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This article appeared in the February 2012 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.

Small-cap companies have outperformed large-caps over the long term and are a great way of improving a portfolio's returns and providing added diversification. If you do the hard work, there is a higher probability of getting strong returns in the small-cap sector. GEOFF WILSON of Wilson Asset Management outlines the main features of outstanding small companies.

Photo of Geoff Wilson By Geoff Wilson, Wilson Asset Management

Here are 10 attributes that Wilson Asset Management's ASX-listed investment companies (WAM CapitalWAM Research and WAM Active) look for in identifying great small-cap companies:

1. Management

Management is extremely important for all companies, particularly smaller ones. Management can make or break a company. When investing in a company, we spend time with management so we can assess them and look at their past performance. Do they have a detailed understanding of their business, particularly the financials? Do they have a clear vision for the company?

2. Earnings-per-share growth

Movements in earnings per share (EPS) has the best correlation to movements in share prices, therefore it is important a company has strong EPS growth. We look for those likely to grow at 15 to 20 per cent per annum over the next two years.

3. Free cash flow

When looking at companies that are growing strongly, it is important to understand how they will fund their growth. We look at the cash the company generates before amortisation and depreciation and after subtracting the dividend payment, capital expenditure and the change in working capital (change in working capital = inventory + debtors - creditors, multiplied by the percentage increase in sales in a 12-month period). It is important that cash flow is positive.

4. Valuation

You can look at a company on a price-to-earnings (PE) basis or a discount-to-assets basis. We try to find companies that are growing (EPS growth) at one and a half to two times their PE. For example, the company is on a PE multiple of 10 times and growing EPS at 15 to 20 per cent per annum. Or you might find companies trading at a discount to the value of their net assets. Obviously, it is important to understand the make-up of those assets. The discount-to-assets opportunities can provide low-risk plays if you are patient.

5. Operations

Operations in a small company are paramount. There should be a tight cost focus and strong financial controls. Avoid firms trying to spread themselves too thinly across various products and services. Also, be wary of companies whose future is tied to one particular event, such as a major gold discovery, drug approval or a change in government legislation, because these tend to be very high-risk plays.

6. Industry position

Analysing the company's market or industry position is important to ascertain how feasible its long-term strategy is; it is crucial that the strategy put forward by management is realistic in the current business environment.

Is the company operating in a new high-growth sector or in a more mature, stable low-growth market? In the early stages of a new growth market, many small companies can exist because there is plenty of growth to go around.

At the other end of the spectrum, especially in retail, it can be very hard for small companies to break into mature markets in a significant way. There are usually a few dominant players with large market share and significant financial firepower to counteract threats posed by new entrants. Try to identify companies that are well positioned in growth industries.

7. Patience

Shares in small-cap companies tend to be more volatile than those in large ones, but hanging in there should pay off in the long run. This does not mean an investor should stick with a company stoically until it has lost 99 per cent of its value. Patience only applies if the company is continuing to execute its strategy in line with its stated timeframe. If the fundamental reasons that attracted you are intact and the management is delivering on its stated strategic plan, then exercise patience and filter out the background noise of the market. The market should recognise the results and the story in due course.

8. Catalyst

Before investing in a company, we identify a catalyst that can re-rate or drive the company's share price higher. That could be a positive earnings surprise, a management change, a structural change in the industry, the sale of a loss-making division, or expansion into a new market. Indeed, anything you believe will positively change the value of the company in the eyes of the market.

9. Strong fundamentals

A good small-cap company should have a strong balance sheet. Although the dollar values involved might look minuscule compared to BHP Billiton, it is still just as important. Companies with high cash levels and low to zero debt are something to look for. Also, watch out for intangible assets on the company's balance sheet, such as goodwill and deferred revenue. These may have to be written down significantly at a future date.

The cash flow statement is also a key document (refer point 2 - Free cash flow). In its purest form, it registers all the cash in and cash out of the business over the period. Look to see if the company has positive cash flow overall and especially that it has positive cash flow from operations. Usually companies that have negative cash flow from operations do not survive.

Good companies with strong businesses usually have very straightforward accounts that are easy to read and understand. A convoluted set of accounts can sometimes be a red flag indicating the company is in trouble or trying to hide something.

10. Liquidity

For most investors in large-cap companies, the liquidity of shares is not a concern. However, at the smaller end of the market, investors need to be cognisant of the size of the position they wish to accumulate in a company and the average daily trading volume in the shares.

It might be a great company, but you still want to be able exit, at either a profit or a loss, if the reason behind your investment fundamentally changes. Investors need to be aware that in very thinly traded companies it may take days, weeks or even months to exit. Hence the old saying, "equity is forever".

The above points are not foolproof but they should assist investors in making their decisions when searching for a small-cap company or two for their portfolio.

About the author

Geoff Wilson is chairman of Wilson Asset Management. His firm's major focus is investing in well-priced growth companies, which it usually finds in the small and mid-cap industrial sectors, for its three listed investment companies:

  • WAM Capital Limited (WAM)
  • WAM Research Limited (WAX)
  • WAM Active Limited (WAA).

From ASX

ASX-listed investment companies and exchange traded funds are an easy way to gain diversified exposure to small and mid-size stocks. Learn more about Listed Investment Companies and Exchange Traded Products.

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