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2 very attractive small caps announce rights issues

Small companies will often announce rights issues to generate much needed capital to fund growth plans. The difficult part for investors and shareholders is knowing whether or not management can be trusted to use that money wisely.

Transparency goes a long way, perhaps more so with smaller stocks than blue chips. If management hold substantial amounts of shares in the company, it’s a good sign that they will work to increase shareholder value. Each of these two small caps’ management hold well over 50 million shares or options.

Quickflix (ASX: QFX) and Allied Healthcare (ASX: AHZ) are two extremely promising small caps and should be on a watchlist for any investor willing take on extra risk to be rewarded with potentially massive capital gains. It cannot be emphasised enough, however, that these are small risky businesses that face a number of uncertainties and headwinds including competition, business and regulation risk.

Nevertheless they are well managed and the potential for increases in revenues is there but they require capital for market research and rollout of their product offerings. From the next graph it’s obvious the number of shares on issue in the past five years have increased.

owenChart1
2013* represents approximate number of total shares on offer, after rights issue.

Problems with rights issues

Share prices fall to adjust for the increased number of shares in circulation. So, for example, if you had 10,000 regular AHZ shares at $0.08 (today’s open) and then were offered 1 for 5 rights issue at $0.05, then you are entitled to purchase an additional 2,000 shares for the discount rate. The adjusted value is $0.075.

However, further implications are realised when additional shares are offered to the market including a reduction in earnings per share (EPS) and dividend payments become more expensive for the company. Meaning if they paid out a dividend as a percentage of capital, it would be diluted by the increased number of shares.

Still worthy of a spot in portfolios?

If you bought Allied Healthcare when I identified it as a potential buying opportunity in July you would still be sitting 42% above that day’s price (although if you sold last week would have realised over 120%!). However, Allied has a number of exciting opportunities in the pipeline and management has carefully outlined the use of the capital from the rights issue as follows:

owenChart2
Source: Allied Healthcare Offer Document

As a shareholder, I will be taking part in the rights issue and intend to hold the shares for some time.

In contrast to Allied’s success, Quickflix has been anything but enjoyable for shareholders, dropping some 75% in the past 12 months alone. Quickflix is tiny (market capitalisation of around $7 million) but plays in a league full of giants such as USA’s Netflix (Nasdaq: NFLX) and Hulu. It will be revolutionary for TV networks and will (eventually) be the death of standard television broadcasters – a big reason that holds me back from media stocks like Ten Holdings (ASX: TEN). The internet will make or break Quickflix.

Australian pay TV provider, Foxtel, has already recognised the potential for overseas giants (which have already patented their names down under) to completely wipe out standard television viewing. The internet knows no boundaries and Netflix or Quickflix-style viewing will take a hold on Australian broadcasting, but Quickflix will only be successful if it can use the $3.4 million for “marketing, content acquisition and working capital” very well.

Quickflix is tiny and a very risky investment, as such, I’m keeping it on the watchlist for now.

OwenChart3
Source: Google Finance

Foolish takeaway

Successful investing requires us to continually monitor our stocks for their potential growth moving forward, objective from the past. As per the first graph, small caps will offer more shares to the market rather than put their balance sheets under pressure with debt – it’s nothing new. Severe price drops are always expected, but investors focusing on the long term may use this opportunity to buy some discounted stocks. It is important to remember however that you shouldn’t invest in these types of stocks unless you’re willing accept high levels of volatility and the possibility of losing your entire investment.

These stocks are risky to say the least, but our favourite stock is more established and pays great dividends. Take a look at the Motley Fools favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of “The Motley Fool’s Top Dividend Stock for 2013-2014.”

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Motley Fool contributor Owen Raszkiewicz owns shares in Allied Healthcare.

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