M&A boom creates opportunities for US small caps in 2013 – Royce Associates

Legg Mason subsidiary Royce Associates says there is an opportunity for US small cap investors because strong corporate balance sheets have raised the prospects for M&A activity.

Bill Hench (pictured), manager of the Legg Mason Royce US Small Cap Opportunity Fund, said M&A transactions in his fund were at a good premium in 2012 – reaching 40% on the latest deal – something that will remain a key performance driver in 2013.

“We saw more than a dozen takeovers in the fund last year – it is easy for companies to do deals because many targets have good balance sheets themselves, so you are no longer taking on a project that needs to be turned around.”.

“In many instances, target companies are getting a nice slug of cash with the acquisition and so the starting point is much better than in the last cycle. Good acquisitions are out there and it is not just big companies buying small ones, there are a lot of strategic actions going on where smaller names are combining.”

Hench is also positioning for a housing recovery throughout 2012.

“We felt the recovery was a case of when not if, with under-building after a period of prolonged overbuilding. We did not have enough inventory, but financing has now come back and we seem to be in a normal recovery.”

Hench said natural gas is the most exciting story in the US, with the potential industrial renaissance driven by cheap energy expected to be positive for small caps. Royce has been playing this theme through equipment makers as well as certain exploration and production names.

“In our experience, the best play has generally been those supplying the companies with the best cashflow, and the best cashflow seems to be those people extracting the gas,” Hench adds.

Hench expects to continue adding consumer names, and said industrials look reasonably valued. He also predicts further consolidation in the financial sector.

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