When investing, don’t ignore the smaller companies ripe for takeover

Restricting investing to large, mature businesses for their franked dividends can preclude investors from opportunities for even better capital gains.

The current red-hot takeover environment confirms there are a host of smaller ASX companies which possess unique assets or financial characteristics that are highly valued by strategic and financial buyers.

There is a diverse range of reasons why these takeovers take place – the target may be in a fast-growing industry, complement a company’s existing product suite or geographic footprint, or provide substantial cost savings when combined with the acquirer’s organisation.

Yet one trait that almost all of the takeover targets have in common is their smaller size. Restricting your investment universe to large and mature businesses simply for the appeal of fully franked dividends may cause an investor to miss out on opportunities for outsized capital gains.

Australian investors are very attracted to dividends, nearly to the point of obsession. This is understandable given the dividend imputation system, which generally provides investors with a corporate tax credit for profits generated in Australia (more commonly known as “franking credits”).

So which stocks are tomorrow’s targets? One of the main reasons that corporations make acquisitions is to enter or accelerate their growth in a new product category.

This can be a defensive move, such as National Australia Bank’s $220m acquisition of neobank 86 400 in 2021. There has been an increasing trend of younger customers moving to more technology focused finance companies over traditional financial institutions, and such an acquisition can be useful at capturing migrating customers and to learn about new market trends.

Regardless of whether the takeover is an offensive or defensive move, the acquirer is almost always noticeably larger than the target.

It is usually the large, profitable and mature company that needs to defend its existing turf from competitive pressures, or expand into new categories as it seeks to continue its growth momentum.

Another reason for public companies to pursue a takeover is public-private arbitrage (the fact that private companies typically trade at a discount to their public peers).

One of the main reasons for this discrepancy in valuation is liquidity – that is, the ability to sell part of the business in the open market. This is relatively easy for managers of public companies (as we recently saw with Dicker Data chairman David Dicker’s share sales to fund his automotive hobby), but finding a buyer for part of a private business can be a challenging prospect.

After many years of running a business, entrepreneurs may wish to reward their hard work with the purchase of a house, boat or a holiday, or even look to retire and not have a family member or business partner to take over the operations.

“Roll-ups” as they are often called are a popular business strategy across many industries, including childcare, automotive smash repairs and insurance.

In fact, insurance broking has been one of the more successful long-term strategies globally, including for local insurance player Steadfast Group: This process may also allow entrepreneurial insurance brokers to initially sell part of their business to the company, with an agreement to sell the remainder over a period of years as they transition to retirement.

An additional benefit to the roll-up strategy can be the economies of scale as a business grows in size. Most businesses have substantial fixed costs, including buildings (warehousing, stores, branches), technology, or purchasing of materials that do not increase proportionally as a business expands.

For example, as Westpac acquired other banks around Australia (St George, Bank of Melbourne and BankSA) it was able to leverage its existing technology and marketing spend, while combining and reducing its number of branches.

Additionally, many industrial businesses are able to achieve better terms when purchasing input materials (such as ingredients for paints, building materials) as they gain scale. This is similar to the concept of “wholesale” rather than “retail” and can compound the benefit of acquiring private companies with low valuations in the same industry.

There are more practical challenges of a small company buying a larger operation, such as the smaller entity’s financial capability of executing the transaction. Similar to how there are more buyers for a $1m house than there are for a $10m one, there are more companies (or individuals) with the interest and financial capacity to pursue a smaller company.

Additionally, smaller companies do not generally have free access to the debt markets (particularly in Australia and especially if they lack hard assets for collateral), and shareholders may not be enthusiastic about participating in a capital raise that exceeds the size of the existing company – with the risk that the transaction fails to deliver the CEO’s vision.

Large companies on the other hand often have superior access to capital, which they can use to close deals and maximise the target’s growth opportunity.

Wesfarmers, for instance, has generated incredibly strong returns from its acquisition and expansion of Bunnings. While this performance is unlikely to be repeated, shareholders will be hoping for continued success from the recent acquisitions of API and Silk Laser will bear fruit.

Ron Shamgar is head of Australian equities at Tamim Asset Management