Three top US small cap stocks to buy now

Mergers and acquisitions activity is due to pick up, says professional stock picker David Schuster. Here, he tips three stocks ripe for takeover.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: David Schuster, co-manager, US Small-Cap Blend Fund, Brown Advisory.

One distinguishing characteristic of US small-cap stocks, and a significant driver of long-term value, is the high level of merger and acquisition (M&A) activity.While activity recently has been muted, in the past 15 years there have been nearly 1,900 takeouts in the Russell 2000 (the US small-cap index).

We do not invest in the expectation that a company will be bought. But we do invest in companies with financial traits that would be appealing to a potential strategic or private-equity buyer. With large-cap company cash levels and valuations high, we are optimistic that M&A activity will pick up significantly.

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Core-Mark Holding Co (Nasdaq: CORE) is a leading distributor of fresh and packaged goods to convenience stores in North America. Core-Mark has invested heavily to differentiate itself through value-added offerings, such as vendor consolidation, focused marketing, and better fresh food distribution. These build customer loyalty and push up the cost of switching suppliers. Divisional heads have the freedom to run operations in the most suitable way for their particular region.

As an industry consolidator, we have been impressed by how smoothly the company brings new clients on board. Core-Mark's smaller rivals lack the capital to be competitive, and its larger rival is more focused on broad-line distribution, rather than convenience stores. The company is attractively valued, given its highly leverageable operating model, which generates huge free cash flow. Similar businesses have been bought at much higher valuations.

Destination Maternity (Nasdaq: DEST) is the only national specialist maternity-wear retailer in America. It has around 40% of the market. The company has a vertically integrated business model and a large footprint of 605 company retail stores, 1,298 leased departments, 1,155 Kohl's store locations and 142 international franchised locations. It also has a highly valuable opt-in database of prenatal customers used for profitable, exclusive category partnerships.

We like the firm's ability to generate strong, sustainable free cash flow and management's disciplined approach to capital allocation. It repaid all its outstanding debt in early 2013 and we expect a further return of cash to shareholders. The quarterly dividend was raised by 10% in June, to $0.19 per share. The company also has $10m available under a share buyback programme.

Also, after four years of falling, US birth rates are now stabilising. With more households being formed, and a drop in unemployment, rates should revert to historical levels, which will help this industry.

Bristow Group (NYSE: BRS) provides personnel transport services to the offshore and deepwater oil and gas industry, via its fleet of aircraft. As well as a remarkable safety record, Bristow is one of only two providers with a truly global fleet supporting this part of the industry. Activity and demand remain robust, particularly for larger, faster helicopters that can fly over longer distances in a wider variety of conditions.

Given the limited supply and high cost of larger craft, Bristow's unmatched financial position and flexibility give it a distinct advantage over rivals as it prepares for new contracts in existing and new markets, and in the search-and-rescue market. Bristow's favourable contract characteristics the majority of the value is in fixed charges, while excess fuel costs are fully reimbursed provide even greater visibility as it navigates the opportunities ahead.

David Schuster is co-manager of the US Small-Cap Blend Fund at Brown Advisory.