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Small caps poised to shine as M&A prospects set the stage

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By Rhea Nath
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4 minute read

A number of investment professionals are predicting the flurry of takeover activity in 2024 will prove conducive for valuations on the smaller end of town.

Speaking at the Australian Wealth Management Summit in Sydney last week, American Century Investments’ vice-president, Chris Chen, observed merger and acquisition (M&A) activity has historically been a good indicator of the “animal spirit” in small caps.

“First of all, the vast majority of M&A we see, they happen in the small cap space, and the reason why they’re so important is the companies that take small cap companies private, they tend to pay a premium. So not only does that benefit the company that’s being taken out, but because of the premium valuation that’s given to the stock, usually it really helps the entire space get a lift in terms of valuation,” he said.

Unfortunately, M&A activity in the small cap space has fallen off sharply since 2021. As of 2023, it remained below the long-term average, he observed.

“Something that has really hurt the small cap space in the last couple of years has been this reduction in M&A activity, but we’re seeing that the desire to do more M&A, the M&A activity expectation, is [now] rising,” Chen said.

Risk appetite has seen a gradual upward swing, reflected in the positive trend of deal data and M&A outlook, with announced US deal volumes increasing year-on-year and quarter-on-quarter in the fourth quarter of 2023.

This, according to Chen, “serves as a really important positive catalyst for small caps”.

Janus Henderson portfolio manager Nick Sheridan, too, believes increased M&A activity could help “unlock” valuations.

“We also expect a revival of merger and acquisition activity in 2024, with cash-rich private equity firms seeking buying opportunities,” he said.

“This could be particularly interesting in places like the UK, where persistent capital outflows have left many stocks looking attractively priced. Globally, while M&A activity remains below its long-term average, deals are being completed at an average 35 per cent premium to the prevailing share price, ensuring that investors are being well remunerated.”

In March, off the back of the latest reporting season which witnessed notable M&A action, Australian fund manager Maple-Brown Abbott also said it anticipates continued M&A activity in 2024, supported by a lower Australian dollar and potentially lower interest rates.

“With the lower Australian dollar, we believe M&A activity will continue to create opportunities in the Australian small-cap sector and be far more pronounced than IPO activity which is also expected to ramp-up,” said Phillip Hudak, co-portfolio manager of its Australian Small Companies Fund.

“Many companies, particularly at the smaller end of the market, could see M&A activity as the year continues. Spartan Resources, for example, is a potential takeover candidate and also a key stock pick given our bullish view on gold.”

According to PwC’s Australian M&A Outlook for 2024, approximately one-third of companies intend to make three or more acquisitions by 2028, while private capital players are poised to deploy a record amount of capital, estimated at around $37 billion.

“Inbound interest is buoying activity, with investors from the US, Japan and Europe accounting for some of the largest transactions in Australia in 2023. Markets for initial public offerings (IPOs) are also looking up,” it stated.

While the US and Europe have both exhibited improving IPO markets in the year to date, with the latter recording its strongest start to a year since the pandemic, PwC said “hopes were high” in Australia for a recovery in listings.

“This confidence will require caution from Australia’s dealmakers, given the level of regulatory uncertainty, with changes looming to Australian Competition & Consumer Commission merger rules and continued focus from the Foreign Investment Review Board.

“All being said, perhaps the second half of 2024 will herald the start of a stronger IPO market locally.”