3 cheap small caps with huge upside potential

Three compelling investment ideas to consider.

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All things being equal, the share market is largely influenced by earnings expectations. Statistics have shown that earnings changes result in 75% of share price movements.

It is for this reason I have found the current reporting season disappointing. Bargain hunters have had limited opportunities to turn significantly positive earnings changes to their advantage. So let's turn our attention to the smaller-cap stocks, where again there has been a relatively limited number exceeding consensus forecasts. However, here are three compelling stories.

1. Vocation (ASX: VET) 

Listing on December 9, 2013, Vocation is a provider of vocational education and training. Could it become the next Navitas (ASX: NVT)? Navitas is a leading global education provider offering an extensive range of educational and training services for students and professionals across Australia and the world.

Earnings for Vocation are expected to be upgraded in the near-term as the interim report showed revenue in the first half exceeding company guidance in the prospectus. The largest drivers of future earnings, student enrolments, have been strong across the group. Additionally, Vocation has access to annuity style income from its Solutions Business Channel.

2. Hills Holdings (ASX: HIL)

This service-based company in the health-care sector enjoyed a 56% increase in earnings before interest and tax (EBIT), despite a 20% reduction in revenue.

This illustrates the success of recent restructuring. While the famous Hills Hoist clothesline segment has survived, a host of disparate manufacturing businesses have been sold. As a result, big write-downs are now in the past and the underlying business has now improved over two consecutive half years.

The case for ongoing outperformance includes an ungeared balance sheet, which may lead to further acquisitive growth or capital management initiatives. Also, higher returns will be achievable over time, as the aim is to become an integrated solutions provider in technological and communication market segments.

3. Breville Group Ltd (ASX: BRG)

Profit guidance was 5% ahead of consensus for Breville Group, the developer of kitchen appliances to the consumer products industry. Overseas growth is the main driver of its earnings and revenue growth was strong across key markets in the United Kingdom, New Zealand, Hong Kong and North America.

The story is particularly exciting in North America. It posted sales increases of 30% this period and has tremendous capacity to expand its small market share. Contributing to this will be the strong product development pipeline and very strong brand recognition.

A future capital return to shareholders may be in prospect, given its existing net cash position of $9 million is expected to grow to around $45 million by 30 June, 2014. Looking out to FY2015, a forecast reduction in capital expenditure should further bolster cash reserves.

Foolish takeaway

In my opinion, both Vocation and Hills Holdings have the greatest near-term upside. Once expectations build for Breville Group's earnings in the longer term, a significant rally will likely follow.

 

Motley Fool contributor Mark Woodruff does not owns shares in any company mentioned.

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