Little fish can be a great catch
Investing in small companies can be risky, but David Potts has found five that might net a very healthy return.
Investing in small companies can be risky, but David Potts has found five that might net a very healthy return. Put the 1600 smallest stocks end to end and you might wonder what the point was. Well, it would take that many to make one BHP Billiton, which just goes to show there are a lot of stocks out there that aren't worth very much.One day some of them will be.The right small stock will do better than a big blue chip, which, fingers crossed, it'll eventually become. "Small caps tend to outperform over the long term," Elio D'Amato, the chief executive of research group and fund manager Lincoln, says.But it can take a long while and many never make it.A raging bull market, which we don't have, aside, they spend an inordinate time undervalued and under-appreciated.All stocks are affected by the market's manic-depressive behaviour but the small ones are even more vulnerable because there's hardly a market in them."Liquidity can be the biggest influence at times," says the editor of the tipsheet Sound Money, Sound Investments, Greg Canavan. "When the market is confident, they outperform the bigger stocks. But they'll underperform in reverse." It usually takes longer for the market to cotton on to the virtues of a smaller company."It's all about patience," says portfolio manager Ben Griffiths, who runs the Eley Griffiths Group's Small Companies Fund. "Some of the best returns are not in the thinking but in the sitting."Good management is of paramount importance."Oh - and making money. But even with good management and profits, small stocks can remain undervalued by the market for years.That makes them risky to hold yet, infuriatingly, it could be even riskier ignoring them, since they're a huge part of the market. In fact, some 80 per cent of stocks are worth less than $200 million.So where to start?Thought you'd never ask. The following are the fab five, fast-growing stocks the experts like.1. Legend Corporation (LGD)It makes semiconductors, cables, connectors, instruments ... just about anything electrical.This includes various gizmos that attach to computers, giving Legend an entry into the boundless - oops - bountiful information-technology industry.Legend is one of the rare winners, outside mining, from a stronger dollar, which cuts the cost of its materials without hurting its sales."It's a ripper little company we have big hopes for," D'Amato says. Lincoln only considers companies that are in rude financial health and Legend would appear to be thriving, with little debt and even paying a fully franked dividend.In fact, the dividend, at just under 2? a share but expected to rise, is returning 5.6 per cent, or 8 per cent after the 30 per cent tax credit for franking, because the shares only cost 28? apiece.Mind you, that's 47 per cent more than its price a year ago.A judge of whether you're getting value in a stock is the price-earnings (P/E) ratio, which shows how many years it takes to get your money back. The lower the P/E ratio, the cheaper the stock. Legend's P/E ratio is 10 - so it would take 10 years to get your money back based on the current profit. Or, rather, its last reported profit. Lincoln says the P/E ratio will be closer to seven with its likely growth.2. NEXTDC (NXT)Any stock with a name all in capitals, or worse, a caPital letter where it shouldn't be, is usually to be avoided at all costs.But NEXTDC only listed in December and until Friday's bloodbath had doubled in price - it's still up 70 per cent when the market is down 15 per cent - so it can be an exception.It's also the first stock to be recommended by tipsheet wise-owl.com since May.NEXTDC is a sort of Millers Self-Storage on steroids. Instead of locking away all your junk out of sight on another site, this gives business secure software and storage sharing in a remote data centre.It also lets you use the internet to program your computer, which sounds a bit like the horse before the cart but is called cloud computing. Talk about a geek paradise.But you can see the appeal to a business - it could avoid the hefty costs of setting up an entire IT department and never lose anything again.The data centres will be energy-efficient, so there could be bonus carbon-tax brownie points, too. Not to mention there's a shortage of data space. "Over 80 per cent of major data centres in the Asia-Pacific region are currently running near full capacity," Imran Valibhoy, the director of equities at wise-owl.com, says. Since NEXTDC is forecast to deliver a return on equity of 15 per cent to 30 per cent a year, a higher share price could be in store, so to speak."Risks include NEXTDC's reliance on external funding, the potential for cost blowouts at remaining developments and the need to secure customer contracts," Valibhoy says. "However, given the pedigree of management and industry dynamics, we are recommending the stock as a high-risk, speculative buy."3. Skilled Group (SKE)Here's a classic case for having good management. It didn't.But that changed in November last year when Mick McMahon, formerly of Wesfarmers, was installed as chief executive, says Griffiths, whose fund is buying the stock.He's impressed by the fact the new chief executive has bought shares rather than seeking underpriced options.Skilled supplies contract workers, especially to the mining, oil and gas industries, where demand is insatiable.Under the new regime, costs are being cut, less-profitable businesses are likely to be sold and the business is being reshaped.Debt is also being paid down, though at the cost of the past two dividends. "It will again return to the glory days of the late '90s, when it was well run," Griffiths says.The market agrees, since the share price has risen 55 per cent, mostly since November, in a falling market over the year.4. Treasury Group (TRG)There are managed funds specialising in small stocks but they take all the fun out of finding a winner, except that Treasury Group might be a candidate itself.It owns several of the best-known boutique fund managers. There's a case for investing in the manager rather than the fund, considering Treasury Group's dividends are yielding 6.8 per cent a year, or slightly more than 9.5 per cent after franking.Oddly enough, its appeal as a high-flyer is that it's been grounded by the market. Fund managers are the only stocks where the sharemarket determines their profit as much as their price.Their fees are based on the value of their share portfolio, itself affected by how much flows in.The stronger the sharemarket, the more that's invested, which is perverse when you think about it, because investors are paying top dollar.Since the GFC, "it's performed pretty badly but that makes it attractive", Canavan says. "The price has performed badly but not the business."And there's not a cent of debt.5. Flexigroup (FXL)This is the company behind those "no interest ever!" deals a lot of furniture and home renovation stores offer: a glorified form of layby where you pay a deposit and the balance is direct-debited monthly.So how does that make Flexigroup money? Simple. There's an establishment fee, a payment processing fee and a monthly account-keeping fee. Yes, it sounds just like a bank - which, in many ways, it is. The only difference is that it got its finance from the real banks - but even that's changed.One of the reasons Sinclair Currie, the portfolio manager and principal of NovaPort Capital, which specialises in small stocks, likes Flexigroup is it has struck cheaper deals by going straight to the money market. "It's a solid underlying business," Currie says. "Its valuation looks reasonable, with a P/E of 11."Although it pays a dividend, unlike the other fab four it has more debt than equity but that's what its business is - borrowing and lending.Surprises ahead in this year's profit-reporting seasonIT'S time to take stock of your stocks.The profit-reporting season has started, following the preview of the confession session, as brokers call it, when companies get any bad news out of the way.There have been several downgrades, especially in retailing, in the past few months but that might stop the market getting any grumpier.The chief market strategist at CMC Markets, Michael McCarthy, says: "For the most part, any surprises have already been captured in these downgrades so the surprises are likely to be better-than-expected earnings."Also worth bearing in mind is that although 2010-11 was pretty lacklustre, once you include dividends the market returned a respectable 11.7 per cent, or slightly more than 8 per cent after taking inflation into account. Maybe it didn't feel like it but that was a better year than average.As a rule, super funds aim for an annual real return of at least 5 per cent a year.Anyway, expect that the two-speed economy, where one lane is for mining and the other for reversing, will be even more pronounced thanks to the stronger dollar.Although the worst results are likely to be in retailing, airlines and media because of the consumer spending strike, their stocks have already been heavily marked down in anticipation.David Jones and Myer are likely to report a profit fall of up to 5 per cent.Building products companies such as Boral and what's left of local manufacturing are also expected to go backwards.Pleasant surprises could be Woolworths and Wesfarmers (the owner of Coles).The chief executive of research group and fund manager Lincoln, Elio D'Amato, says: "We are expecting more buoyant results from consumer staples and perhaps investors have been harsh on them in recent times."But "banks are definitely at risk this time round", he says.Again, their share prices have been marked down accordingly.Watch for the outlook statements, if any are offered, from management. Especially what's said about rising costs.Even so, two bright spots already stand out: the high dividend yields and the number of companies talking about "capital management" read share buybacks or special dividends.Including the 30 per cent tax credit from franking, the top 200 stocks are yielding close to 6 per cent based on their latest prices.Some blue-chip stocks are producing an unprecedented 12 per cent or more return on their dividends after franking.They include Tatts Group, Telstra, David Jones, Perpetual, Bank of Queensland and Southern Cross Media, although their near-term outlook is poor. Their yields are high because their share prices have been slashed, which is why their price-earnings (P/E) ratios range from just nine to 11.The lower the P/E, the cheaper the stock, though often there are good reasons.Broker RBS Morgans predicts "some capital management from those companies with excess cash and franking credits on the balance sheet".JB Hi-Fi has already said it would buy back 9.9 per cent of its shares."For the materials sector, strong cash flows, balance-sheet strength and the potential for capital management [special dividends, buybacks or dividend increases] are likely to be the dominant themes," RBS Morgans says.