For patient investors willing to do their own research there are a lot of opportunities among small-caps, especially those that receive little coverage or are out of favour.
The main reason to invest in small-caps is their potential to deliver phenomenal growth...but patience is required
Valuation
The tricky part is in trying to assess their value. When valuing established mid- or large-cap stocks two preferred metrics are free cash flow (FCF) and return on capital employed (ROCE).
For small-caps that are in a high growth phase but are yet to be profitable, other valuation metrics are more usefully employed. These include the price-to-sales ratio or, better still, enterprise value-to-sales. The former uses a company’s market capitalisation but the latter is deemed a more accurate measure as it takes into account a company’s debt level.
Often with loss-making small-caps, the price target hinges upon a discounted cashflow (DCF) valuation. This is one measurement that you should be especially wary of as it relies upon projections many years ahead. For example, it was used during the dot-com boom to justify unrealistic share price valuations.
It is therefore advisable to use more than one metric when analysing any company.
Moreover, qualitative measures such as the strength and integrity of a company’s management, the degree of innovation and its ability to beat the competition aren’t susceptible to such formulaic analysis.
Growth
The main reason to invest in small-caps is their potential to deliver phenomenal growth. Also, once they start to deliver they’re often acquired by larger companies seeking a means to grow more quickly or to fill a gap in their market offering.
That is why understanding the market in which a company operates, its strategy and scope for growth is particularly important when investing in small-caps where the risks can be appreciably higher than in larger companies. Of course, the gains can also be much greater.
Patience is also required, as any appreciable share price gain is unlikely to occur within a 12 month period, even if a catalyst has been identified. Plans can be delayed or changed, markets can fall and we are all at the mercy of ‘events’. Therefore, it is important to stay diversified and not to invest funds that may be needed at short notice.
5 Small-caps Worth a Closer Look
For an investor seeking undervalued small-caps, the five listed below are examples of stocks that look attractive for a variety of reasons, although they all offer varying degrees of risk.
EKF Diagnostics (EKF)
This medical diagnostics company is becoming increasingly profitable at the EBITDA (earnings before interest, tax, depreciation and amortisation) level as it grows revenues. Consensus broker forecasts are for pre-tax profits of £2.4 million for the year ending December 31, 2013. If its high growth rate continues it could make an attractive acquisition target.
Inland Homes (INL)
This company is profitable and trades at a large discount to its Net Asset Value (NAV), which was 27p a share as of June 30, 2012. Traditionally, this company only obtained planning consent for brownfield land and then sold it on at a small profit. However, it is now moving into development in order to capture the additional margin. As the market recognises this change, there’s the potential for the stock to be re-rated and its discount to NAV to narrow.
PV Crystalox Solar (PVCS)
At around 13p, this stock still trades at a discount to its cash balance, estimated by its house broker JP Morgan to be around 17p at the end of 2012. It’s shot up in recent months following news that it would return some of this cash pile to shareholders later this year. However, there remains the risk that with restructuring costs not yet announced, a good portion of that cash may be used to reorganise a loss-making business.
Toumaz (TMZ)
Its inclusion here is based purely on its growth potential and the fact it already holds a dominant position in supplying household global audio brands with chips for digital radios. The rationale is that positive newsflow and increased sales into new markets (network audio and healthcare) will drive up its share price as it moves towards profitability, forecast in 2015. Given that it is very high risk and loss making, any investor would need to be confident about the management, end markets and the potential of its technology.
Vectura (VEC)
Although not yet profitable, this company, which develops respiratory drugs, is backed by cash (approximately £70 million) and appears to have solid growth prospects from drug licences and royalties. For example, a drug licensed to 
Novartis (NOVN) is being rolled out across Europe, from which it will receive royalties. The consensus forecast from seven brokers is that by March 31, 2014 it will produce pre-tax profits of £0.5 million.
Chris Menon holds shares in Toumaz, EKF Diagnostics, Inland Homes and Vectura.
