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."

Bank of America Merrill Lynch thinks deal activity in 2012 will surpass 2011, which saw 99 deals in the small-cap space for a total of $84 billion, along with 35 mid-cap ($2 billion to $10 billion) deals, and that the pace of M&A could rival pre-financial crisis levels circa 2006-2007. In 2006, the firm said, there were 129 deals for small caps and 42 for mid caps.

According to Bank of America Merrill Lynch, tech and healthcare are likely to see the most buying interest, as they did in 2011 when nearly half of the deals were done in these two sectors.

To try to ascertain which specific Russell 2000 components could end up in play, Bank of America Merrill Lynch looked at valuation metrics for the companies that were bought in 2011 and ran a screen to see which names currently fit the bill.

The parameters used were market cap above $200 million, trailing five-year sales growth of more than 5%, net cash as a percent of market cap over 10%, a free cash flow yield of 8% and a long term debt to capital ratio below 30%. The stock also needed to be buy rated by the firm if it was under coverage.

The screen yielded 23 names, 10 from tech and 6 from healthcare. The firm notes that: "Our analysis should not be construed as any indication that any company on the list will be an actual candidate for a merger or acquisition."

Here's the list in full, broken down by sector: Caribou Coffee ( CBOU) and Systemax ( SYX), consumer discretionary; Cal-Maine Foods ( CALM), Medifast ( MED), Village Super Market ( VLGEA), consumer staples; ArthoCare ( ARTC), Depomed ( DEPO), National Healthcare ( NHC), RTI Biologics ( RTIX), ViroPharma ( VPHM), Wellcare Health Plans ( WCG), health care; Argan ( AGX) and Cubic Corp. ( CUB), industrials; Entropic Communications ( ENTR), j2 Global ( JCOM); LTX-Credence ( LTXC), Nanometrics ( NANO), OmniVision Technologies ( OVTI), Progress Software ( PRGS), Quest Software ( QSFT), Rambus ( RMBS), Synaptics ( SYNA), and Xyratex ( XRTX), technology.

Of the group, the three largest market caps belong to Wellcare Health, $2.5 billion; ViroPharma, $2.1 billion; and Quest Software, $1.7 billion. The five companies with largest percentage of net cash to market cap, according to the firm's research, are Wellcare, 69.5%; Argan, 67.5%; OmniVision, 52.1%;; LTX-Credence, 44.1%; and Depomed, 31.9%, The names with the highest sales growth over the past 5 years are Entropic, 95.4%; Depomed, 73%; Argan, 45%; and Medifast, 40.7%.

-- Written by Michael Baron in New York.

>To contact the writer of this article, click here: Michael Baron.
Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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