The rewards of small cap investing

Are you interested to investing in small caps?

There are a number of reasons why they can yield higher returns: smaller companies can grow more quickly than their larger peers and are also more easily acquired. With market caps less than $1bn, it's often not worthwhile for fund managers managing billions of dollars to analyse them, meaning they're less well researched, while insiders often have more meaningful stakes in them compared to larger companies.

Yet these higher returns also come with higher risk. Smaller companies are often more at the mercy of suppliers, customers and competitors. And perhaps selling only one product or service and with business models that often haven't yet been tested in economic downturns, good management is even more critical than with larger companies.

Macmahon

One company that has displayed many of these attributes in recent years is Macmahon Holdings (ASX:MAH).

We first upgraded Macmahon to Speculative Buy at $0.11 two years ago. (For our current view on Macmahon, click here). Its $140m market capitalisation then and low liquidity meant that it was being ignored by most analysts.

Operating in mining services, it isn't a great business: mining service companies consume capital as they expand, often financing new machinery and equipment using debt, their contracts with miners can be cancelled at any time, and there's always the risk that competition forces them to deliberately underquote to successfully gain new contracts.

Despite the value on offer – Macmahon was selling at one-third tangible book value – these risks meant we recommended a maximum portfolio weighting of 1% as part of a portfolio of similar stocks.  

The 1% weighting is lower than we'd usually recommend for small caps but, generally speaking, we'd suggest the maximum investment in a small cap should be less than larger, more stable companies with proven business models and management such as a Wesfarmers (ASX:WES) or Commonwealth Bank (ASX:CBA).

Like any company, we also suggest investing in stages to take advantage of any further price falls.

And boy, did Macmahon's share price fall, going below 4 cents after Fortescue (ASX:FMG) abruptly cancelled its Christmas Creek contract and Macmahon had to rely on its bankers' generosity for its continued survival.

Turnaround

However, the company has since staged a remarkable turnaround.

It sold its business in Mongolia, subsequently repaid its debt and started buying back stock with its substantial net cash balance. If its high debt load had previously turned you off, this was a good time to invest, with the company selling on an EV/EBIT multiple of 3 up until recently.

Macmahon has contracts locked in – or as locked in as one could expect in the mining services industry – for the next four to five years, over $50m in net cash, surplus assets on the balance sheet and is also well placed to score more contracts as miners loosen their purse strings after the mining bust.

Takeover offer

Seeing this value, earlier this week 20% shareholder CIMIC (ASX:CIM, formerly Leighton Holdings) launched a takeover at 14.5 cents. Even with the 30% premium to its previous trading price, CIMIC is getting a bargain, paying well below Macmahon's tangible book value per share of 17 cents.

With CIMIC already owning 22% of Macmahon, however, it's difficult but not impossible for a counterbid to emerge. There are a number of substantial shareholders that, combined, could prevent CIMIC from getting to 90% and compulsorily acquiring the remainder so small shareholders will have to wait and see how they proceed.

Even so, the Macmahon example illustrates the rewards – as well as the potential pitfalls – of investing in small caps. 

UPDATE: you can view the recording of an Analyst Q&A on investing in small caps here. 

Note: the author owns shares in Macmahon and intends to hold them while he awaits developments.