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This article appeared in the August 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Know how to identify small companies with attractive characteristics.

Photo of Peter Rae By Peter Rae, Morningstar

Investing in small-cap companies, those outside the largest 200 by market capitalisation can be fraught with danger. The risks are generally higher and they are not as well researched as the big companies, which are well covered by the major broking houses.

With a narrow business base and less diversification, small companies are often more exposed to downturns in their particular industry or in the broader economy. Those in cyclical industries can be particularly vulnerable and experience major swings in earnings, and the risk of collapse can be much greater.

However, there are a number of quality small-caps that have strong, well-managed businesses and have delivered strong returns over many years.

So what makes a quality small-cap business? We focus on a number of key attributes that set a business apart from its peers: those with strong or leading market positions, an established niche in a particular market segment, or particular business strengths such as strong maintainable brands.

Particularly attractive are businesses with an economic "moat" - the competitive advantage that one company has over others in the same industry. These include innovation skills, first-mover advantages, and a superior cost position, the ability to provide a range of products to suit the needs of a variety of markets, or high switching costs (moving between products) or locking out of competitors.

Quality management is an essential requirement for all companies but is particularly important when looking for good small-caps. Although qualifications are important, a previous track record and a proven ability to deliver strong returns are key qualities to look for in management.

Past performance is not necessarily a guide to future performance, but we look for companies with a history of delivering strong growth and sustainable, high returns on equity, and assess whether those returns are likely to continue and what are the key drivers of outperformance.

Financial strength is also an important consideration, as is low or no debt and/or strong interest cover.

In choosing quality small-caps we try to avoid highly cyclical exposure. Most companies are exposed in some form or other to the business cycle, but we try to identify those that, by virtue of their business strength, financial position and management capability, are able to withstand economic downturns without a major impact on performance.

Four small-caps we consider to be quality businesses are ARB Corporation (ARP), Carsales.com (CRZ), Invocare (IVC) and Reckon (RKN). Each has some attributes we look for in higher-quality small companies.

(Editor's note: Do not read the ideas below as share recommendations. Do further research of your own or talk to your financial adviser before acting on ideas or themes in this story. The examples below are meant to illustrate the qualities Morningstar looks for in small companies. No consideration in this analysis has been given to the valuation of these companies.)

This is by no means an exclusive list; there are a number of companies that meet our criteria for quality small-caps. It is important to remember that small-cap companies are generally higher risk and may not suit all investors. For most investors, small-cap holdings should form only a small part of a well-diversified portfolio.

ARB Corporation (ARP)

ARP is a manufacturer and distributor of four-wheel-drive accessories. It has been one of the best long-term small-cap investments on the Australian market, with a 10-year compound rate of total shareholder return of 22 per cent. This is because of expertise in product innovation, marketing, exporting, distribution network expansion and production efficiencies. The management is as accomplished and credible as any in the small-cap sector. Return on equity averaged 25 per cent over the past 10 years despite low debt, with ROE ranging between 22 and 29 per cent. Such strong, consistent returns are rare in the small-cap sector.

Admittedly, a main reason is that so far the 4WD accessories market has not been large enough to make it worth competitors' time and effort. Management is nimble in responding to threats and opportunities. Given the potential for competitors to replicate ARP's Australian distribution channels, we do not consider it has an economic moat.

Carsales.com (CRZ)

Although technically an advertising business, as an online classified aggregator Carsales.com can also be viewed as a technology company. It has a short history as a listed entity but including the period before listing, growth has been strong. We expect this to continue as advertising continues to shift from print media. A strong brand and first-mover advantage should enable CRZ to maintain market dominance.

Nielsen Online domestic traffic for audited site traffic shows CRZ accounts for 80 per cent of all page impressions for car classifieds, the other 20 per cent taken by competitors Telstra, Fairfax and News. This clear market dominance, built through first-mover advantage and established strong brand awareness, represents a powerful competitive advantage. When people are looking to buy a car, the first place they go is carsales.com.au, which means sellers will want to list their vehicles on the site. This in turn entices more buyers and sellers, making it difficult for competitors to take market share.

However, the internet landscape is open to rapid change, which brings an element of risk and uncertainty surrounding the emerging threats to the business of CRZ, so we don't consider it to have an economic moat. But we think car, bike and boat classifieds are best served by a localised online market operator. An example is the New Zealand website Trade Me, which retains a dominant localised site that has proven to be difficult to dislodge because of local brand awareness.

We consider CRZ a quality business because its brand has established itself as being the website of choice to access automotive online classifieds. With the movement from print to online advertising gathering momentum, we expect CRZ to take a disproportionate share of this extra revenue.

Invocare (IVC)

With the acquisition of Bledisloe Group, IVC's share of the Australian funeral market increases to 26 per cent, and to more than 15 per cent of the cemeteries and crematoria market. The acquisition also gives market leadership in New Zealand. IVC has the only two national funeral brands, White Lady and Simplicity. It will now operate from almost 200 strategically located properties, focused on capital cities and major regional markets in New South Wales, Queensland and New Zealand. IVC acquired a funeral services company in Singapore in 2006, the leader with a 10 per cent share in a relatively small market.

The nature of the business means low sensitivity of demand to price. Limited availability of cemetery land in populated areas is a considerable barrier to new entrants, providing a narrow economic moat and further pricing power.

IVC's business model operates with multi-branded front-end businesses, supported by back-office shared service functions. The reliability of cash flows justifies a high level of balance-sheet gearing. Low capital expenditure requirements allow a high payout ratio. The shares suit investors seeking dependable dividend income that grows a little above inflation.

Reckon (RKN)

RKN is a leading supplier of management solutions for the wealth management, SME, accounting and legal sectors across Australasia, the UK and US. The majority of earnings come from domestic sales of accounting software products Quickbooks and Quicken, which are licensed from US-based Intuit Inc. Intuit is responsible for the majority of R&D on these flagship products and this provides a competitive advantage over rivals.

Growth initiatives mainly involve moving existing desktop-based Quickbooks clients to the new Quickbooks Online, which will result in greater overall revenues because of annual subscription-based pricing. Part of the appeal is that the new online products are compatible with Mac, iPad, iPhone, Android and Blackberry devices.

RKN has a strong business model, a good track record (around 30% total shareholder return annually over the last five years) and it has been gaining market share against its formidable competitor, MYOB. The company has diversified its revenue streams and is well positioned to capitalise on future market opportunities. But given the potential for rapid technological change in the IT sector, we do not consider RKN has an economic moat.

About the author

Peter Rae is a senior equities analyst at Morningstar.

From ASX

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