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Beat the big fund managers with these 3 rocketing microcaps

One of the biggest advantages that small investors have is that they can invest in companies that big fund managers are forced to ignore (because they can’t buy enough shares to make a difference). Lower liquidity makes share prices more volatile but don’t confuse volatility with risk: if you are holding for 12 months or more, then tomorrow’s share price is irrelevant. Warren Buffett has outlined – in every letter to shareholders – that as the capital he manages grows, so too does the difficulty of allocating it. Famously, he said he could achieve returns of 50% p.a. with capital of under $1 million.

I’m kicking myself for missing the opportunity to invest in Reverse Corp Limited (ASX: REF) because the shares are up over 1,200% in the last year alone. The company’s 1800 Reverse service allows those without phone credit to shift the cost of a call to the receiver – at a hefty premium, of course. In emergencies the service is particularly useful, but the company has a number of competitors. Poor management decisions (to invest in secondary businesses) led to a falling share price over a number of years, but the company has clearly turned around its business in the last 6-12 months.

In late September 2013 when I first looked at the company, I noted that Reverse Corp had a market capitalisation of under $5 million, and operating profits of over $1 million. My notes from September highlight the fact that excluding cash, the company traded on a P/E ratio of about 3.5, and that while the management restructure had cost the company in employee entitlements, it would likely boost earnings in 2014.

Looking back on my notes, I can’t believe I didn’t buy shares in the company: the value was staring me in the face. Apparently, I was expecting profits to drop, not grow, and I thought the loss making businesses that the company owns would do further damage to the bottom line. As it turns out, the company made about double the profit I expected it to, and the share price has tripled. I’m pretty embarrassed I missed that opportunity. I’m not a buyer at current prices (15c per share), but the company could easily boost profits by selling (or liquidating) its underperforming businesses, and I expect the share price to rise further over the next two years.

Another microcap turnaround on my radar is Kip McGrath Education Centres Limited (ASX: KME), a franchisor of private tutoring centres. There are three main reasons Kip McGrath was in trouble. First, the strong Australian dollar reduced the value of the revenue streams from overseas. Second, the former business model – exclusively face-to-face tutoring without adequate support for franchisees – was, to quote the Chairman “losing relevance in today’s tutoring market.” Third, the company bought a college education business that generated losses and subsequently failed to gain re-accreditation resulting in wasted time, wasted salary expenses, and some hefty write downs.

That’s in the past now, and if management has learned from their mistakes, the company could have a much brighter future. It has certainly improved its online capabilities and has moved to an apparently superior revenue sharing model with franchisees. The new cloud-based software (which allows students to complete parts of the program at home) is expected to improve student retention. Of the 550-odd franchisee centres, over half are already using the new software and 94 have moved to the new full service franchise revenue sharing model. Shares are up 270% in the last year alone.

However, Kip McGrath is a speculative investment because it has only just started growing its profits (again). If revenue growth continues, operating leverage should mean that profits rise very quickly, at least for a few halves. The company will suffer if the Australian dollar continues to strengthen and benefit if it falls. In any event, my investment thesis depends on cloud computing keeping costs down as the company expands its network, and this is far from guaranteed.

Another promising microcap is Azure Healthcare Ltd (ASX: AZV), which sells monitoring hardware and software to hospitals. The company’s mission is to make it easier for nurses and other healthcare professionals to monitor patients in hospitals. Since I wrote this article, the share price is up about 10%, but the increasing demands placed on healthcare systems should create demand for Azure’s products because they improve efficiency.

As with Kip McGrath Education Centres, the thesis for investing in Azure Healthcare relies on operating leverage. Operating leverage is most significant when a company is just becoming profitable: it arises when revenue increases without an equally significant increase in costs, meaning a higher proportion of that revenue falls to the bottom line. For example, Azure Healthcare’s revenue increased 43% in the first half of 2014 over the second half of 2013, but profit was up 357%. If profit growth is even a fraction of that over the next few halves, the company stands a strong chance of more than justifying its current share price – which is up 650% in the last 12 months.

Foolish takeaway

Microcaps such as Azure Healthcare, Kip McGrath Education and Reverse Corp are illiquid stocks, suitable only for patient long-term investors. I prefer Azure Healthcare and Kip McGrath Education over Reverse Corp because I think they are widening their business moats and focusing on the core business. I therefore expect that they will become safer investments over time. Reverse Corp should do well if it strengthens its key brands and divests from its unsuccessful businesses, though growth may be hard to come by.

All three companies are recovering from poor decisions made in the past, although Azure Healthcare and Reverse Corp have substantially renewed management teams. Looking past the terribly ill fated acquisition, Kip McGrath appears to be making the right moves to improve the business. Company founders often make great leaders, so it’s pleasing to see that each of these three companies retains a founder on the board of directors.

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Motley Fool contributor Claude Walker (@claudedwalker) owns shares in Kip McGrath Education Centres and Azure Healthcare. He welcomes feedback from large and small capital allocators alike.