Small-cap firms are flush with cash and ready to put it to work, two Delaware managers say.

As small-cap stocks head into their strongest season, November through January, two small-cap portfolio managers say to expect increased merger and acquisition activity and cash flow within this sector.

Two Delaware Investments small cap portfolio managers – Chris Beck, senior vice president and chief investment officer for the small-cap value/mid-cap value equity team at Delaware Investments, and Frank Morris, senior VP and chief investment officer for core equity investments at Delaware Investments – discussed the small-cap sector of the market and what they anticipate going forward at a press lunch on Wednesday in New York.

As of Sept. 30,  the Delaware Small Cap Value Fund achieved a top 10% ranking and Small Cap Core Fund achieved a top 19% ranking in their respective categories year to date.   

Morris noted the considerable merger and acquisition activity in the past year in the small-cap space, especially within his core fund. Over the last 19 months, Delaware’s Small Cap Core Fund has held more than 10 companies that either merged or were acquired. 

“There’s plenty of capital out there, either from corporations who are flush with cash in their balance sheets or private equity firms that do mergers and acquisitions,” he explained.

Going into the recession, M&A activity stalled, but Morris expects it will “pick up throughout the rest of this year and over the next several years.”

Delaware Investments accredits a continued increase in M&A activity to favorable credit markets, limited organic growth opportunities, an improved economic climate and strong balance sheets.

“We’re now at that stage when you look at capacity utilization where it becomes advantageous now to buy somebody else’s equipment and property and plant,” he added.

While Beck, however, hasn’t seen as much M&A activity within his small-cap value funds, he also expects an increase in future mergers and acquisitions.

“[I]t’s something that clearly to me is going to happen because, again, you’ve got liquidity and the balance sheets for companies and they do want to spend this money somehow or give it back to shareholders, which is fine with us,” he said.

Morris and Beck also discussed trends they’re seeing in companies’ uses of excess cash, including share buybacks, debt reduction and dividends. Beck and Morris noted a significant increase over the last couple years in dividend increases. “If somebody said to me, what is the one main possibility of a tailwind for both small caps and large caps over the next couple years, I would say it’s dividend growth,” Beck said. “Because right now the payout ratio is very low, historically. It’s in the low 30s.”

Beck says he could see dividends growing 10%-12% over the next three to five years.

“It probably will be driven by a lot of the financial firms that had to cut their dividends in a major way several years ago,” he added. “So that, to me, is the one real potential tailwind that most people really don’t talk about, but I think it’s out there.”

Morris, too, has seen a dramatic pick up with small-cap companies not only increasing dividends but also buying back stock.

“When you’d ask [small-cap companies] if they’re buying back their stock they’d say, ‘No, no, no. We can’t decrease the float,’” Morris said. “They’ve now taken on more of a role of being more shareholder friendly.”

Barring that these companies have the investment ability to put that capital to work themselves, Morris said “they’ve taken on the approach of giving it back to us.”

“I think what you’ll see going forward is increased dividends, increased buybacks and increased M&A — all of which adds up for a nice opportunity for small cap managers like Chris (Beck) and myself.”

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