I spend much of my time looking for quality ASX shares for Australian investors. These are the sort of ASX shares that can remain in an ASX share portfolio for a long-time. You know what I’m talking about. If ASX share BHP halved in price tomorrow, you would want to buy more. This is a share that is going to be around forever. What I’m talking about are the BHPs of the Small Cap world. The types of shares that if they fall, you would want to buy more. Here are my ten quality criteria, which include special mention from some of my favourite ASX small caps.

Read more about Investing in Small Caps. Why we picked these ASX Small Cap gems and their outstanding performance.

1. Balance sheet strength is vital for ASX Small Caps

Security is important when you are investing in the ASX share market 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. Quality companies with strong balance sheets include ASX Small Caps Clover (CLV) and Macquarie Telecom (MAQ).

2. Cash flow: every ASX Share survives on Cash

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 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. Outstanding ASX Small Cap companies when it comes to operating cash flow include Nick Scali (NCK) and Evolution Mining (EVN).

3. Sales growth: Small Caps need 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. Small Caps that I’ve backed that have produced impressive sales growth include Freedom Foods (FNP) and Nanosonics (NAN).

4. Old quality: Big Companies now in Small Caps!

One of the types of stocks we look for is 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 (ELD) and the company that was previously known as PaperlinX, re-named Spicers (taken over).

5. Management is key for Small Cap Growth

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. We’ve also been very impressed with ASX Share MacTel (MAQ) and its ability to strategise for the long term and deliver against its goals.

6. Industry competition: Small Cap industry niche

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 caps are simply better than their bigger, more cumbersome counterparts. While there may be intense competition in the food industry, ASX Small Cap Freedom Foods (FNP) has impressed through its innovative product offering.

7. Barriers to entry can be very profitable for ASX Share investors

A company that can establish significant barriers to entry to competitors can be very profitable for investors. These include the food industry, which includes the likes of ASX Small Cap Capilano Honey (taken over) and ASX small cap Tassal Group (TGR). Australian companies have done well in medical technology by establishing barriers to entry, notably other ASX small caps Clover Corp (CLV), Sirtex Medical (taken over), and Medical Developments (MVP).

8. Operational complexity means investigating the costs

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.

9. Customer base must be part of a share investors analysis

The customer is always right. The ASX listed small cap shipbuilder Austal (ASB) has clients that include the Australian and US governments. In contrast, another Small Cap, Alliance Aviation (AQZ) has impressed by initially serving a small number of important clients for FIFO work – the likes of BHP and Rio Tinto, to extending its franchise through careful diversification into adjacent sources of demand.

10. Threat of disruption, small caps revolutionising their industry

Some small caps offer services that substitute for the industry standard. Ingenia Communities (INA) and Lifestyle Communities (LIC) are both ASX Small Caps that provide a simple, cost-effective retirement solution to a lot more Australians than the traditional retirement village operators that have costlier and more restrictive ownership models.

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