Yesterday I highlighted an investment strategy I first read about in a Spring 1999 research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy. The premise, simply stated, is to identify undervalued small capitalization stocks where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’m going to explore it in some depth over the next few weeks.
The idea is reminiscent of “Super” Mario J. Gabelli’s Private Market Value with a Catalyst methodology, the premise of which is the value of a company “if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium:”
To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.
“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.
Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recall were each called “Endangered Species Update” and discussed the returns from the strategy. It seems that those follow-up reports are now lost to the sands of time. All that seems to remain is the press release of the final report:
For the last few years, Piper Jaffray has been reporting on the difficulties that small public companies face in today’s equity markets. Since the late 1990s many well run, profitable companies with a market capitalization of less than $250 million have watched their share prices underperform the rest of the stock market. With limited analyst coverage and low trading liquidity, many high-quality small companies are “lost in the shuffle” and trade at significantly lower valuation multiples than larger firms. Since our 1999 report “Wall Street’s Endangered Species,” we have held the position that:
This is a secular, not cyclical, trend and the undervaluation will continue. The best strategic move to increase shareholder value is to pursue a change-of-control transaction. Company management and the Board should either sell their company to a large strategic acquirer with the hope of gaining the buyer’s higher trading multiple, or take the company private.
In the last few of years, many small public companies identified this trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.
Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:
Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.
In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.
Piper Jaffray did follow up the reports in a 2006 article called Is There a Renewed Prospect of Going-Private Transactions? Their conclusion:
Small-Cap Stocks Outperform
Small-cap stocks have experienced a dramatic resurgence over the past five years. With weak performances from large-cap stocks, small-caps have become more favorable investments with better returns and stronger trading multiples. Here is what we have seen:
- Over the last one-, three- and five-year periods, companies in the Russell 2000 have offered average returns of 21%, 227% and 240%, respectively, compared to S&P 500 companies with average returns of 16%, 89% and 57%, respectively.
- The valuation gap that we saw five years ago between the bottom two deciles of companies in the Russell 2000 and the S&P 500 no longer exists, with the last two deciles in the Russell trading at only a 3% discount to the median EBIT multiple of S&P 500 companies and a 9% premium over the median P/E multiple.
(Click to embiggen)
Despite the rebound in valuations, small-cap stocks continue to face the same capital market challenges:
- For companies with market caps between the $50 million and $250 million range, there are approximately 1.3 analysts covering each stock versus 7.7 analysts for companies with market caps of more than $250 million.
- Trading volumes are slightly higher, with the last three deciles trading an average 202,276, 176,092 and 223,599 shares, respectively, per day, but still significantly below the volume of S&P 500 companies, which trade an average of 4.0 million shares per day.
More to come.