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Quality Small-Mid Caps at Bargain Prices

Richard Hemming

Quality Small-Mid Caps at Bargain Prices

We show you the best stocks to buy at bargain prices. we give you quality small caps to build your share portfolio for the medium-long-term. In this week’s research rundown we cover our universe of 100 plus stocks, highlighting for subscribers the quality end of the spectrum. 
 

REMAIN CALM AND ONLY BUY SMALL PARCELS; DON’T CHASE!

As we often say at Under the Radar, volatility is an investor’s friend, although it doesn’t seem like it when you look at your portfolio’s valuations.
 
We first want to re-iterate to remain calm and to buy only in small parcels. Prices are fluctuating wildly, so only buy the dips and don’t chase the price up. There will always be another buying opportunity if you are patient.

Focussing on the fundamentals is the key to making money for the next three to five years from this market rout.

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We spend much of our time looking for ASX shares that are good value and when times like this come about, it’s much easier to find ASX shares that are high quality at bargain prices. These are the sort of companies including small caps and blue chips that can remain in a portfolio for a long-time and are certainly worth paying a premium for. You know what I’m talking about. If BHP halved in price tomorrow (which it almost has) you would want to buy more (which we are). 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 stock that when they fall, as they have been in this febrile market, you want to buy more.
 

Buy Quality Small Caps and Blue Chip Stocks - we show you what to look for.

Here are our ten quality criteria, which includes special mention from some of my favourite small caps, but it’s worth emphasising that dividends, either now or in the future are a direct by-product of this quality.
 
 
  1. 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.
     
  2. 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.
     
  3. 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.
     
  4. 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. Examples of fallen angels include UGL (taken over) and the company that was previously known as PaperlinX, re-named Spicers (taken over).
     
  5. Management
    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.
     
  6. 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.
     
  7. Barriers to entry
    A company that can establish significant barriers to entry to competitors can be very profitable for investors. These include the food industry and medical technology through establishing barriers to entry.
     
  8. 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.
  1. Customer base
    The customer is always right is self evident but there are companies that have impressed in expanding their customer base, such as from purely mining services into the wider field of infrastructure.
     
  2. Threat of disruption
    Some small caps offer services that substitute for the industry standard.
 
 

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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