The small cap world is where I think you can find the best opportunities.
Small caps are the least followed businesses, few analysts and fund managers go there. That simply means they get less coverage and probably have a smaller valuation.
It can also mean theoretically that you can generate stronger returns simply because of the size. It's very hard to double a business the size of Commonwealth Bank of Australia (ASX: CBA), it's a lot easier to double the size of a $250 million business.
I had $5,000 to invest in small caps, this is how I'd do it:
Paragon Care Ltd (ASX: PGC) – $1,500
At the moment this is my favourite small cap. It's a healthcare equipment, device and bed supplier. Its main customers are hospitals and aged care providers. The number of people passing through those two types of healthcare facilities is expected to increase with Australia's ageing population.
Paragon offers its clients a centralised purchasing system where they can buy items. Paragon is steadily acquiring more healthcare supplier businesses so that it can expand its product range. It's becoming a one-stop-shop for healthcare equipment.
The company itself has projected that earnings per share (EPS) is likely to grow by at least 20% in FY19 due to all of the earnings it has acquired in the last 12 months.
It's currently trading at around 15x FY18's estimated earnings.
Duxton Water Ltd (ASX: D2O) – $1,000
Duxton Water is a business that owns water entitlements and then leases it out to agricultural businesses.
There's nothing inherently amazing about the business idea, however the value of water is quite likely to grow in the future due to demand for food and the nature of how limited fresh water is. This will hopefully lead to growth in the capital value and income value of the water credits.
It's currently trading with a partially franked dividend yield of 4%.
WAM Microcap Limited (ASX: WMI) – $1,250
A lot of small caps are trading on quite high valuations, so it could be an idea to just invest in fund managers with small cap expertise at the moment.
Wilson Asset Management has been excellent at identifying small cap opportunities for over two decades. In WAM Microcap's first year of operation to May 2018 its portfolio delivered a return of 28.4% before fees. This performance was despite holding a decent amount of cash throughout the whole period for protection and also for opportunities.
It currently has an expected grossed-up dividend yield of 4%.
Naos Emerging Opportunities Company Ltd (ASX: NCC) – $1,250
Naos' fund manager expertise is also in identifying small caps. This listed investment company (LIC) looks for shares with market capitalisations under $250 million.
Over the past five years it has returned an average of 14.92% per annum before fees by operating a high-conviction portfolio of around 10 to 15 shares that it believes can produce a return of 20% per annum over a rolling three-year period.
It currently has a grossed-up dividend yield of 8.8%.
Foolish takeaway
These four shares have the potential to soundly outperform the Australian index over the long-term, which is why I hold three of them in portfolio. I firmly believe that investors wishing to beat the market need to have some of their portfolio exposed to small caps.
