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This is how I’d invest $25,000 into small caps

The world of small caps is by far the best place to be if you know where to look.

Small businesses have so much more growth potential. A $200 million company can grow in size by ten times and reach $2 billion in size. A $10 billion business that grows in size by ten times would be $100 billion.

If you’re Warren Buffett or Bill Gates you can’t move the investment return gauge much with a $200 million company, even if you acquired the entire business. That’s the benefit of having much smaller portfolios.

An added bonus is that not many investors look at small caps, meaning they trade on lower valuations.

Here’s how I’d invest $25,000 into small caps:

Paragon Care Ltd (ASX: PGC) – $6,000

Paragon is my favourite small cap idea at the moment. It’s a healthcare product distribution business that supplies items like beds, devices and equipment to clients such as hospitals and aged care facilities.

It has a centralised purchasing platform for clients to buy what they need – think of it like a small-scale healthcare version of Amazon, but not quite as good.

Paragon is steadily acquiring more businesses to increase the amount of products it sells, such as the recent surgery equipment acquisition. The more products it sells the better economies of scale it achieves.

Management predict that it can achieve organic growth of around 10% this year, yet it’s only trading at under 11x FY19’s earnings.

Duxton Water Ltd (ASX: D2O) – $3,000

Duxton Water owns water entitlements and leases them to agricultural businesses. Fresh water is a very important and limited resource.

There is a drought going on in regional areas at the moment, which is bad for farmers but it is boosting the price of water. Over the long-term water is likely to become more and more valuable. However, rainy years are likely to send prices down, at least temporarily.

I plan to hold my shares for the long-term, hopefully benefit from long-term capital growth and receive the partially franked dividend yield of 3.5%. If it trades at a decent discount to its NTA in the future I will be interested to buy more.

Propel Funeral Partners Ltd (ASX: PFP) – $3,000

Propel is the second largest funeral operator in Australia.

The funeral industry is a morbid one but seems to have ultra-long-term growth tailwinds. Death volumes are expected to grow by 1.4% per annum between 2016 to 2025 and then increase by 2.2% per annum from 2025 to 2050.

Sadly, the ageing population will eventually lead to a bigger and bigger number of funerals being required and it’s also a very defensive sector.

Propel could boost its earnings strongly in the short-term with some strategic acquisitions.

It’s currently trading at 20x FY19’s estimated earnings.

WAM Microcap Limited (ASX: WMI) and Naos Emerging Opportunities Company Ltd (ASX: NCC) – $6,500 each

If you’re not confident in picking your own small caps then you could just choose to invest in listed investment companies (LICs) that are focused on small caps instead.

Wilson Asset Management and Naos both have good pedigree in finding small caps that beat the market. They both also aim to pay a growing stream of fully franked dividends.

I like that they both aim for industrial businesses, as they are less likely to be cyclical – meaning they hopefully keep growing no matter what stage of the economic cycle we’re in.

Foolish takeaway

I believe all of the above ideas could beat the market over time, which is why I’m invested in most of them for my portfolio. At the current prices I think Paragon looks particularly appealing.

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Motley Fool contributor Tristan Harrison owns shares of DUXTON FPO, Paragon Care Limited, Propel Funeral Partners Ltd, and WAM MICRO 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.