I think that small caps could be the best place to find shares that will outperform the market.
Small caps are not like blue chips. They are volatile, there are higher risks and they aren't well covered by the investment community. But it's the fact that they aren't well followed that could actually make them undervalued – less investors should mean a lower price/earnings ratio.
There is no set definition of what a small cap is, so I'm choosing ones outside of the ASX 300:
City Chic Collective Ltd (ASX: CCX)
One of the best performing small caps over the past two years has been City Chic, and I think that can continue.
City Chic sells female plus size clothing. The divestment of a number of other businesses has been a big success whilst the acquisition of Avenue's e-commerce business opens up another path of growth.
In FY19 the company generated comparable sales growth of 12.2% with underlying earnings before interest, tax, depreciation and amortisation (EBITDA) growth of 25.2%. The underlying EBITDA margin improved to 16.8%, up from 15.1%.
Online sales now represent 44% of total sales, with 36% growth compared to FY18. The company is closing concession stores that have performed poorly.
The northern hemisphere now contributes 20% of overall revenue, with wholesale sales to businesses like Macy's, Nordstrom, Amazon and Asos.
City Chic is trading at 27x FY20's estimated earnings.
Duxton Water Ltd (ASX: D2O)
Duxton Water owns water entitlements. The value of its water assets, and the overall net asset value (NAV), has gone up considerably over the past two years because of the drought in regional areas, however the share price has not gone up as much.
When you look at the latest NAV of $1.76 you will see that it's trading at a 20.5% discount to the $1.40 share price. This NAV figure actually assumes Duxton Water disposes of its entire portfolio and includes estimated taxes, the NAV excluding tax provisions for unrealised capital gains is actually $2, which is a 30% discount.
Investors can benefit from the growing half-yearly dividend payments from Duxton Water – the expected grossed-up dividend yield is currently 5.8%. However, it must be expected that water values will fall somewhat when there's a rainy year.
WAM Microcap Limited (ASX: WMI)
If you're not sure about trying to pick out small caps yourself, you could always let a skilled investment manager like WAM Microcap do the picking for you.
Since inception in June 2017, WAM Microcap's investment portfolio has produced returns of 21.9% per annum before fees, taxes and expenses. Over the past year the gross return has been 35.6%. These are great numbers and show the investment team is skilled at picking out the right shares.
When share markets falls it's likely that WAM Microcap's portfolio will be hurt more than the larger shares, but over the longer-term it's the small caps that can produce bigger returns.
WAM Microcap is steadily increasing its ordinary dividend whilst paying out special dividends to make sure it doesn't become too big.
It currently offers a grossed-up ordinary dividend yield of 4.3%.
Foolish takeaway
Each of these small caps are attractively priced and have promising long-term futures. With how strong WAM Microcap's returns have been, I'd be inclined to invest more money there first, but City Chic has very good prospects too.
