2 superior small caps for your watchlist

Beaten down sectors of the market are offering some good buys.

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Not all market sectors are experiencing good times and it may pay to look at the value opportunities available in the downtrodden mining services and technology industries. Both of these sectors are starting to show early signs of emergence from a cyclic downturn.

Imdex (ASX: IMD) supplies innovative drilling fluids and advanced downhole survey instrumentation to a range of industries including civil engineering, minerals, oil/gas and water. Currently, its main exposure is to minerals production and development followed by oil and gas. Management's intention is to derive 30%-40% of revenues from the oil & gas sector within the medium term. This will help establish a solid footing for reliable earnings growth over the next few years.

Following a 58% profit fall in 2013, Imdex is selling at nine times earnings and a yield of 3.5%. However there are a number of reasons to feel positive about the outlook for this company.

  • Based on 2013 results the financials are sound with strong operating cashflow, low gearing (22%) and an interest cover of 10 times.
  • Imdex has developed innovative solids removal technology; minimising environmental effects and lowering water and other operating costs.
  • Imdex owns a 30% share of VES International which is the third largest provider of downhole survey services in the global oil and gas market.

Imdex continues to invest in developing the business, and has established a technological advantage over much of the competition. Although the outlook for 2014 remains subdued Imdex is well positioned in a specialised segment of the resources industry.

SMS Management & Technology (ASX: SMX) experienced a slump in earnings over 2013 with earnings per share declining to 30.6c and the fully franked dividend reduced to 25c. However figures alone don't tell the whole story here – SMS has used this industry downturn to rationalise the business base and make highly strategic acquisitions – these moves will in turn provide strong operating leverage when the IT industry inevitably rebounds. The main reasons for my growing confidence in this company include:

  • Zero debt and a cash balance of $37 million – giving the capacity to make further value adding acquisitions when justified.
  • SMS Management maintains a good reputation with both quality clients and IT partners.
  • Targeting high growth sectors of the IT industry such as cloud based managed services – these are typically three- to five-year fixed contracts and provide earnings certainty.

This company is well managed and is astutely positioning itself for significant growth over the medium term.

Foolish takeaway

Successful stock picking is all about assessing future prospects, finding value and identifying quality companies in their own field. Imdex and SMS Management & Technology have been very positive in placing themselves to do well when their respective industries resume growth (which they will) and both rate highly on my own watchlist and are definitely worth a look.

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Motley Fool contributor Peter Andersen doesn't yet own shares in the companies mentioned in this article.

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