The Incredible, Shrinking “Urge to Merge”

Submitted by Wall St. Daily as part of our contributors program.

At this stage of an economic recovery – about two years after the official end of the recession – mergers and acquisition (M&A) activity should be ramping up. Especially considering the significant stockpile of ammunition out there – almost $2 trillion in cash on corporate balance sheets.

So what the heck’s going on?

The latest data out of Thomson Reuters reveals anything but a robust market for acquisitions.

In the first nine months of 2012, the total dollar value of global M&A activity fell 16% compared to 2011 levels. In the United States, the downturn’s been even more pronounced, with deal activity off 21.5%.

Ernst & Young’s latest Global Capital Confidence Barometer – a regular survey of over 750 C-level executives – sheds some light on the issue. In short, the culprit is uncertainty.

Almost 80% of executives think the global economy shows no signs of improvement. And when you’re worried about economic growth, you don’t take unnecessary risks like making massive acquisitions. On such merits, it’s no surprise that the survey also revealed executives’ appetite for mergers fell from 31% to 25% in April.

Now, Wall Street hot shots aren’t exactly pleased about the shrinking “urge to merge.” Why the sour grapes? Because a drop in deals means less fees for them. It’s sad, but true. It’s all about the money.

Ironically, though, their loss can actually be our gain for once. Let me explain…

Small is Where it’s At

By no means is dealmaking dead. Hardly. Literally hundreds of billions of dollars in acquisitions are being made in the United States alone. It’s just that the days of the barbarians busting down the gates – with mega-mergers of $20, $30, or $40 billion – are gone.

Or as Apollo Global Management’s Senior Managing Director, Josh Harris, explains, a $3 billion deal is “pretty large in today’s environment.” I’m afraid even that’s stretching it, though. The Ernst & Young survey reveals that only 7% of respondents expect to execute a deal worth more than $1 billion. Instead, 84% expect to make purchases of $500 million or less.

Since the end of 2011, these small deals of $500 million or less are on the rise – up 12% – as a percentage of total deal activity, according to Thomson Reuters.

It doesn’t matter that the pieces are in place for big deals. Like cheap and available credit, excess cash and attractive valuations. (The S&P 500 Index currently trades at 15 times earnings, which is in-line with the long-term average, even after three-plus years of rising stock prices.)

Ultimately, with the global economic outlook still weak, companies prefer to play it safe. So they’re shunning big, risky mergers in favor of small, safe acquisitions. And therein lies the opportunity…

You see, Wall Street’s research on the small-cap market is notoriously lacking. Analysts are slow to discover small companies with the biggest takeover appeal – if they discover them at all. Translation: Individual investors possess an enormous advantage over Wall Street in this case.

That’s a rarity, so we need to exploit it.

Bottom line: Although Wall Street can’t profit as much from M&A activity, we certainly can. Accordingly, I recommend hunting for small-cap takeover targets in the healthcare and technology sectors.

Why? Simple: The highest premiums are being paid in these two sectors.

For the first nine months of 2012, the average deal premium for healthcare acquisitions in the United States checked-in at 42.1%. For technology acquisitions, the average premium was 51.8%. Both compare favorably to the average premium for all acquisitions worldwide of 31.9%.

If you don’t have the time to hunt for specific opportunities, no worries. We’ll do it for you. We uncovered AuthenTec (Nasdaq: AUTH) almost a year before Apple’s (Nasdaq: AAPL) acquisition, which sent shares soaring 65% in a single day.

And just yesterday we released the October issue of WSD Insider, where I reveal the market’s most compelling, yet under-the-radar, small-cap takeover target. If you’ve yet to upgrade your subscription to WSD Insider, go here to find out how.