Small cap ASX shares could be the best way to generate large returns for your portfolio over the long-term.
It's much easier to double profit from $10 million to $20 million than it is to double profit from $1 billion to $2 billion. The law of large numbers makes it harder to keep growing at a good pace the larger a business becomes.
I don't think a business like Commonwealth Bank of Australia (ASX: CBA) can generate much organic compound profit growth because it's already so large.
However, I think these three small cap ASX shares could be worth buying for long-term returns:
City Chic Collective Ltd (ASX: CCX)
City Chic is a retailer of plus-size women's apparel and accessories. Initially, that industry doesn't sound like a huge growth opportunity – but the company is growing at a fast pace. In FY20 City Chic achieved sales growth of 31%.
COVID-19 obviously caused major disruption with City Chic having to close stores. However, the company saw robust demand online. The company already sold a solid amount of products online before COVID-19, but at the end of May 2020 it had seen 57% of online sales growth during the store closure period. I think that's impressive.
The business is aiming to be a global player in the plus-size fashion market. I think management have a smart strategy of acquiring competitors that are in financial difficulty and turning them into online-only offerings. Online brings better (and cheaper) efficiencies. Catherines in the US is the latest target.
I like that the small cap ASX share is looking to grow strongly internationally. Australia is a great place to do business, but it has a relatively small population.
At the current City Chic share price it's trading at 22x FY22's estimated earnings. I think that's a good price for the small cap ASX share.
Duxton Water Ltd (ASX: D2O)
I think Duxton Water is one of the most interesting small cap ASX shares. It's a company that purely owns water entitlements and leases them out.
Obviously farmers need water to grow their crops, so Duxton Water offers an essential service. It's indirectly benefiting from Australia being a major supplier of food domestically and internationally.
There is a long-term shift of water demand by farmers to permanent crops that use more water, such as almonds.
The recent dry conditions have pushed up water values over the past few years which has helped the small cap ASX share, though the Duxton Water net asset value (NAV) has declined over the past few months. There has been a bit more rain this year compared to the last few years.
However, I think it has long-term potential because fresh water supply is a very important resource. Demand for Australian produce is expected to grow over the long-term.
The water company has provided guidance of dividend growth over the next couple of years, which is good for income investors.
At the current Duxton Water share price of $1.40, it's trading at a low double digit discount to the pre-tax NAV. I think that's decent value for the small cap ASX share.
Just be aware that the ACCC is currently reviewing the water market. If there is a negative outcome to water values due to the ACCC, I think it could prove to be a long-term buying opportunity of Duxton Water shares.
WAM Microcap Limited (ASX: WMI)
Maybe you love the idea of investing in small cap ASX shares, perhaps you're just not sure of which ones to invest in. I do believe that you need to be picky. Some small cap ASX shares can be very high quality, whereas others could be very risky.
The investment team at Wilson Asset Management (WAM) have proven to be great investors for this listed investment company (LIC). Over FY20 the portfolio returned 11.8% before fees, expenses and taxes – outperforming the S&P/ASX Small Ordinaries Accumulation Index by 17.5%.
I like that with this LIC you get a diversified portfolio of some of the most exciting growth opportunities on the ASX, as judged by the WAM team. At the end of June 2020 some of its largest positions were Objective Corporation Limited (ASX: OCL), Temple & Webster Group Ltd (ASX: TPW) and Johns Lyng Group Ltd (ASX: JLG).
At the current WAM Microcap share price it offers a grossed-up dividend yield of 6.3%.
