Three things to note before you buy small cap stocks

Credit: Simon Cunningham

Searching for companies with the potential to grow tenfold is fraught with danger; for every big winner like Bellamy’s Australia Ltd (ASX: BAL) and Blackmores Limited (ASX: BKL), there are multiple losers which never make it to the headlines.

Nevertheless, the allure of a ten-bagger means small-cap stocks remain the most interesting space to find the next big winner.

Here is what I look out for when investing in small-cap stocks using Mobile Embrace Ltd (ASX: MBE) as an example.

1. Free cash flow

As the adage goes, cash is king. Free cash flow is the number one thing I look for when investing in small-cap stocks as a company’s survival depends on its ability to earn money and pay its debts.

A company which is able to generate free cash flow suggests its business model is working as its customers are willing to pay for its goods/services without spending too much in return. It also implies that the company has a manageable debt load.

Mobile Embrace appears to satisfy this requirement with its 2016 full-year results revealing net cash increased $8.4 million to sit at $18.0 million at the end of the financial year. While strictly not a result of operational activities, given $12 million was raised from a share purchase plan to fund $15.5 million worth of acquisitions, excluding these one-off items Mobile Embrace generated $6.3 million from operations. Free cash flow (excluding one-offs) was $4.9 million, up on prior year, indicating robust cash generation.

This represents a good balance between current operations and future growth initiatives.

2. Profitability

As noted above, free cash flow can be augmented by one-off items such as capital raisings and accretive acquisitions. Accordingly, investors should overlay a company’s free cash flow with its profitability to ensure the business is actually performing.

In this regard, Mobile Embrace is firing on all cylinders (and at accelerating rates). Management declared net profit after tax swelled to $4.9 million on earnings (EBITDA) of $9.5 million. The result was driven by a whopping 83% increase in sales revenue, demonstrating its growth strategy is truly taking hold.

3. Price

Finally, to quote Warren Buffett, price is what you pay; value is what you get. Investors mustn’t buy small-cap stocks simply because they are “cheap”, as this strategy can lead to long-term pain.

More often than not, lesser known stocks demand high price-earnings multiples because of their future potential, rather than current earnings. Therefore, if investors focus solely on price-earnings ratios, they might end up buying stocks they shouldn’t and skip ones they should be buying.

Mobile Embrace is an example of the latter, given it trades on a price-earnings ratio of about 27 which is almost double that of Commonwealth Bank of Australia (ASX: CBA). However, unlike CBA, Mobile Embrace grew earnings per share by 57% in its last financial year and reported a 61% increase to net profit after tax.

If these numbers can continue, Mobile Embrace’s current share price will be considered cheap in a few years’ time as its future earnings justify its current price.

Foolish takeaway

Mobile Embrace ticks all the right boxes for investing in a small-cap stock to make it a buy today. However, like any speculative investment, it carries a lot of risk given it is still proving itself in the market.

Whilst I do believe it has a solid future ahead of it, I don’t recommend selling all your other holdings to buy Mobile Embrace. Investors must remember to maintain a balanced portfolio and therefore should limit their holding in Mobile Embrace to less than 2% of their total portfolio value.

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Motley Fool contributor Rachit Dudhwala has no position in any stocks mentioned. The Motley Fool Australia owns shares of Bellamy's Australia. 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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