The best small-cap shares can deliver eye-watering returns if you're lucky, but knowing where to find them is not easy.
Spheria Asset Management is a leading small and micro-cap professional investment manager and it recently named two businesses it particularly likes today.
It runs separate small and micro-cap funds alongside a listed investment company named Spheria Emerging Companies Limited (ASX: SEC) that runs an actively managed portfolio for investors.
The managers take a bottom-up fundamental research and value-driven approach to hopefully leave them with a margin of safety in buying cheap businesses.
Let's take a quick look at two small caps they like right now.
City Chic Collective Ltd (ASX: CCX) – "44% of this retailer's revenue comes from online with growth in that channel coming in at 36% in FY19. It's 100+ retail stores are also experiencing positive like-for-like sales growth, in a highly challenging consumer marketplace. Most excitingly 20% of revenue is derived from the Northern Hemisphere (primarily out of the United States) where the business has a rapidly growing, profitable and capital light wholesale and online operation."
You can't argue with that and City Chic shares could be cheap.
Ht&E Ltd (ASX: HTE) – "The macro has been weak… we see the business as well placed to take ad revenue share given recent ratings strength and benefit from an eventual recovery in business and consumer confidence. On our numbers the stock trades at a material discount to its closest peer Southern Cross Ltd (ASX: SXL) at circa 7.5x EV/EBIT. This assumes HT1 are entirely unsuccessful in their tax dispute with the ATO but gives value for HT1's 25% stake in Soprano (a rapidly growing and highly profitable global communications SaaS business) and minority investment in the online travel business Lux Group."
On Spehria's numbers HT&E Ltd could also be cheap.
Interestingly, the fundie also used a recent investor update to warn how index tracking or passive investment funds were distorting small cap valuations and hampering performance.
For example several small cap businesses like Pro Medicus Ltd (ASX: PME), Austal Limited (ASX: ASB) and Clinuvel Pharmaceuticals Limited (ASX: CUV) have rocketed in price prior to and after their inclusion into the heavily tracked S&P/ ASX200 Index (ASX: XJO).
Some hedge funds have even boasted of trading the stocks prior to their inclusion in order to turn a quick profit by selling to index funds later, while algorithmic or computer programmed traders are also likely buying the shares prior to their inclusion to sell for a quick profit.
These kind of valuation distortions generally cannot last forever in efficiently priced markets though, which means true value investors like Spheria may be a a good bet.
