M&A update: Valuation gap between small- and large-caps widens

Small-cap tech stocks deeply discounted

Global merger and acquisition (M&A) totaled $1.29 trillion through the end of May, up 24% from last year. Energy & Power, High Technology, and Financials are leading deal activity volume on a sector basis with the Telecommunications and Media & Entertainment sectors seeing the highest change in year-over-year volumes.

Meanwhile, the U.S. Energy sector continues to see a wave of consolidation with the sole mega merger deal in May being ConocoPhillips’ (NYSE: COP) $22.8 billion proposed acquisition of Marathon Oil Corporation (NYSE: MRO). This follows the closing of Exxon Mobil Corp’s (NYSE: XOM) $70 billion acquisition of Pioneer Natural Resources Company, which closed in early May.

With oil majors seeking cost synergies and bulking up their reserve base, we are likely to see further consolidation in the sector from acquirers who have been on the sidelines watching their competitors gain market share. As we have previously discussed, the completion of key infrastructure projects like LNG Canada and the Trans Mountain Expansion are likely to be catalysts to spark energy sector M&A activity north of the border.

Pickup in M&A activity to persist

Dealmakers continue to expect a pickup in M&A activity this year with Barclays plc indicating it expects to see 15% to 20% growth in M&A over the next 12 months “as conditions and optimism have improved and a very quiet 2023 left much pent-up deal activity.”¹

With inflation decelerating, investment-grade and high-yield bond spreads tight, and equity markets near record highs, there are favorable conditions and increased confidence for acquirors to target deals. This positive outlook on M&A was also reaffirmed by recent Ernst & Young analysis, the EY-Parthenon Deal Barometer, which incorporates the latest macroeconomic figures and also estimates that U.S. M&A deal volume will rise 20% in 2024.²

According to the Ernst & Young report, “This perspective aligns with the EY CEO Outlook survey pointing to CEOs and institutional investors having a positive M&A outlook for corporate deals and PE activity in 2024. CEOs are looking at deal-making activity as a key lever to address their near-term priorities, with the top deal driver being the acquisition of technology, new production capabilities, or innovative startups. They are also looking at their current portfolio of assets and operations and considering what will help their longer ambitions. The spike in intentions to divest assets over the next 12 months, which is broadly based across geographies and sectors, highlights how far CEOs are along their path to futureproofing for a different environment.”

Outlook

Markets were back to making record highs in May with the S&P 500 Composite Index up 5.0% in the month, bringing its year-to-date return to 11.3%, while the Nasdaq Composite Index was up nearly 7.0% through May. Even with falling commodity prices and weak energy tape, the S&P/TSX Composite was up 2.8% in the month.

With equity markets broadly moving higher, bond yields declined during the month although persistent inflation in the U.S. has weighed on yields. While inflation has remained higher than hoped by the Fed, April’s consumer price index (CPI) data suggested inflation has resumed its slight downward trend. CPI rose 0.3% in the month compared with a 0.4% increase the previous month, but declined to 3.4% on a 12-month basis.

With U.S. first-quarter 2024 gross domestic product being revised lower, to 1.3% from 1.6%, there is concern about the potential for stagflation if sticky prices and a strong job market prevent the Fed from cutting rates as economic growth lags.

In Canada the disinflation trend has been more prominent, with headline inflation falling to 2.7%. For the first time in nearly three years, headline inflation is within the target range, providing a clearer path to rate cuts. With inflation, wage, labour, and economic trends hard to predict, the path forward for the U.S. and Canadian economy remains uncertain.

We continue to see a widening gap between small- and large-cap company valuations, most prominently in the technology sector where many high-quality small-cap tech companies trade at deeply discounted levels. While deal activity in our core universe slowed during March, the pickup in activity seen in late May is encouraging and we expect it to persist in the coming months.

With encouraging outlooks from deal advisors, bankers, and CEO surveys, it appears that there is pent-up demand for deals with motivated buyers. Pender’s equity portfolios are primed with many businesses we believe have the potential to be acquisition targets. With equity markets broadly higher and the AI, electrification, space, and reshoring trends driving growth expectations higher, businesses will be looking to acquire the capabilities and skills needed to compete for the long-term.

Notes

1. Josyana Joshua, “Double-Digit Growth in M&A Activity to Continue, Says Barclays,” Bloomberg, May 31, 2024
2. Gregory Daco, Mitch Berlin, et al, “M&A outlook signals rebounding US deal market activity in 2024,” EY Parthenon, May 10, 2024

Amar Pandya, CFA, is Portfolio Manager of the Pender Alternative Arbitrage Fund and the Pender Alternative Special Situations Fund at PenderFund Capital Management.

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