Lawrence Ullman is the chief executive of Ullman Wealth Management Inc., which provides private capital-management services to high-net-worth individuals, endowments, charities and foundations.
In a notable trend this year, private equity buyers have been extracting significant value from the downturn in certain corners of Canadian financial markets by acquiring select small-capitalization public companies. Challenging market conditions, marked by compressed valuations, have paved the way for more than $6-billion worth of acquisitions in recent months. Investors in these acquired companies have received an average 56-per-cent premium to the stock’s trading price prior to the deal announcement.
Identifying potential acquisition targets that could offer this kind of premium presents a unique opportunity for investors to outperform in a challenging market environment. Such companies often feature high free cash flow, defensible business models and a conservative debt profile, considering that these are some of the key attributes that appeal to potential acquirers.
A number of companies that went public on the TSX as valuations surged during the pandemic remain out of favour and well below their original IPO pricing, creating a potential discrepancy between the value of the underlying business and the current trading price. Several of the recently acquired companies were part of this wave of Canadian IPOs in 2020-21, now considered one of the worst-performing vintages for Canadian IPOs on record.
As many stocks from this period ultimately struggled, some trading at fractions of their IPO prices, shareholders have found themselves eager to recover losses. Consequently, they have become more amenable to accepting takeover deals that are often at significant discounts to valuations of just a few years ago.
For example, only two years after going public, Q4 Inc. QFOR-T entered into an agreement to be bought by U.S. private equity firm Sumeru Equity Partners, which plans to take it private. While the premium to recent trading levels was generous, it marked only half the value of its October, 2021, initial public offering price of $12 per share. Q4 is one of at least eight small-cap companies to come to such an agreement in 2023.
What may also be keeping smaller company valuations subdued is a trend of small-cap funds shifting their portfolio holdings away from smaller and presumably less liquid listed equities. Our research has shown that across a selection of the largest small-cap investment funds, a shift in focus toward investing in higher-market cap companies has taken place.
In the largest fund, for example, we see that the average weighted market cap has risen by approximately 80 per cent from late 2018 to November, 2023. While some of that appreciation could be accounted for by market appreciation, the overall net effect has been a trend to larger company selection by portfolio managers. This avoidance of smaller companies may be in part what is keeping their valuations suppressed, contributing to a sort of valuation vacuum within the small-cap group.
Finally, and more broadly speaking, as small-cap value stocks have significantly underperformed large-cap growth stocks over the past two years, they warrant reconsideration given their relatively compressed valuations. Large-cap stocks have taken centre stage this year, resulting in a compelling narrative for smaller companies that have largely been pricing in a recession for some time.
The S&P 600 Small Cap Index trades at a 13.5 forward P/E multiple, as at the end of November, a level not seen since the global financial crisis. As many of these companies lack the widespread name recognition of their larger-cap peers and remain somewhat under the radar from an analyst coverage perspective, therein also lies some of the appeal and opportunity. The wreckage of the pandemic IPO period, in particular, could harbour promising investment prospects for those willing to conduct thorough research and due diligence.