We’re almost there! It’s so close that we can almost touch it.

In less than a day, we’ll learn how much the Federal Reserve will cut benchmark interest rates.

This will be the first time any such thing has happened since 2020, when the world fell apart. So, everyone’s been speculating for weeks and even months about the immediate details of the upcoming action.

Will rates drop by 0.25% or 0.5%? Will markets react positively to it, and if so, by how much? Or will they see it as a reason to panic?

Because, you know, there’s always a reason to overreact if you really want to look hard enough.

You know me, though. I don’t believe in letting the melodrama – or euphoria – dictate my investment responses. With very few exceptions, my portfolio is full of stalwart companies with long-term promise.

They boast:

  • A history of dividend-growing business decisions through thick and thin

  • Attractive existing positions within their respective areas of expertise

  • Excellent balance sheets with more-than-manageable debt levels and cash reserves on the side

It should come as no surprise to my regular readers how that’s the kind of company I want to talk about again… just as I would if tomorrow was any other old market day.

But since tomorrow is actually rather significant, I want to talk about these kinds of companies with a twist – a mergers and acquisitions (M&A) twist, to be precise.

I expect the Fed’s announcement tomorrow – for however much it may cut – to boost businesses’ confidence in buying each other up.

In which case, properly positioned investors can make a good profit on the small-cap stocks being bought. They just have to know where to look.

Some Small-Cap Stocks Should Start Looking Up

I brought the topic of small-cap stocks up in Thursday’s issue, “Wide Moat’s Last Frontier,” writing how their size:

… means there’s greater room for financial gain when they do succeed. It’s a lot easier for a million-dollar company to double or even triple its profits than it is for a billion-dollar company.

One big deal could do the trick for the “little guy” operator.

Or, in the case of their investors, one big buyout.

Of course, the past few years have not been kind to big buyouts. Not after interest rates began to rise in 2022 to combat rampant inflation.

According to Statista, there were 15,103 M&A transactions in the U.S. in 2020, followed by a whopping 23,161 in 2021. But then that dropped down to little more than 18,000 in 2022 and 16,786 in 2023.

This year is looking comparable to last year’s showing. At best.

This only makes sense since higher interest rates mean higher costs of borrowing. And higher costs of borrowing make growth opportunities less attractive, to say the least.

This problem is especially pronounced in the small-business community, though even large caps have become more cautious. That’s why the Harvard Business Review noted earlier this year that non-banking firms were sitting on $6.9 trillion in cash.

The article adds that, “Even as interest rates have risen, cash now represents $1 out of every $5 of total assets held by” such institutions.

I expect those figures to start declining as we wrap up 2024. And depending on how much the Fed continues to cut interest rates from here, who knows…

2025 might see quite the boost in M&A activity, with small-cap after small-cap getting swallowed up by larger, cash-rich rivals.

A Small-Cap Reality Check That Still Leaves So Much Room To Run

Before I go any further, I need to curb your enthusiasm somewhat to point something out…

I never, ever, ever recommend buying shares based on buyout possibilities alone. If a company – no matter its size – isn’t making intelligent choices that support investors’ long-term needs, it’s not for me.

Buyout possibilities are just that: possibilities. And I don’t want to be stuck holding the bag if they don’t pan out.

You shouldn’t either.

Even with that “limiting” mindset though, I’ve still correctly called a growing number of M&A deals in recent years, including:

  • KKR (KKR) and Global Infrastructure Partners acquiring CyrusOne for $15 billion in September 2021. Those small-cap shares jumped 25% on just speculation of that sale.

  • PotlatchDeltic (PCH) purchasing Catchmark Timber for more than $919 million in June 2022. That stock shot up 27.7% on the news in premarket trading.

  • Blackstone Real Estate Partners announcing this past April that it would acquire Apartment Income REIT Corp in a $10 billion dollar deal. Those shares popped 23% as a result.

One of the biggest real estate investment trust buyers this decade has been Realty Income (O). As the world’s largest net-lease REIT – and my favorite stock to talk about – it’s always seeking more growth opportunities.

This included the $11 billion purchase of competitor VEREIT in April 2021 and the $9.3 billion deal for Spirit Realty last October. Those actions have helped it reach a $54 billion market cap today, complete with an A rating on its balance sheet.

These attributes put it Realty Income in an even better spot to take advantage of lower interest rates. Banks trust it to pay back and pay off.

And I’m quite sure it will be making the most of that trust again before long.

Meanwhile, in the shopping-center REIT space, we have Kimco (KKK). It’s been busy with its own buys, even in this higher interest-rate environment.

For instance, back in January, it acquired RPT, thereby adding 56 new properties comprising more than 13 million square feet to its portfolio.

Nor is it just the REIT sector that could see increased consolidation in the months ahead. There are several big banks with hundreds of billions in cash on hand that could easily be put toward acquisitions.

Insurance companies… big tech companies… The list goes on from there, with Warren Buffett’s Berkshire Hathaway (BRK-A)(BRK-B) also making recent news for all the money it’s sitting on.

Buying into some of these big-cap names can be quite expensive. But their takeover targets tend to be much more reasonably priced.

That’s why I’m doubling down on my efforts to locate the smaller-sized competitors they’re even now looking into – before any actual announcements are made.

Regards,

Brad Thomas
Editor, Wide Moat Daily