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5 Keys to Smart Small-Cap Investing

Small caps can be fertile ground for finding promising long-term ideas

Todd Wenning 20 November, 2012 | 9:00AM

This article is part of Morningstar.co.uk's Equity Investing Week.

For the individual investor with a long time horizon and a calm demeanor, there's a lot to like about small-cap shares. With so much media attention paid to blue chips and with institutional investors being limited in their ability to purchase meaningful stakes in small companies, individual investors have a better chance of finding undervalued and underappreciated names in the small-cap arena. 

Indeed, a collection of studies by Tweedy, Browne Company entitled "What Has Worked in Investing" found that a small market capitalisation was one of the five characteristics associated with shares that produced exceptional long-term returns.

As such, it's worth considering how we might identify promising small cap investments. Here are five attributes that I look for when assessing small cap shares.

1. A Current or Strengthening Moat Source
Since smaller shares are often competing against larger companies with more resources, the most promising small caps either currently possess or are showing progress towards establishing an economic moat.  Otherwise, they are less likely to make the leap into larger-cap territory. A classic example of a bourgeoning moat might be Tesco (TSCO), which in 1990 had just a 10% share of the UK grocery market; today, Tesco's share is around 30%. As the company added stores and increased sales, Tesco's bargaining power over suppliers concurrently increased, thus strengthening its cost advantage versus smaller stores. Tesco's Clubcard scheme, which was launched in 1995, also contributed to the company's economic moat as it provided valuable customer insight and increased customer loyalty.

2. Compounding Growth Opportunities
A small company that can consistently generate double-digit returns on equity and capital and reinvest most of its profit back into the business at similarly high rates of return can produce significant growth. Temporary power generation and temperature control specialist Aggreko (AGK) is a good example of the compounding growth effect. Over the past decade, Aggreko posted very strong returns on capital employed whilst retaining most of its profit to reinvest in the business. As a result, since 2003, Aggreko's net assets and share price have grown at an annualised rate of 18.4% and 30%, respectively.

3. Skillful Management Teams
Warren Buffett famously joked that a "ham sandwich could run Coca Cola"—meaning that the large business runs so efficiently and its brands are so valuable that management isn't required to do much to keep the business thriving. That isn't the case for smaller businesses where management decisions can have a more pronounced effect on results. Admittedly, judging the skill of a management team from the outside can be difficult, but there are a number of factors that can provide valuable insight. First, we can analyse management's capital allocation decisions—that is, decisions regarding dividends, share repurchases, reinvestment and acquisitions. A company that has made a string of unwise acquisitions or has consistently paid too much for share repurchases, for instance, may be a sign that management has poor capital allocation skills. 

4. Solid Balance Sheets
Because smaller businesses can be more sensitive to swings in the business cycle, too much debt can exacerbate even slight changes in demand and impair the company's ability to compete against larger companies. All else being equal, then, a conservative balance sheet is an attractive trait in a small-cap company. Industrial engineering firm Rotork (ROR), for instance, has seen its share price rise over 700% since November 2002, and has done so whilst maintaining a tidy balance sheet. Given its consistent profits, Rotork certainly could have leveraged up to make a large acquisition at some point, but wisely avoided the temptation of "empire building" and instead focused on strategic bolt-on acquisitions.

5. Ability to Generate Free Cash Flow
In general, small companies are more focused on investing for higher profits down the road and often burn through cash in the process. In some cases that can be the correct strategy, but a company that can strike a balance between investing for the future and generating cash flow today is probably doing something right. One example of this might be Domino Printing Sciences (DNO), which has produced free cash flow each year for more than a decade whilst reinvesting enough to grow its earnings per share at a double-digit pace over that period.

Small cap shares are not without their risks, however. In addition to higher trading costs, small cap share prices can be more volatile, and investors should expect to do most of the research on their own as small caps do not get much coverage in the financial news. Of course, that is also one of the reasons that small caps can be fertile ground for finding promising long-term ideas!

Finally, whichever method you use to evaluate small-cap investments, it's important to stay diversified as even the most promising company idea can run into a string of bad luck.

Todd Wenning owns shares in Tesco.

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Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Aggreko PLC1,516.00 GBX0.93-
Domino Printing Sciences PLC772.50 GBX0.06-
Rotork PLC2,734.00 GBX0.92-
Tesco PLC289.70 GBX-1.40
About Author Todd Wenning

Todd Wenning  is an equities analyst with Morningstar.