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3 top small-caps for your watch list

It is widely believed that small stocks are riskier than their larger peers, but is this true?

The case for

  • Little companies typically have fewer business lines than large ones and so it is more likely that a single event could damage a small business to the extent that it could not recover. This risk can be overcome by holding a large number of diversified small-caps, but this also erodes returns.
  • Small stocks are generally more volatile, thanks to less liquidity, less efficient pricing and because the underlying businesses themselves are more changeable. Holding volatile stocks is a painful experience and it requires a high level of conviction to resist the temptation to sell.
  • Most large companies have a solid track record of consistently delivering profits and so there are few poor businesses of this size. In contrast, there are many terrible companies at the bottom end of the market and so it is harder to pick strong ones.

The case against

  • Small companies are less efficiently priced because there are fewer participants in the market. Most of the money is held by large institutions that have no reason to buy small stocks, since such holdings would have an insignificant effect on their returns. Inefficiency provides more opportunity for investors to pick up bargains which reduces risk.
  • Small companies are often easier to understand than large ones because they are much simpler. This makes them easier to value, although their value can change fast since they are capable of growing quickly.
  • Really, it is not about whether small stocks are riskier than large ones, but whether they deliver superior risk adjusted returns. Small-caps can offer greater returns thanks to the possibility of faster growth, if they are no more risky than large stocks then clearly they offer a preferable investment proposition.

Here are three small-caps with the potential to deliver high returns.

Capilano Honey Ltd (ASX: CZZ)

This honey distributor and packer is a widely known brand and controls much of the supply of Australian honey both domestically and internationally. The company is benefitting from the trend towards healthier living and I estimate that it is trading on a forward looking enterprise value to free cash flow ratio (EV/FCF) of less than 15.

Azure Healthcare Ltd (ASX: AZV)

Azure Healthcare is a global manufacturer and distributor of nurse call systems and is cementing its position within this niche industry through expansion into the US. Thanks to recent technology gains, nurse monitoring devices are becoming increasingly important in helping hospitals operate more efficiently. Demand is expected to grow as populations around the world age and according to my calculations, Azure’s normalised EV/FCF is currently around 16.

Empired Ltd (ASX: EPD)

Thanks to a series of sizeable acquisitions, Empired has been able to grow its service offering, which has led to the award of four significant contracts since the start of March. It is also benefitting from the growing acceptance of cloud computing and the associated shift towards outsourcing of organisational IT functions. If the company can meet its profit margin goal of 12.5% earnings before interest, tax, depreciation and amortisation, then it is likely to trade on a forward price to earnings ratio of less than 10.

Foolish takeaway

Ultimately, whether you choose to invest in mainly large or small stocks is a personal choice that depends on specific circumstances. For example, do you have the temperament to accept a high level of volatility? Do you have the time or inclination to trawl through all the rubbish at the small end of the market to find the odd hidden gem?

Regardless of which category you fall into, every investor can learn something from the greatest of our time, Warren E Buffet. As Benjamin Franklin said, “An investment in knowledge pays the best interest.”  To find out more, just follow the link below.

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Motley Fool contributor Matt Brazier owns shares of Capilano Honey Limited. You can find Matt on Twitter @MatthewBrazier1

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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