Value stocks

There’s normally a good reason for a company’s shares to trade at less than $1. Companies with such low prices generally are small, speculative and receive only limited attention from professional investors.

But for investors looking for big returns – and who have an equally big appetite for risk – the bottom end of the market is a good place to hunt.

Some of the rules for investing in small capitalised stocks (small caps) are different to investing in the big end. Buying stocks at the bottom end is about picking bargains rather than relying on long-term trends.

BHP Billiton shares provide exposure to the commodities boom and the rise of Asia. There’s a decent dividend, cash flow is strong and the miner’s share price is unlikely to crash. If you believe the Asian growth story, BHP is a fairly safe long-term play.

In contrast, buying a small mining stock is probably giving an investor exposure to just one commodity, or if it’s an explorer, the potential exposure to one commodity. The company may or may not have a buyer for whatever it digs out of the ground.

Often cash flow is critical factor to a company’s success or failure. Fewer resources are devoted to corporate governance and there’s often sovereign risk, depending on where the company operates. If the company hits pay dirt, its share price will soar. If not, investors shouldn’t expect much return.

However, investing in small caps can be very rewarding.

Small-cap stocks have outperformed their larger peers in 2010. The S&P/ASX 200 is slightly lower than at the end of last year, while the small cap index is up almost 5 per cent. Generally small caps trade at a discount to larger stocks on a price-to-earnings basis and economic uncertainty is seldom kind to smaller companies.

Among the 10 best performing stocks this year, only two started the year with a share price less than $1. Rare earths miner Lynas Corp has more than doubled in price this year and iron ore group Sundance Resources is the sixth best performer in 2010.

But that means eight of the top 10 have share prices that trade well over $1, albeit some still fall into the small caps category.

This week, BRW’s small-cap expert, Tony Featherstone, looks at some of the best buys in the market. After speaking to investors, he nominates 11 stocks to follow from a range of sectors, including retailing, advertising and media, telecommunications, health research, property and mining.

The recommendations come with a warning: do your own research before buying and some of the rules that apply to large caps still apply to the bottom end of the market.

Diversification is critical to long-term investment success – it spreads risk and limits the downside. That means diversification within the small cap sector as well as among asset classes.

Investors must be comfortable knowing they could lose their money. They need to be able to sleep at night.

Finally, investors must work on a risk-reward basis when buying shares, rather than just reward.

There are plenty of bargains among stocks worth less than $1 but the sector’s not for the faint-hearted.

Sean Aylmer

BRW

Comments (0)