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3 small caps set to deliver 50% upside over 3 years

A fund manager that targets small companies that will deliver 50% upside over a period of three years, sounds too good to be true. Not according to Morningstar, who are suitably impressed.

The two principals and co-portfolio managers of the Novaport  Smaller Companies Fund are indifferent to where they think the small-cap market will go over the next three months, six months, nine months or a year. Their mantra is “We invest in companies not stocks, the way a business owner may decide whether or not they are going to invest in a company”.

Below are the three companies that are contributing to the fund’s recent solid performance.

Kathmandu (ASX: KMD)

The vertically integrated designer, marketer and retailer of outdoor clothing and accessories, rose 97% for the year ended 30 September 2013. It remains one of NovaPort’s preferred retail exposures, making up around 4.75 per cent of the fund’s total stock holdings.

This investment bears testimony to the fund’s indifferent stance on market direction or even the preferred sectors. Clearly retail has been struggling, but Kathmandu appealed to Novaport  as it took some of the macroeconomic forecasting risk out of the equation.

The original investment was made when it had 76 stores during its initial public offering (IPO). A demonstrable rollout profile of 150 stores over a 5 year period virtually locked in substantially higher earnings, given that the balance sheet was strong enough to avoid dilutive capital raisings.

Additionally, by dint of ownership of its brand, internet purchases could only be made on the company website. Thus, the company avoided the fate of fellow retailers such as Myer (ASX: MYR) and David Jones (ASX: DJS), that had little or no protection against the online migration of retail spending.

Sirtex Medical (ASX: SRX)

Sirtex is a developer of cancer treatments with an innovative new treatment for liver cancer. The wide adoption by oncologists and clinicians is growing around the world as they realise the benefits of delivering high doses of radiation directly to the tumour.

However, the fund’s managers do acknowledge the risks inherent in the stock.

Morningstar are certainly mindful of those risks, citing a single-product portfolio that has a narrow moat, as the company faces the possibility of a superior competing technology. However, in their view the large upside potential compensates for these risks.

Fisher & Paykel Healthcare (ASX: FPH)

Unlike Sirtex, Fisher & Paykel has been assigned a narrow moat by Morningstar and shares of the company, which makes devices for use in respiratory care, acute care and the treatment of obstructive sleep apnoea, are up nearly 70 per cent over the past year.

When people think of the name Fisher & Paykel they often think of fridges, freezers, clothes dryers and washing machines, but interestingly the healthcare company has its genesis in one of those everyday household appliances. A pump used in a washing machine was turned into a ventilator, that is now used in hospitals around the world.

Morningstar senior equities analyst Nachiket Moghe, believes that as the market leader in respiratory and acute care, Fisher & Paykel Healthcare should be able to maintain its narrow moat. “As a result, we think Fisher & Paykel Healthcare will continue to experience pricing power and strong constant currency growth rates.”

One risk is that unlike its peers, Fisher & Paykel Healthcare is not well diversified geographically and derives an overwhelming proportion of its revenues from the US.

Foolish takeaway

There is always a place for small companies in a well-diversified portfolio. There are fantastic opportunities that may form a part of any strategic asset allocation.

Drilling down further into asset allocations, the weighting of specific stocks within your small company’s portfolio should take into account the risks inherent in those stocks. In the case of Sirtex, a smaller weighting may be appropriate due to the higher risk.

The other two stocks are more conservative investments and have also gained the imprimatur of Morningstar. In short, you may feel comfortable clothed in Kathmandu and cleaning up with your Fisher & Paykel.

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Motley Fool contributor Mark Woodruff does not own shares in any of the companies mentioned in this article.

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