Australian Small Caps: value vs. cheap

“For strong free cash flow and returns to be sustainable, a business needs to demonstrate it has sustainable competitive advantages.”

Summary below by Anthony O'Brien

A small companies fund is very different from the Small Companies Index.

A good small companies fund should invest in a concentrated group of stocks, which collectively have a better return profile than the index. It will also have a stronger balance sheet, significantly better management, more free cash flow and a higher ROE than the index average.

The ideal small companies portfolio will also offer significant value relative to the index. We use the term ‘value’ rather than ‘cheap’ because the average PE of the portfolio might, for example, be higher than the index.

Therefore when assessing an investment opportunity, we spend a lot of time analysing the company’s value proposition, customer concentration risk, product/service distribution, intellectual property and the quality of the asset base.

To provide some clarity on how we assess ‘value’, we highlight our insights on two small company stocks; BC Iron and TPG Telecom.