In an environment of rising and/or persistently high interest rates, one of the largest victims in the public markets is always small-capitalization stocks.

Persistent inflation caused by poor economic, fiscal, and monetary policy like we have today drives institutional capital to safety. Institutional capital becomes risk-averse and tends to avoid smaller capitalization stocks that have higher volatility and much less liquidity.

And when you’re managing billions and can earn 4.42% on your money in 2-year U.S. Treasuries virtually risk-free, why take on the risk?

Treasuries and high-quality, large-capitalization growth stocks throwing off free cash flow tend to be the focus for institutional capital at times like these. The mega-large caps are particularly attractive given their liquidity. It gives funds comfort that they can move massive positions when they need to.

And this is exactly the kind of market behavior we’re seeing today. 

In fact, it’s at an extreme with institutional capital flocking heavily into the Magnificent 7 stocks – Apple, Tesla, Microsoft, Alphabet, Meta, NVIDIA, and Amazon.

This has resulted in elevated valuations for a very small number of large caps, and generally depressed valuations for high-quality, small-capitalization stocks.

Conditions like these never last. 

Small-capitalization stocks always outperform over time. 

And the economic and political developments of the last few weeks have increased the likelihood of at least one Fed Funds interest rate cut before the end of the year. The September FOMC meeting will be an attractive window to do so.

Lower interest rates, or even the expectation of them, will be a boon for the small-cap markets, especially for high-quality tech and biotech names.

Which brings me to the announcement from a few days ago… Alphabet (Google) intends to acquire cybersecurity startup Wiz for about $23 billion.

Now, at $23 billion, I’m sure we’re all thinking that Alphabet is acquiring a large-cap, high-tech stock, right? After all, assuming the deal goes through, it will be the largest acquisition in Google’s history.

This is where it gets interesting…

An Aggressive Valuation

By all metrics, if Wiz was a publicly traded company, it would be a small-capitalization company.

The company was founded just a few years ago in 2020. At the end of that year, it raised a very large $100 million in its Series A funding. 

There was clearly a lot of interest in Wiz’s approach to cloud security, drawing capital from major venture capital firms like Sequoia, Index Ventures, and Insight Partners. It was at that point the company was on my radar.

It has been a fast ascent for Wiz. Each subsequent funding round got larger, culminating in an impressive $1 billion Series E round this May, at an impressive $12 billion post-money valuation for a company just four years old. What a rocket ship…

And then came the acquisition offer from Google. The media has been fixated on the regulatory risk of the deal going through or not. 

After all, Google acquired cybersecurity firm Mandiant in 2022 for $5.4 billion. Mandiant was formerly known as FireEye. FireEye changed its name to Mandiant in October 2021 as the company was evolving with a strong cloud security focus. I had predicted FireEye’s acquisition a couple of years prior.

The thinking is that given Google’s dominance in both search and mobile phone operating systems, as well as its already heavy presence in cybersecurity, it will suffer intense regulatory scrutiny over acquiring Wiz for $23 billion.

That’s not wrong, but it’s not what makes this acquisition interesting.

Wiz isn’t a large-cap tech stock. It’s not like Google is acquiring Palo Alto Networks or Fortinet. That would never fly with regulators.

Wiz recently crossed the $500 million annual recurring revenue (ARR) milestone. That’s the point at which monthly revenues, if multiplied by 12, would equate to $500 million in annual revenue. That’s around $41 million in revenue a month.

From both a revenue and normal valuation perspective, that’s a small-cap stock. Valuating Wiz on a $500 million ARR is a forward-looking metric. A $23 billion offer from Google equates to a forward valuation multiple of 46 times annual revenue. Over the moon!

And this is despite Wiz reportedly losing $100 million over the last 12 months. While it’s on the right trajectory, it’s still losing a lot of money.

A high-quality, high-growth, small-capitalization public company like this might be valued at six to eight times forward sales in a market like this, and I’m probably being generous. That would put the valuation of Wiz between $3-4 billion, which again would be a small-capitalization stock.

That’s what makes the offer from Google to acquire Wiz at 46 times forward annual sales so interesting.

It’s such an aggressive valuation multiple for Wiz, the kind we only tend to see in a roaring bull market for small-cap tech stocks.

What to make of it? Why is Google so happy to “overpay” for Wiz?

Private Markets Lead the Public Markets

This deal is relevant because M&A activity in the private markets tends to lead the public markets. 

Private capital tends to become more conservative in the private market ahead of public market declines. And it tends to get more aggressive before we see a “risk-on” approach in public equities.

We can interpret this acquisition offer as a sign of things to come.

And not coincidentally, early this morning, another exciting small-capitalization company – publicly traded GitLab (GTLB) – revealed it is exploring a possible sale.

GitLab is a phenomenal software company that is cash-rich, has incredible margins, almost no debt, and is generating more free cash flow with each quarter that passes. 

GitLab is forecasted to bring in about $735 million in revenue this year and $69 million in free cash flow. In other words, a more attractive business than Wiz.

The media cites growing competitive pressure from Microsoft’s GitHub as the reason that GitLab is exploring a sale, but that’s not what’s going on.

GitLab is crushing it as a business and is the software developer location for applying artificial intelligence (AI) to software development. This space is red hot right now and is one of the most practical and widely adopted applications for AI.

The far more likely reason for considering a sale is that the board of GitLab looked at the acquisition offer from Google at 46 times forward sales and recognized that it may just find a buyer at a valuation many times higher than where it’s trading today.

If we applied a 46 times EV/Sales multiple to GitLab’s forecasted 2024 sales, we’d be looking at a $33.8 billion valuation. That’s 356% higher than where GitLab is trading. 

Even if we cut that valuation multiple in half to 23 times EV/Sales, GitLab would be at a $16.9 billion valuation, 128% higher than today’s valuation. 

It’s worth exploring a sale with numbers like these. And even if the company doesn’t find a buyer, the business will continue its high-growth, high-profit path.

And there’s one other factor that is likely in play… 

Alphabet owns 7.35% of GitLab. If, through Alphabet’s ownership, it can influence the GitLab board to explore a sale, it will be in an ideal position to acquire the company.

After all, Microsoft owns GitHub – GitLab’s largest competitor – and the regulators allowed that deal to go through. It would be hard for the regulators to argue that the Microsoft/GitHub deal was “OK,” but an Alphabet/GitLab deal isn’t.

Either way, these latest developments signal that momentum will pick up with high-tech small caps, and valuation multiples will expand. 

This will be a very welcome change from the small-cap bear market we’ve seen over the last 18 months.