Good companies make good company for small cap investors

APAC News Under the Radar Small Cap Quality what to look for

In a volatile market independent small cap expert Richard Hemming says finding quality companies is a great strategy

10 December 2019 | Richard Hemming, Editor, Under the Radar Report

I spend much of my time looking for quality stocks. These are the sort of companies that can remain in a portfolio for a long-time. You know what I’m talking about.

If BHP halved in price tomorrow, you would want to buy more. This is a stock that is going to be around forever. What I’m talking about are the BHPs of the small cap world. The types of stocks that if they fall, you would want to buy more, here are my ten quality criteria:

Balance sheet strength
Security is important when you are investing and so are options. Only lawyers and receivers make money if a company goes broke. We are not allergic to debt but we look very closely at a company’s assets and liabilities. A quality company will not ask investors for capital unless it has compelling reasons, such as funding a growth opportunity.

Cash flow
Profits are one thing but a company survives on cash. Cash is king and it’s important to determine how cash levels change over time. The reasons behind this are complicated and are related to working capital needs as well as to demand for products and investment in the future. Over time it is reassuring if cash from operations is approximately in line with profit before interest and tax (EBIT). This means the company can internally fund investment for growth.

Sales growth
Investing in Small Caps is about accessing growth. Growth at the bottom is much harder to achieve if sales aren’t growing. And right now, sales growth is harder than ever to come by.

Old quality
One of the types of stocks we look for are fallen angels. These are big companies in Small Caps, which is why they are at the quality end of the spectrum. They are turnaround stocks because their profitability has been hit by events such as taking on too much debt, or for an operational reason such as a cost blow out.

This a very subjective quality but arguably one of the most important as management are stewards of shareholders’ capital and in Small Caps, there is often more reliance on management because the lens of disclosure is less intense. We’re looking for things such as the absence of profit downgrades, track record on acquisitions and alignment of incentives with shareholders. In Small Caps, you often have founders running the company, which is most often a good thing, but minority investors always need to be vigilant.

Industry competition
The ability of a Small Cap to establish a niche is important in maintaining pricing power. There are only two key positions a small company can occupy: low cost or niche. Without pricing power you need the kind of scale that can only be achieved with large amounts of capital. There are areas where smaller companies are simply better than their bigger, more cumbersome counterparts.

Barriers to entry
A company that can establish significant barriers to entry to competitors can be very profitable for investors.

Operational complexity
Small Caps are as much governed by their abilities to reduce costs as they are by their ability to grow revenues. If the suppliers they deal with have too much pricing power, their ability to reduce their costs is constrained. It’s no accident that many successful companies have tight control of their input costs, which maximises their gross profit margins when they achieve sales growth.

Customer base
The customer is always right, stable government contracts and supply agreements with large established clients make good customers.

Threat of disruption
Some small caps offer services that substitute for the industry standard, this sets them apart from the competition.

Richard Hemming is an independent analyst who edits Under the Radar Report is licenced to give general financial advice only (AFSL: 409518).