Is Somnomed Limited the next ResMed Inc?

While many investors prefer the comfort of the big name blue chips, I confess most of my portfolio consists of small-cap stocks. Indeed, I parted with my only blue chip stock, TPG Telecom Ltd (ASX: TPM) when the share price reached over-enthusiastic levels in early April. These days, the largest company I own is United Overseas Australia Limited  (ASX: UOS), a Malaysian property developer priced at $633 million that trades under book value, is debt free and has decent growth prospects to boot. If you find another property developer that good, be sure to let me know please.

The truth is that smaller companies offer – in general – greater potential for gains than do larger companies. That’s because a large portion of the share market is made up of managed funds that seek to hug the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) for marketing reasons. Because they receive a fee based on the quantum of funds under management, it’s much easier for them to make a profit by marketing themselves to new clients than it is to actually outperform the market. Furthermore, as their funds grow, small-caps become simply irrelevant for them. That means demand is greater for larger companies, they are more frequently covered by analysts and less likely to be cheap.

For this reason, I’m particularly interested in trying to find companies like ResMed Inc. (CHESS) (ASX: RMD) before they become large-cap companies – and one such opportunity is Somnomed Limited (ASX: SOM).

SomnoMed sells the SomnoDent – a device that treats the milder forms of sleep apnoea. While it is true that ResMed is able to treat more severe forms with its machines and masks, SomnoDent comes to the fore because it is a simple mouthguard-like device that is easy to transport and an awful lot quieter. However, the investment remains quite risky because the company has yet to turn a profit, and is spending much of its steadily increasing revenue on marketing.

There’s no doubt that Somnomed is in a competitive market but the company has grown sales per share most years since 2005, and it has grown revenue every year since 2005. To me, that says that the company is quite capable of holding its own and growing sales to the point where it is profitable.

As a guide, over the last 10 years ResMed has traded at 3.2 – 5.3 times revenue (towards the higher end of the range when the company was smaller, and had a greater potential for growth.) I estimate SomnoMed will achieve revenue of at least $23 million in FY 2014, so based on the assumption that it has plenty of growth ahead, I think it is quite attractively priced at $1.50 per share (market cap: $69 million). The question, for investors, is whether it is valid to compare SomnoMed’s business to that of ResMed.

SomnoMed is undoubedly a bit risky, and ResMed is already well known. This growing company sits in between. It's profitable and pays a dividend, but is small enough to have the potential to generate major gains for shareholders.

Indeed, at least 2 directors have, within the last 6 months, purchased shares in this growing company at slightly above the current share price. Better yet the CEO owns over 15%!

The Motley Fool's top dividend stock offers growing sales, accelerating profits and a grossed up dividend yield of over 7%! Find out the name and code right now -- your copy of "The Motley Fool's Top Dividend Stock for 2014" is FREE. Simply click here!

Motley Fool contributor Claude Walker (@claudedwalker) owns shares in SomnoMed.

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