As we move into the rump of the profit reporting season, it won’t just be minority investors like us that monitor the results of small listed companies, or “Small Caps” closely. It’ll also be some of the big (or at least bigger) corporates.

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We define Small Caps as ASX listed companies with market caps of less than $500 million and take it from me, takeovers are on the increase in this space. 2018 has already begun and already there has been two that are on the blocks, which include a stock we first recommended a number of years ago, the liver cancer treatment specialist Sirtex Medical, and there was also another offer for the gas exploration company AWE, which trumped a prior offer from Mineral Resources.

Since we commenced over six years ago, we’ve recommended over 130 different companies, of which 21 have been taken over; a strike rate of over 15 per cent. In 2017 this percentage was even higher. You just have to look at Australia’s sluggish economic growth, and indeed the low growth being experienced around the globe, to see that mergers and acquisitions of Small Caps are not going to fade any time soon.

Of the companies we cover alone, you might recognise these names which have been taken out, or are in the process of being taken over in the past few months alone: Superloop, an ASX listed company, took over fellow junior telco BigAir; US private equity giant Oaktree Capital is taking over surf wear group Billabong International, engineering; construction and mining services companies UGL and Seymour Whyte have been taken over by industry players; IT services group ASG was taken over by Japan’s Nomura Research Institute, which then took over another Under the Radar favourite SMS Technology; also in that sector two companies that we have tipped Macquarie Telecom has been trying to buy another Bulletproof, although we avoided Bulletproof at much higher levels; while another Japanese company Persol, snapped up the Perth-based blue-collar workforce specialist Programmed, which was a very pleasant surprise at the time. It never stops, and it never will.

Taking over a company makes economic sense now more than ever. If you’re a big company you can borrow at 3 per cent or so, the earnings increase from a company you’ve bought ought to be a lot more than that. You get the double whammy, after all. On the one hand the acquirer gets the extra revenue growth; and then you get (in theory) extra earnings growth by cutting costs such as management, accounting and administration.

Even if a company is not attractive to the corporates, there is still masses of cash in the private equity sector, whose highly paid executives have nothing else to do but look for corporate transactions.

So what are we looking for in a potential Small Cap takeover target?

People talk about “economic cycles being important” and it’s true that poor conditions can drive companies to consider consolidations that would not have been achievable in good times. Ultimately to be attractive, a company should be strong enough to stand on its own but also offers attractions to a third party in terms consolidating its market positioning. With the right target, it can generate an increase in market share and reduce unit costs.

Admittedly these qualities cover just about every company we cover. Remember, as investors we’re looking for the same qualities as the corporate executives, which all revolve around value.

Takeovers are most likely to happen in a fragmented market; and if you add into that equation industry turmoil, you see that magic “C” word rearing its head: “consolidation”.

This was what Oaktree Capital were looking for with Billabong and its US based competitor Quicksilver, now known as Boardriders Inc. We had recommended Billabong in July last year and two months later it turned out that the PE bean counters in Los Angeles saw the same thing that we did: value in a company in distress and that industry consolidation is a reality in bricks and mortar retail, with heavy rental lease obligations hanging around their necks.

Of course, when we tipped Billabong, we didn’t do so on the basis it would be taken over because those leases are also a poison pill. When you are looking at mergers in retail you have to factor in that those huge lease liabilities remain. Still, there is a good chance that something will happen in profit warning plagued Specialty Fashion, which owns Millers, Katies, Autograph, Crossroads, City Chic and Rivers, which remains profitable.

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