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2 small-cap growth shares to own for 2016

If you’re anything like me, shares find their way on to your watchlist for a lot of reasons: high growth prospects, changes in management, new products or services or sometimes, just because they are interesting.

Unfortunately, that can mean that the watchlist gets crowded and that you don’t keep track of the prospects of the companies on it as they change, and only see the day to day share price movements. Spreading yourself too thin means that when the time comes to take action, you might miss the cue.

So here are some growth stocks from the smaller end of the market that could be set to outperform in 2016, and might well be worth watching more closely.

Retail Food Group Limited (ASX: RFG) may have begun life as a simple Queensland-based franchisor of bakeries and donut shops, but it has expanded well beyond those humble roots.

The company is now a master franchisor for a range of national brands including Crust Pizza, Michel’s Patisserie, Pizza Capers, Donut King, Brumbies Bakeries as well as a host of coffee retailers including Gloria Jean’s.

One of the most interesting things about the company is the economies of scale it is achieving in what is already a high margin business: coffee roasting and retailing. The typical cup of coffee costs around $0.30 to make and retails for between $3.50 and $4.00. By owning vertically integrated assets in the huge coffee market in Australia, from roasting, to distribution to end stage retail, Retail Food Group cuts its costs and increases its margins.

In addition, the economics of franchising for a master franchise owner are hugely attractive, as it is franchisees that take on the bulk of the financial risk, while the master franchisor sits back and collects a stable amount of royalties (usually between 6% and 10%) as a percentage of sales in exchange for non-financial support.

Retail Food Group has also executed sub-franchisor agreements for India and China, so is well placed to capitalise on the megatrend of the urbanising middle class in both of those countries. It is a great business model because it does not have to dominate any of the markets in which is plays in order to reap handsome profits.

In 2016, investors should track total franchisee numbers across brands as this is a good lead indicator for revenue and profits for RFG.

DuluxGroup Limited (ASX: DLX) is another growth stock that is often overlooked because investors think they know the story: sells paint, tied to building cycle.

In fact, Dulux is probably one of the best growth stocks on the ASX because it is tied to three cycles: home building, home buying, and renovations. We hear a lot about the housing market boom and potential bust, but the fact is, that even if prices fall 5% or 10%, homes will still be bought and sold.

The difference with Dulux is that it is exposed on a slightly lagging basis to housing booms. The reason is simple: if you’ve just bought a new home, it’s unlikely you are going to head straight for Bunnings and invest a few hundred dollars and your time on weekends for the next few months on painting your new home. However, after homeowners have adjusted to the new mortgage payments and perhaps saved a little money, the “spruce up” cycle begins. The recent high turnover of dwellings is a lead indicator that this will be happening soon.

In addition, home owners who did not sell will be feeling the wealth effect of rising property prices. It is clear that many homeowners use some of this new “on paper” wealth to reinvest in their homes and increase the value, through minor renovations and yes, painting.

2016 should see many stocks surprise as investors react to changes in the “accepted” story as deeper trends play out on business economics, so be sure to regularly take a closer look at the corners of your watchlist where you think you already know the score.

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Motley Fool contributor Ry Padarath has no position in any stocks mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia owns shares of Retail Food Group Limited. 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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