Radar's SIX Investment philosophies for small cap investing.

There are risks in any investment, but when you are paying very low prices for small cap assets that have relatively big potential, there is less that can go wrong if there are hiccups. You can have many of these types of small cap stocks in your portfolio and a lot won’t do anything. But for the ones that do, it will be worth the ride. Small Caps really do boost your portfolio.

Under the Radar's average annualised return on all our 100+ stocks is 36% (At June 2015). This includes stocks that haven't performed well, and our top 10 stocks which have returned 270%. We are the most transparent newsletter on the market and subscribers can login online and see all the companies we cover and the key metrics and our current views on each stocks.

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1. Growing sectors - we look for companies with fast and growing demand for their products

One of our analysts used to be a gaming analyst, rating companies that operated casinos, poker machines and wagering businesses. It became clear that no matter how good the management was, it didn’t make a difference. Anti-smoking laws and a general crackdown via increased regulation by the state of gambling meant that the profits of the whole industry were contracting. It is always good to have a top down view of things. The companies that we have made big money from have had fast and growing demand for their products.

2. Competitive Advantage

Most small cap companies are in business because they have a strong niche. The key is to work out what stage that niche is at. Are they at the beginning of their growth? If they are at the beginning of their growth the company's revenue growth potential is unknown. There is a leap of faith in any investment in new technology. TZ Limited is a good example, because its product is very new.

Or, the company could be really successful in a small area (like Australia) and the potential could be overseas. Another Small Cap Research Tip, Swick, is a prime example of this, with big opportunities in Indonesia and North America.

3. Management

Does management clearly explain to the market how the company makes money? It might sound simple, but its ability to explain this succinctly, often dictates its ability to hand profits to you, as an investor. Good management is one that has an eye on increasing returns for investors. The rest is often hype.

4. Return on investment

We seek out ASX listed Small Caps that produce high return on capital employed. We expect a company to make a 20 per cent return on the capital invested in new projects before financing considerations. If it can’t do this, it shouldn’t be making the investment.

A good guide is to look at the company’s history of return on equity. If it is above 10 per cent, this is a good sign. Many companies, however, are turnarounds, so you have to look hard at any new capital expenditure plans they have.

Big acquisitions are often a daunting prospect, but they can work favourably. A good example is Mayne Pharma, which has transformed its business after the $105m acquisition of US based Metrics. Prior to the deal its market cap was $55m. It is now more than three times that.

5. Understand the cash flows and reconciliation to profit

There is accounting based profit, and there is cash flow. We will take the second every day of the week. When a company capitalises its costs, meaning it does not expense them, it can artificially increase its profits. Companies that do this too often are an accident waiting to happen.

6. Low valuation to potential

Here we look mainly at paying low forecast PEs. A PE is simply the market’s guestimate of the net present value of the future cash flows that get paid to shareholders. A PE of 10 means that the company is forecast to achieve earnings growth of 10 per cent a year. In 10 years its earnings should have doubled. We are always looking for companies that we believe will grow faster than the rate the market predicts.

This is harder to do with companies that have little or no earnings, but you can guage a lot from a company’s market capitalisation. In relation to TZ, we believe it will get its hands on about $11.5m cash – this is about 60 per cent of its current market capitalisation. Throw in some multi-million dollar contracts we expect it to win, and you get the idea.

How do I choose which small caps are right for me?

When you are looking to invest in Under the Radar’s Research Stock Tips it is best to work out your own, individual preference, for risk and return and to look at how you have made big profits in the past.

The editor’s family put $70,000 into Bolnisi Gold at 8 cents and below between December 1996 and October 2003. That stock rose to $3.27 by June 2007 making $1.5million. That’s what we’re talking about!

7 Steps to your own investment philosophy

1. What has made you money in the past?
2. What do you consider to be too risky?
3. What messages do you want to hear from management?
4. What is the minimum return you want from an investment?
5. Do you only want to invest in a stock that is dirt cheap, or do you want to invest in a stock that has momentum on its side – meaning earnings and stock price appreciation?
6. Do you need to see a catalyst in the next six months to take the plunge?
7. How long are you looking to hold on to your average investment for?

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