Sifting Through Small-Caps for Acquisition Targets

NEW YORK (TheStreet) -- The Russell 2000 index has enjoyed a gangbusters start in 2012 but, with correlation on the wane over the past few months, investors need to be in the right names to participate.

Correlation, basically the percentage of individual stocks that move in the same direction as their respective indexes, was a big theme in 2011 as everything seemed to swing in the same direction on a day-to-day basis, making picking individual stocks nearly a moot point.

Credit Suisse though noted on Friday that there's been some serious decoupling going on among the small caps with correlation among Russell 2000 stocks falling from 74% in early September 2011 to just 20% as of late January.

"This hasn't helped small cap fund managers much -- fewer than half of small cap funds are outperforming their benchmarks over the past 3 months and in early 2012," the firm said. "The decline in correlations has come alongside a decline in small cap ETF volumes, but has accelerated as 4Q11 earnings reporting season has come into view. In the past, small cap correlations have often come down once reporting season has picked up."

Through Thursday, the Russell 2000 was up 7% year-to-date vs. a 4.6% gain for the S&P 500, 4.2% appreciation for the Dow Jones Industrial Average, and 8.2% for the Nasdaq Composite (Thank you Apple(AAPL)!).

One strategy for investing in small caps is trying to figure out which ones will be snapped up in deals. Earlier in the week, Bank of America Merrill Lynch said it expects M&A activity in the group, which is generally understood to include public companies with market caps below $2 billion, to accelerate this year.

"Absolute valuations are attractive with forward P/E [price to earnings multiples] and price to book trading below their long-term averages and over 20% of the universe trading under 10X fiscal year 2012 earnings," the firm said. "We also see that balance sheets remain in good shape in small caps and mid caps with high levels of cash as a percent of market cap and debt to capital ratios that are reasonable. We also see the potential acquirers, the large caps, are in good financial condition with debt levels close to their long-term average and above average levels of cash."