My top 2 small-cap stocks for 2014 (and beyond)

Most of my portfolio is invested in small-cap stocks. Indeed, I own shares in just two companies that have a market capitalization of over $300 million. This is for three main reasons. First, I find it easier to find attractively priced small-cap stocks, because many analysts and fund managers don’t even look at such companies. Second, smaller companies can grow at faster rates than large companies (it’s easier to double sales from a small base). Third, I don’t suffer from the popular preoccupation with receiving a high dividend, and I don’t mind share price volatility (it’s the long term that counts).

However, a collection of small companies does lend itself to volatility, often lacks a strong dividend stream, and involves the risk of significant capital loss. Many investors will feel more comfortable holding huge established companies, even if the potential gains are less. Everyone has their own style, and their own psychological strengths and weaknesses. But most investors would consider a couple of smaller companies for their portfolio, so here are my top two picks (at current prices):

Possibly my favourite company trading on the ASX, 1300 Smiles (ASX: ONT) is considered to be too expensive by many investors. It’s undoubtedly true that the dental health company is not cheap. The current market price of $138 million gives a P/E ratio of over 22. What’s more, there may not be significant earnings growth in 2014, as the company has slowed its rate of acquisition and will be hit with the full-year impact of the closure of the Chronic Dental Disease Scheme for the first time. If the market is expecting strong profit growth for 1300 Smiles in FY 2014, and the company fails to deliver (which is possible) the share price could fall dramatically. If it does, I’ll back the truck up.

Managing Director Dr Daryl Holmes appears to be a highly effective and honest individual, who cares for his minority shareholders. What’s more, there seems to be an emphasis on the organisation contributing to a better world: I think many people underestimate the loyalty this earns a professional organisation. It also helps that they provide affordable preventative dental care plans and will finance more complicated procedures. For those without private dental plans, this is particularly helpful.

Over the long term, I struggle to imagine how this debt-free company, with cash for acquisitions could fail to grow. The fact that the company is not rushing into buying businesses doesn’t bother me in the slightest. If future acquisitions are prudently made, then the 1300 Smiles network (and brand) should gradually spread throughout the country.

My next small-cap pick is former market darling Silver Chef (ASX: SIV). Silver Chef is the perfect example of what can happen when the market loses sight of the possible downside. As recently as September, shares in the company traded at above $8.50, putting the company on a demanding P/E ratio of around 22. The company then announced a profit downgrade, sending the shares tumbling to below $5. They currently trade at about $5.25, implying a forward P/E ratio of less than 12.

Silver Chef rents and leases equipment to businesses. The company mostly serves hospitality businesses, but has moved into construction equipment with its new GoGetta business. This business has failed to grow at anticipated rates, leading to the profit downgrade that smashed the share price. The company is also expanding into Canada. These growth initiatives won’t change the fact that Silver Chef’s business is linked to business activity generally; the company’s fortunes are tied to the fortunes of the small private businesses it serves. However, at current prices the company pays a dividend of about 6%, which is better than a bank account. I think the downside risk to the share price is lower now that the company has lost its market darling status. Debtor management is a key competency, and delinquency rates are a key metric to watch.

Foolish takeaway

I would happily buy both these companies at around current prices. I’m heartened by the fact that multiple directors of Silver Chef bought shares after the profit downgrade. Both Silver Chef and 1300 Smiles benefit from the involvement of their founders, and both have significant growth potential. I believe these two companies will handsomely reward long-term shareholders.

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Motley Fool contributor Claude Walker (@claudedwalker) owns shares in 1300 Smiles and Silver Chef.

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