Catalysts: Investing in “take-outs”
At the time of writing, David Barr’s track record for picking small cap take-out1 targets stands at 40 portfolio holdings taken out since the Pender Small Cap Opportunities Fund was launched (June 2009). In just over seven years of identifying catalysts, that averages out to around one every two months.
As the Manager of a small cap fund, liquidity is never far from our minds. We are focused on ensuring we preserve and grow the capital investors have entrusted to us and an acquisition is both a liquidity event and a potential value creation event.
So how do we pin point a take-out candidate from the wide field of publicly traded entrepreneurial prospects? “The truth is we rarely buy expecting a take-out”, says David Barr, President & Portfolio Manager. “However it’s a by-product of our process, our private equity approach to public markets.”
More than stock picking, we fundamentally analyse every aspect of a potential holding, which includes the customer base, the competition and the industry as a whole. It also helps that we have held board positions, “You’re in the boardroom when management is deciding whether to acquire another company, so you really understand the motivation behind buying a company, which gives you an ability to assess what types of companies other people want to buy.” Conversely we have been on the boards of companies contemplating acquisition and again, find this experience can be applied to investment analysis.
Here are some of things that correlate to identifying potential take-out candidates.
Smaller companies have a headstart. They are easier to acquire than large companies. The acquisition can broaden the acquirer’s product or service offering or eliminate a pesky competitor. The acquirer can then impose its cost structures on the target company and eliminate various costs and expenses that can cause suppressed profit margins in a small cap company due to lack of scale, making the acquisition a financially accretive exercise.
A company selling “the next big thing” may seduce many investors, but Pender is not drawn to these businesses. Often the fundamentals don’t live up to the hype, and this is amplified in the small cap arena. We are trying to uncover businesses that have a proven, market-leading proposition, an established customer base and a strong management team. These are the characteristics that make for a strong investment candidate for Pender. The same characteristics make for attractive take-out targets. Big businesses are not interested in acquiring problematic dependents. They are looking to build their business through strong acquisitions.
Due diligence drives our valuation. We determine the intrinsic value and what an independent third party would pay for a company – the Private Market Value. This private equity approach to evaluating public companies allows us to ensure that we can take advantage of attractive entry points and not overpay for an investment. And while the market may not fully recognize the value being created by the company, odds are that another company will.
Every once in a while, a small company breaks through industry norms to shake up an entire sector. It outcompetes existing players with, for example, a disruptive technology. The more havoc it creates, the more likely it becomes that a competitor will want to buy it. The hard part is to spot the potential of the company before it starts to make waves and to buy it at a lower, pre-discovery price.
Active but not activist
We are not activist investors, a term that has been associated with “corporate raiders” who bought large stakes in companies to extract value, often through large divestures. We are however active investors. We regard an investment as a tangible stake in a real business and we actively manage the holdings in our funds with a fiduciary duty to mitigate capital impairment and achieve returns for our unitholders. We do this through ongoing fundamental analysis of a company’s prospects and risks. In select cases, we become more intimately involved with a company, maybe as a member of the board, in order to act as a friendly champion of the company (as opposed to a hostile agitator) and to support management in increasing a company’s take-out potential.
Avoid value traps
On the flip side of the coin, as important as picking the right stocks is avoiding the wrong ones. Our past experience of investing in private companies has taught us how to side step value traps. These are stocks that appear to be cheap and therefore attractive. But, they are cheap for a reason. Some “value” investors can’t resist a deal, but when shareholder value is declining, combined with a decrease in intrinsic value, then your margin of safety is being eroded and the invested capital becomes “trapped” as the stock never recovers. Fundamental analysis provides the warning signs so we aim to avoid value traps wherever possible.
1 “Take-out” is an informal term we use to mean merger or acquisition.