investor, said M&A should pick up this year as some of the macro uncertainty starts to dissipate. Companies should start looking longer term instead of worrying about political and macro flare-ups such as federal budget talks in the near term.
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