M&ANIA: Smaller Cap Commodity Companies Can Be Targets For Takeout

M&ANIA
Smaller Cap Commodity Companies Can Be Targets For Takeout

Alfred Lee, CFA, DMS
Investment Strategist, BMO ETFs
Global Structured Investments
alfred.lee@bmo.com

October 6, 2010

Recent Developments:

• Last week, Brazil's finance minister, Guido Mantega, made headlines when he suggested that an "international currency war" had broken out. Recent interventions by the central banks of Japan, Korea and Taiwan have allowed those countries to lower the value of their currencies in an effort to help make their exporting industries more competitive. Although China has recently mentioned that it will slowly allow the yuan to rise, it is highly unlikely that it will be a free float currency since that would have tremendous disruptive affects on China's economy.
• With the central banks of major developed economies committed to holding interest rates at near record lows, such as the U.S. and Japan, the value of the currencies in those economies will also remain low due to the lower relative interest rates. With talks of "Quantitative Easing 2.0" on the horizon, this will likely further devalue the U.S. dollar.
• When paper currencies in a large part of the world are being devalued, investors may want to consider real assets such as commodities and potentially real estate. Commodities are traditionally a hedge against a falling U.S. dollar, although they are now being used as a hedge against all currencies. This is especially true for gold. Commodity based companies in this type of environment would likely see higher profits since revenues would rise and some of the costs would be fixed.
• Smaller-cap commodity companies may be seen as more attractive since larger cap names are limited in organic growth. In addition, takeouts or mergers and acquisitions are becoming more common as companies can take advantage of low interest rates and cheap loans.

Opportunity:

• Investors that want to execute this trade can easily target a commodity specific small-cap sector through the following BMO ETFs:
• For those investors that want exposure to small-cap gold companies, the BMO Junior Gold Index ETF (ZJG) is available. This ETF tracks the Dow Jones North American Junior Gold Index, which is comprised of 25 small-cap North American gold companies. Please note that given the recent run up in the BMO Junior Gold Index ETF, we recommended that our readers trim positions in this ETF. As we remain bullish on gold and specifically smaller cap gold companies over the long-term, we recommend buying this ZJG on pullbacks.
• For those investors that want exposure to small-cap oil companies, the BMO Junior Oil Index ETF (ZJO) is available. This ETF tracks the Dow Jones North American Junior Oil Index, which is comprised of 61 small-cap North American oil companies.
• For those investors that want exposure to small-cap natural gas companies, the BMO Junior Gas Index ETF (ZJN) is available. This ETF tracks the Dow Jones North American Junior Gas Index, which is comprised of 30 small-cap North American natural gas companies.
• We do suggest that investors allocate a small portion of their portfolio to small-cap funds. While junior commodity stocks may offer sizable long-term returns, they are volatile in nature. Small-cap commodity funds are especially sensitive to macro-economic and political events and their fit should be considered on an overall portfolio level while maintaining an overall risk budget.

Chart A: Target Firms Being Acquired At Sizeable Premiums

Source: Bloomberg, BMO ETFs

Chart B: North American Energy and Mining Companies Have Been Targets

Source: Bloomberg, BMO ETFs

Chart C: An Overwhelming Majority of Deals Have Been For Smaller Cap Companies

Source: Bloomberg, BMO ETFs

*All prices as of market close October 1, 2010 unless otherwise indicated.

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