It's one of the sharemarket's most dynamic sectors - but investing in small-cap companies is an art in itself, writes Richard Webb.
RECKON you can spot the next Google? Or the resource minnow about to drill a goldmine? What about the engineering services bit-player set to outperform in a sector already steaming ahead?
Welcome to the world of small-company investing, where stocks can go through the roof one day - then return to earth with a thump the next. Where by their very nature, the ones that succeed grow themselves out of the frame.
But it's where, if you get it right, you can see your money double while the sharemarket is heading backwards - and where you will need to take a hands-on approach to investing, and can also take the satisfaction that comes when the other investors finally catch on.
According to Ben Griffiths, portfolio manager of the Eley Griffiths Group Small Companies Fund, to invest in the small-company sector successfully you need to have an entrepreneurial spirit - but when you do get it right, ''it can offer fantastic returns''.
The Eley Griffiths fund has $524 million invested in small companies and generated a 10 per cent return over the past year when the All Ords has been flat.
Mr Griffiths says to make small-company investing work, you need to search for the hidden gems and do your homework on the business and industry. Then get to know the management and what it is planning to do - its vision and how it manages capital. He says he talks to 500 companies a year.
Finally, you have to have the confidence and commitment to hold on for the long term - because it may take some time for a small company to begin to perform and for the rest of the investment community to catch on.
''If it is well managed in a high-growth industry, then you are off to a flying start,'' he says. ''But small companies can take a number of years to deliver - they are long-duration plays and require patience and a belief you've backed the right company. You've got to sit it out.''
The Eley Griffiths fund generally won't look at a listed company with a market worth of less than $80 million or so, because of trading liquidity - liquidity in a small company's shares becomes really important when you want to sell.
Austock senior client adviser Michael Heffernan agrees that liquidity is critical in small-cap investing. ''I like to focus on the mid-cap to small-cap, not on the minors. The liquidity has got to be there - there have got to be enough buyers and sellers.
''If the stock hasn't got great liquidity, I don't encourage my clients to invest, even if everything else looks good.''
Mr Heffernan says small-cap investing is often misunderstood too - and many listed companies are too small to even consider.
There were 2192 companies listed on the ASX at June 30, according to the ASX website, but the ASX Small Ordinaries Index tracks companies ranked 100 to 300 by market value. The All Ordinaries Index is tracking the 500 biggest companies by market value.
This means there are 1800 or so listed companies too small to be in the small companies index, and 1500 of these don't even make the All Ordinaries Index. Mr Heffernan says the average investor shouldn't be looking at stocks outside of the All Ords. He looks for small companies that are reasonably valued - with a prospective price-earnings ratio of 10 to 15 times - and generating a return on capital of 15 to 20 per cent, and recommends investors have about 15 per cent of their portfolio in this area.
At present, Mr Griffiths likes Sedgman, Reject Shop, Mermaid Marine and Monadelphous. Mr Heffernan also likes Reject Shop, Matrix Composites, InvoCare and McMillan Shakespeare.
Mr Griffiths tells a great story of what it's like when you get it right: his fund got into Andean Resources, a precious-metals explorer that focuses on Argentina, at 40¢ a share four years ago. Last week the company got a bid valuing these shares at $6.50 a piece.
That's more than 16 times your money in four years. Nice work if you can get it.
