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How I’d invest $5,000 into small caps

The small cap region of the market is the best place to find outperformance in my opinion. Many fund managers don’t venture there, due to size and risk.

It’s much easier for a businesses to grow its profit from $20 million to $40 million than it is to go from $200 million to $400 million. It gets harder and harder to grow the bigger the business becomes, which lowers long-term returns for investors.

That’s why I’m focusing more on small caps like these at the moment:

National Veterinary Care Ltd (ASX: NVL) – $1,500

National Vet Care is a rapidly-expanding vet business which runs a national network of clinics and also has a vet management and procurement business.

A recent announcement of lower-than-expected profit margins sent the share price into a decline, but I think this offers good long-term value considering management are predicting revenue growth of more than 25% in FY19 plus a stable profit margin.

An acquisition strategy isn’t the most compelling investment thesis, but if National Vet Care can maintain a conservative balance sheet and continue expanding it should deliver solid returns thanks to a pretty defensive industry and the growing pet population.

It’s currently trading at around 20x FY18’s estimated earnings.

Paragon Care Ltd (ASX: PGC) – $2,500

Paragon is currently my favourite healthcare idea. It’s a supplier of various equipment, devices and beds to healthcare clients like hospitals and aged care facilities.

It has a centralised website for ordering, meaning it benefits from ‘platform’ effects as it grows in size through acquisitions to supply more products.

Synergies and business integration are a risk at the moment, but as long as nothing goes wrong Paragon looks attractive trading at around 10x FY19’s estimated earnings with a trailing grossed-up dividend yield of 5.4%.

Duxton Water Ltd (ASX: D2O) – $1,000

Duxton Water is a business that invests in water entitlements and hopes to profit from lease income and capital growth in value of the water entitlements over time.

Sadly, regional Australia is suffering from drought and water entitlements are becoming much more valuable to agricultural businesses. Duxton could be a decent long-term idea because water scarcity is a potential problem for the country, as well as the growing value of food due to a growing global population.

It’s currently trading at around its net asset value (NAV) per share. There’s no immediate discount, but it will hopefully deliver good underlying growth in the coming years.

Foolish takeaway

At the current prices I’m quite drawn to Paragon due to the long-term tailwind of the ageing population, yet it’s trading at a low forward valuation with a decent dividend too.

Want some more exciting small cap ideas? These hot stocks could be perfect for your growth portfolio.

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Motley Fool contributor Tristan Harrison owns shares of DUXTON FPO, NATVETCARE FPO, and Paragon Care Limited. The Motley Fool Australia owns shares of NATVETCARE FPO. The Motley Fool Australia has recommended Paragon Care 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 Scott Phillips.

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