Top 10 tips to find great small companies

At Wilson Asset Management, our major focus is investing in well priced growth companies, which we usually find in the small and mid-cap industrial sectors for our three listed investment companies.

As discussed in previous articles, small cap companies outperform their large cap peers over the long term and are a great way of enhancing your portfolio’s returns and providing added diversification. In the small cap sector there is an asymmetry of information. If you do the hard work, there is a higher probability you will get strong risk adjusted returns. We describe below some of the attributes we look for in identifying great small cap companies.

• Management. Management is extremely important for all companies, particularly smaller ones.  It can make or break a company. When we are investing in a company, we make sure we spend time with management so we can assess them. We look at their past performance. Do they have a detailed understanding of their business, particularly the financials?  Do they have a clear vision for the company?
• Earnings Per Share growth. I believe that movements in Earnings Per Share (EPS) have the best correlation to movements in share prices. It is important to find a company that has strong EPS growth. We look for companies that are growing at 15% to 20% per annum over the next two years. 
• Free Cash Flow. When you are looking at companies that are growing strongly, it is important to understand how they will fund growth. We look at the cash the company generates before amortisation and depreciation and after subtracting the dividend payment, capital expenditure and the change in working capital (change in working capital equals inventory plus debtors minus creditors times the percentage increase in sales in a 12 month period). It is important that cash flow is positive.
• Valuation. You can look at a company on a Price to Earnings (P/E) basis or a discount to asset basis. We try to find companies that are growing (EPS growth) at 1.5 to 2.0 times their P/E. Say the company is on a P/E of 10x and growing at 15% to 20% per annum. On other occasions, you may find companies that are trading at a discount to the value of their net assets. Obviously, it is important to understand the make-up of those assets. The discount to asset opportunities can provide low risk plays for patient investors.
• Operations. Operations in a small company are paramount. Companies should have a tight cost focus and strong financial controls. Avoid firms trying to spread themselves too thinly across various products and services. Also, be wary of companies with a future tied to one particular event such as a major gold discovery, drug approval or a change in legislation, as these tend to be very high risk plays.
• Industry position. Analysing the market or industry position is important in order to ascertain how feasible a company’s long term strategy is given its operating environment. This is crucial as the strategy put forward by management must be realistic given the current business environment. Is the company operating in a new high growth sector or is it operating in a more mature stable low growth market?In the early stages of a new growth market, a lot of small companies can start up and perform well, as there is plenty of growth to go around.At the other end of the spectrum (think retail), it can be very hard for small companies to break into mature markets, as there are usually a few dominant players with large market shares and significant financial fire power to counteract the threat of new entrants. You are trying to identify companies that are well positioned in growth industries.
• Patience. Small cap stocks tend to be more volatile than their large cap cousins, but hanging in there can pay off for investors in the long run. This does not mean an investor should stick with a stock stoically until it has lost 99% of its value. Patience only applies if the company is continuing to execute its strategy in line with its stated time-frame. If the fundamental reasons that attracted you to the stock are still valid and the management is delivering on its strategic plan as stated, then be patient and filter out the background noise of the market. The market should recognise the results and the story in due course.
• Catalyst. Before we invest in a company, we identify a catalyst that we believe will re-rate or drive its share price higher. The catalyst could be a positive earnings surprise, a management change, a structural change in the industry, the sale of a loss-making division or expansion into a new market. A catalyst could be anything that you believe will positively change the value of the company in the eyes of the market.
• Strong fundamentals. A good small cap company should have a strong balance sheet.   Although the dollar values involved might look minuscule compared to BHP Billiton, they are just as important.  Companies with high cash levels and low to zero debt are something to look for.  Also, watch out for intangible assets on the balance sheet such as goodwill and deferred revenue.  These may have to be written down significantly at a future date.The cash flow statement is also a key document.  In its purest form, it registers all the cash flowing in and out of the business over a period.  Look for positive cash flow overall and especially positive cash flow from operations. Usually companies that have negative cash flow from operations don’t survive.Good companies with strong businesses usually have straightforward accounts that are easy for the user to read and understand. A convoluted set of accounts can sometimes be a red flag indicating that the company is in trouble or trying to hide something.
• Liquidity. For most investors in large cap stocks, this issue isn't a concern. However, at the smaller end of the market, investors need to keep in mind the size of the position they wish to accumulate in a company and the average daily trading volume in the stock.While the company in question might be a great one, you still want to be able exit at either a profit or a loss if the reason behind your investment fundamentally changes. Investors need to be aware that in very thinly traded stocks it may take days, weeks or even months to exit.  Hence, the old saying, ‘equity is forever’.

The above points are not foolproof but they should assist investors in making their decisions when searching for a small cap stock or two for their portfolio.

Chris Stott is the chief investment officer at Wilson Asset Management.