Small cap discoveries: 10 criteria for picking the BHPs of tomorrow

I spend time looking for quality stocks, those that if they fall, you should be ready to jump in. Here are my 10 quality criteria.

Nick Scali furniture head of product development Stephanie Scali

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 should be ready to jump in. Here are my 10 quality criteria.

Balance sheet strength

Security is important when you are investing: only lawyers and receivers make money if a company goes broke. We are not allergic to debt, but we look 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. Quality companies with strong balance sheets include Clover and Macquarie Telecom.

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. Over time it is reassuring if cash from operations is approximately in line with profit before interest and tax. This means the company can internally fund investment for growth. Outstanding companies when it comes to operating cash flow include Nick Scali and Evolution Mining.

Sales growth

Investing in small caps is about ­accessing growth. Stock price growth is much harder to achieve if sales aren’t growing. And right now, sales growth is harder than ever to come by. Small caps that have produced impressive sales growth include Freedom Foods and Nanosonics.

Turnaround time

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 blowout. Examples of fallen angels include UGL (taken over) and Elders and the company that was previously PaperlinX, renamed Spicers (taken over).

Management mojo

This a subjective quality but arguably one of the most important as company leaders are stewards of shareholders’ capital. 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 need to be vigilant. We’re impressed with Macquarie Telecom and its ability to strategise for the long term and deliver against its goals.

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. While there may be intense competition in the food industry, Freedom Foods has impressed through its innovative products.

Barriers to entry

A company that can establish significant barriers to entry to competitors can be profitable. These include the food industry, including Capilano Honey (taken over) and Tassal. Australian companies have done well in medical technology through establishing barriers to entry, notably Clover Corp, Sirtex Medical (taken over) and Medical Developments.

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

Ship builder Austal has clients that ­include the Australian and US governments. Alliance Aviation has impressed by initially serving a small number of important clients for “fly in fly out” work — the likes of BHP and Rio Tinto — to extending its franchise through diversification.

Threat of disruption

Some small caps offer services that substitute for the industry standard. Ingenia and Lifestyle Communities provide a simple, cost-effective retirement solution than the traditional operators.

Richard Hemming is an independent analyst who edits undertheradarreport.com.au

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