Wednesday, July 24, 2013
Big companies are dying for growth right now...
At least, that's what industry leaders like Microsoft, Google, and McDonald's showed us this week after reporting worse-than-expected quarterly results. These giants have done a great job of cutting costs and restructuring operations in the past. However, today, they are having trouble increasing sales.
It's not just these three companies. From 2011 through 2012, the 50 largest U.S. companies (based on market cap) only managed to increase sales 2.5% on average.
And this trend is getting worse. According to media firm Thomson Reuters, the average S&P 500 company is expected to report negative sales growth this quarter. In short, that means sales will be less this year than this time last year.
But this alarming trend bodes well for small-cap stocks...
You see, despite this massive headwind of slower sales, large-cap stocks are the strongest I've seen in my near-20-year career. They are leaner and more diversified in terms of global operations. They also have nearly $2 trillion in cash on their balance sheets.
Some of this cash has been used to increase dividends at a record pace. That's a great thing in a low-interest-rate environment. It's also been used to buy back massive amounts of stock. That's one reason why earnings for most large caps are hovering near record highs – despite slow sales.
But large caps are also spending tons of cash buying small-cap companies. According to the Jordan, Edmiston Group, a leading independent investment bank specializing in mergers and acquisitions (M&A), there were 1,351 M&A transactions in 2012. That's a 50% increase from 2011.
The record-setting volume was driven primarily by smaller deals. In fact, only 14 of these deals were over $1 billion. That means 99% of the deals in 2012 were small-cap transactions.
And this trend is accelerating in 2013...
Many of these transactions include large pharmaceutical companies buying early-stage biotech stocks with strong pipelines. They also include large technology stocks, like Oracle, Microsoft, and Google, buying small-cap companies with specific patents that can coexist with their existing technologies.
Even large-cap oil companies have been buying up smaller players with prime real estate in areas like the Cline, Bakken, and Eagle Ford shales. I've seen this first-hand after visiting these areas over the past few months.
Either way you look at it, large caps need to find growth. And one way they are doing it is by buying small-cap companies with huge growth potential.
To play this trend, I suggest screening companies in the Russell 2000 Growth Index. The index includes 2,000 small-cap names with strong growth forecasts. You're looking for companies in the index with solid balance sheets and experienced management teams. These are two qualities several of my friends in the M&A business look for in a takeover candidate.
Of course, the odds are against us in predicting the next takeover target. So another way to play this trend is to invest in the iShares Russell 2000 Growth Index Fund (IWO). This fund tracks the Russell 2000 Growth Index.
The Russell 2000 Growth Index has almost doubled the returns of the S&P 500 over the past 10 years. Based on the massive M&A activity I'm expecting from cash strapped large caps who are in need of growth, this index is likely to continue that outperformance for many years to come.
Over the last six months, Frank's readers have been making money on a certain kind of small-cap stock... "Many still trade for great prices and offer great yields," he says. "But I'm seeing the press mention these stocks more often. If you're interested in this kind of income, make sure to buy soon..."