Will 2014 be the year of the small cap?

Investors in recent years have trended heavily towards Australia’s high-yielding blue-chip stocks, due to the safety they offer and because of the low interest-rate environment. However, after three years of underperformance, 2014 could be the year where investors turn their attention back towards the nation’s promising small-cap stocks.

Australia’s small-cap index conceded 23% in 2011, rose 3% in 2012, fell 4% in 2013 and dropped a further 3.2% in January. In the same time, the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) has risen nearly 8%, guided by strong performances in 2012 and 2013. It was in 2010 that investors in the small-cap section last experienced a notable gain, when the index rose 11% compared to a flat result for the broader market.

So could 2014 be the year that Australia’s small-cap stocks blossom? It certainly could be – the Australian dollar is falling, which is boosting earnings for businesses with international exposure; global economic conditions are improving; and consumer and investor confidence are both climbing. Here are three small-cap stocks that you could consider adding to your portfolio today:

Greencross Limited (ASX: GXL): With a P/E ratio of 48.6 and trading at $8.38 per share, Greencross does not appear cheap, but investors may need to be prepared to pay up for this quality business. The provider of veterinary services has enormous room to grow as it acquires more businesses and continues to break into the largely untapped Australian market. Gearing is one factor that investors will need to watch closely. While it is currently sitting at 55%, it could certainly climb higher as it continues to expand acquisitively.

Select Harvests Limited (ASX: SHV): The almond producer delivered enormous returns last year. While the small-cap sector fell 4% in 2013, Select Harvests gained more than 300% as it focused on cutting costs and increasing production. California, which is the world’s largest producing region, is entering its third year of drought and this is pushing up the price of almonds globally, which should also result in higher profits for Select. Shares are trading at $5.88 and offer a trailing dividend yield of 2.6%.

Newsat Limited (ASX: NWT): Newsat is Australia’s only pure play satellite company which has the right to several orbital slots which will allow coverage to a large portion of the globe (perhaps as much as 75%). While it is expected that its Jabiru-1 will be ready to launch as early as 2015, the company has already secured nearly US$650 million worth of pre-launch contracts and is expected to bring in US$3 billion of revenues over 15 years at a profit margin of 82.5%. While it should be considered speculative, it could deliver enormous returns in the future. Shares are currently trading at 45.5c.

Foolish takeaway

Investors should note the additional risks when investing in smaller companies. They are more susceptible to falls in the market and any bad news or publicity could see shares plunge in value. As such, they should form a smaller portion of your overall portfolio.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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