Lewis Edgley: Takeover activity is picking up for ASX small caps

Merger and acquisition activity is returning to the smaller end of the Australian share market, as buyers look through short-term uncertainty and focus on mispriced assets. Pendal’s LEWIS EDGLEY explains

• Small-cap M&A is accelerating amid mispricing
• Buyers see value in quality industrials
• Find out about the Pendal Smaller Companies Fund

AFTER several years in which small caps have lagged their larger peers, valuation gaps have become hard to ignore — and strategic buyers and private equity appear increasingly willing to act.

Lewis Edgley, co-portfolio manager of Pendal’s MicroCap Opportunities and Smaller Companies funds, says the recent pickup has been striking.

“We observed around 15 small cap bids or approaches in the eight weeks to the end of August,” he says. “This was a huge pickup compared to this level of M&A activity we’ve seen in the preceding year.”

The activity has been broad but not evenly spread.

Edgley notes that 10 of the 15 approaches were for industrial companies, the remainder were in resources.

That split reflects where buyers are finding value: in quality industrial businesses that have been de-rated, and in resource names benefitting from stronger commodity momentum.

Where bidders see hidden value

Among the industrial names attracting interest, FleetPartners has been one of the clearest examples, according to Edgley.

The fleet leasing business received an initial proposal at $3.60 a share, representing a 27 per cent premium to its last traded price, before the situation developed into what Edgley describes as “a four-party bidding war with subsequent bids as high as $4”.

While the stock is trading around $4.20, above the initial bids, he says the small caps team sees meaningful further upside from here.

“Our view of value sits in excess of the current share price, but the ultimate price will be a function of where the current bidders see value. We expect this to become evident in coming weeks.”

Other companies that have caught buyer interest include Peet, which received a cash-and-scrip proposal from Ingenia; Austal, where an offer for its US business highlighted significant value in the remaining Australian operations; and SkyCity, which disclosed approaches it considered too low and opportunistic.

Edgley also points to AUB Group and Iress as businesses where potential M&A optionality remains, while stressing that the investment case for both does not rely on a takeover.

“We think that M&A is not over, there’ll be continued activity,” he says.

“When we look at our own fund, we think about where we are likely to see bids come from. We think both Iress and AUB Group for us are obvious candidates for future M&A.”

Both businesses have been approached previously, but a takeover didn’t progress for one reason or another.

However, Edgley says the potential for another takeover approach is strong given the strategic nature of the assets as well as a “significant amount of valuation upside”.  

“AUB is now the sole listed insurance broking business on the ASX. There were three, but over the last two years Steadfast and PSC Insurance have been taken out.

“It is important to note, our thesis on both AUB and Iress does not rely on M&A and a takeover – we just see this as upside optionality”

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Pendal Smaller Companies Fund

Patrick Teodorowski & Lewis Edgley,
Portfolio Managers

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Why small caps look ripe for re-rating

The backdrop is a market where small caps have materially underperformed large caps.

“We’ve seen small caps underperform significantly for the last couple of years versus large caps,” Edgley says. “The valuation divergence has become even more significant.”

He adds that small caps are trading close to one standard deviation cheap relative to their long-term average, and a full standard deviation below large caps on a relative basis.

“When there is mispricing of stocks in public markets, eventually there’s always another buyer out there that will look to take advantage of that,” Edgley says.