M&A Good for Small Stocks

It is not just the pharmaceuticals sector that is poised to benefit in a pick up in mergers and acquisitions. Smaller stocks are prime takeover targets

Emma Wall 6 May, 2014 | 8:51AM
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Emma Wall: Hello and welcome to the Morningstar series, 'Why Should I Invest With you?' I'm Emma Wall and here with me today is Richard Bullas, manager of the Bronze Rated Franklin UK Smaller Companies Fund.

Hello, Richard.

Richard Bullas: Hi, Emma.

Wall: So I thought we'd start by looking backwards over the last year. 2013 was a pretty exceptional year for your fund, returning over 50%. What happened to enable that sort of performance?

Bullas: We did well, thanks Emma. We had a fantastic year. I mean it was quite a stellar year for small-caps in general, and we significantly outperformed the small-cap index. It really came through stock selection. We took over the fund back in the middle of 2012 and completely restructured the fund. So putting about 15, 20 new ideas, sold half the assets, and sort of laying our groundwork back in 2012 in the summer really helped sort of the fund outperforming in 2013.

So really through stock selection we have some superb performance in the last couple of years. Companies like Xaar (XAR), you see a technology inkjet printhead company, stood sort of three or four-fold last year; structures as Ted Baker (TED), which is up 100% last year, so it doubled. Certainly with a strong tailwind for U.K. small-caps and certainly with some good stock-picking, we had a good year.

Wall: I mean, one of the themes that can help to boost that sector is M&A. M&A is hotting up now that we're fully into the recovery. Obviously, Astra and Pfizer this week talked about merger, outside your realm in terms of market cap, but is M&A something that you consider when you're looking at stock selection?

Bullas: It doesn't really fall into the initial sort of investment process; it's always nice to having small-caps and, small-caps is a quite a prevalent area for M&A. But you're right, there's obviously a pickup in the M&A in the last six months, it was started in mega-caps, something in the U.S., it's now coming across into Europe and into U.K., I'd say certainly into the pharmaceutical stocks.

It's starting to filter down, I think a little bit into mid and small caps also. We've seen quite a few sort of small-cap stocks quarterly on the stock market actually buying private businesses looking for organic growth in terms of buying that sales and top line.

So I think that's why it's continuing. The environment and the backdrop is pretty good for M&A. Credit availability is increasing. Certainly, investor confidence and chief exec and chairman confidence is certainly high as well; so there's that confidence to do deals and put cash resources to good use. Companies are in good health. They have the capital to deploy to do M&A. So I think it will continue. I think it'd be a theme to continue without a doubt.

Wall: The CBI's recent report is backing up that positive stance. They are saying their outlook for the next three months, although that's pretty short-term, is exceptionally positive. Do you agree with that; that U.K. corporates are in great shape?

Bullas: I mean, yeah. You got to remember actually since the financial crisis, the recession has been very hard for a lot of businesses, something like five or six years ago. So now we've sort of turned the corner. The economy is moving from recovery mode into sustainable growth mode, and there's been sort of delay in terms of how certain chief execs and chairmen feel in terms of that confidence. Starting without, trying to come through now, so we're starting to see that pick-up in business investment.

But the backdrop for U.K. small-caps and sort of mid and small-caps in particular is very good. The economy is now, I'll say, moving to sort of 3% plus GDP growth, one of the best in the G7 at the moment. Corporate balance sheets are in good health. Balance sheets are being repaired during the downturn. So companies are coming through, I'd say, with capital to deploy. But also companies have got very low net debt to EBITDA ratios on the back of that, so again there is the possibility to gear up. So, I would expect that trend in that backdrop, a positive backdrop to continue into 2014.

Wall: At the risk of playing devil's advocate, sometimes it sounds too good to be true. Are there any risks in this sector? I mean, is there something niggling away in the background?

Bullas: Yeah, I think you need to balance the positive backdrop which we're seeing with the U.K. economy and that's playing through to U.K. domestics with the valuations you pay for those companies. So, as I’ve mentioned before you've had still a stellar re-rating in the small-cap market for the past two years, certainly last year significant rerating from a big sort of undervalued discounts to wider market small-caps to where they are today virtually trading in line with the wider market.

So that valuation discount has been made up. But I'd argue even valuations look okay. They are not bargain-basement prices they were 18, 24 months ago. On the flipside it's not as if they look extended either. Where the question mark I think is looking at the moment is in terms of earnings, we are still in a period of earnings uncertainty. You had sort of a delayed reaction from the backdrop improving in terms of the macro to actually feeding through to corporate profitability.

So, you are seeing some material damage in profitability at the moment, so it is mixed. I think it's going to remain mixed actually until we get better visibility in terms of business investment and business spendings are moving to 2014 and towards the backend of the year.

But expect that to come through without a doubt. I am quite hopeful that earnings recovery will come through at some point, but there is – you are in that sort of that high interest period where you're balancing that sort of growth with the earnings risk as well. So it's going to remain selective, I believe.

Wall: Richard, thank you very much.

Bullas: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Xaar PLC150.00 GBX0.00

About Author

Emma Wall  is former Senior International Editor for Morningstar

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