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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 spend much of our time looking for stocks that are good value and when times like this come about, it’s much easier to find stocks that are high quality at bargain prices. These are the sort of companies 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, 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 stock that when they fall, as they have been in this febrile market, you want to buy more. Here are our ten quality criteria, which includes special mention from some of my favourite small caps.
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. Quality companies with strong balance sheets include Clover (CLV) and Macquarie Telecom (MAQ).
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. Outstanding companies when it comes to operating cash flow include Nick Scali (NCK).
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).
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).