The ASX is home to a number of quality small caps that I think are worth investing in.
Small caps have much more growth potential than large caps because of their starting size. A $200 million business can grow ten times its size before it reaches a market capitalisation of $2 billion. If a $2 billion company grew in size by ten times it would be one of the largest businesses in Australia.
Small caps also tend to be under-researched and undervalued due to the limited number of investors that hunt in that area of the market. Lower valuations and more growth potential sounds like a good combination to me.
If I were lucky enough to be handed $20,000 to invest in small caps, this is how I'd do it:
Paragon Care Ltd (ASX: PGC) – $6,000
Paragon Care is a distributor of healthcare items like beds, surgery equipment and devices.
It owns a single purchasing platform, like a healthcare version of Amazon, to allow customer to browse and buy what they need. Over time this should lead to much greater economies of scale and higher profit margins, similar to how other e-commerce businesses have grown.
Paragon has been acquiring additional healthcare supplier businesses so that it can offer more products on its platform, giving its clients like hospitals and aged care providers a wider range.
Despite recently announcing yet another accretive acquisition and also raising capital at $0.91, Paragon is trading at $0.75 per share. This means it's trading at 10.5x FY19's estimated earnings with a grossed-up dividend yield of 5.9%.
Duxton Water Ltd (ASX: D2O) – $4,000
Duxton Water is a company that invests in water entitlements and leases them out to agricultural businesses.
Water is a very important resource for all types of farms, so it's a good way to get indirect exposure to Australia's growing food industry.
Water values have increased significantly over the past year due to the current drought faced in regional areas. Water should increase in value over the long-term due to the scarcity of fresh water, as well as rising food prices. It could go higher in the short-term if these dry conditions persist over the next 12 months.
Duxton Water is currently trading at a slight discount to its net asset value (NAV) per share and it also comes with a partially franked dividend yield of 3.7%. I think it could be one of the best alternative ideas on the ASX at the moment.
WAM Microcap Limited (ASX: WMI) and Naos Emerging Opportunities Company Ltd (ASX: NCC) – $5,000 each
I can understand if you don't want to spend the time researching small caps, however that doesn't mean you need to ignore that area of the market altogether.
WAM Microcap and Naos Emerging Opportunities are two of the leading LICs that focus on small caps, targeting shares with market capitalisations under $300 million and $250 million respectively.
They have both beaten the ASX index since inception and aim to pay a growing dividend from the market-beating profit.
WAM Microcap has recently started paying a dividend and offers an ordinary grossed-up yield of 4.3%. Naos Emerging Opportunities has a grossed-up dividend yield of 8.4%.
Foolish takeaway
I believe that all four shares have the quality to beat the market over the long-term. At the current prices I am most drawn to Paragon due to its low valuation and organic growth target of 10%, however the other three could also beat the market over the long-term too.
