Small companies have lagged their larger peers by nearly 40% over the past two years. While the All Ordinaries Index (ASX: ^XAO) is climbing to new five-year highs, the ASX Small Ordinaries Index (ASX: ^XSO) is not far off five-year lows. The All Ordinaries is a measure of the top 500 stocks on the ASX, while the Small Ordinaries is an index of companies in the top 300 stocks, but not in the top 100 stocks, i.e. stock numbers 101 to 300 as rated by S&P based on market cap and liquidity.
The Small Ordinaries index actually reached a five-year high at the beginning of 2011, which coincided with the five-year high of miners BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). Based on this I would imagine much of the underperformance of the Small Ordinaries is to do with the decline in mining services companies over the last 18 months.
Unfortunately, I don't have an index of small caps ex-mining stocks, however I would imagine this index would track fairly closely, or slightly above, the All Ordinaries for the last two years. I believe this trend will continue as large market cap stocks appear expensive and long-term investors look to increase risk for greater returns.
Small caps certainly have the ability to deliver great returns; small caps like G8 Education Limited (ASX: GEM) and Corporate Travel Management Ltd (ASX: CTD) jumped by over 200% each since 2012, however these are often the exception, not the rule. When looking for small caps, I like to buy companies generating improving cash flow, increasing profits and with room to grow. Here are two such companies:
eServGlobal Limited (ASX: ESV)
eServGlobal provides mobile payment solutions to over 1.2 billion mobile phone users around the world. It has two revenue streams; its legacy mobile payment and finance solution business, and a new joint venture with Mastercard Inc (NYSE: MA) that allows users to transfer money from one phone to another in 51 countries. I'm looking for long-term growth for eServ noting that the Mastercard deal could be potentially a huge driver of income in coming years.
Infomedia Limited (ASX: IFM)
Infomedia owns and licences software that details vehicle after-sales parts and services to the car industry. Infomedia's software is, by all accounts, the industry standard, which means that the customer base is stable and the majority of revenue is recurring. New products should see earnings grow nicely over time.
Foolish takeaway
Small-cap stocks aren't for everyone. They are riskier, harder to buy and sell, but can also deliver great returns for patient investors. These two companies have already had good runs, however I believe they could be much higher in five years' time.
