http://www.moneymanager.com.au/articles/2007/07/30/1185647821708....

http://www.moneymanager.com.au/articles/2007/07/30/1185647821708.html

It's every investor's Holy Grail. The small company with the potential to become the next BHP - or at least the next Worley Parsons or ABC Learning. The company set on a skybound trajectory with the likelihood of growing its earnings year-in and year-out. The company that currently trades for peanuts but with the potential to increase its share price many times.

The company, in short, that could turn your investment portfolio's performance from merely respectable to shoot-the-lights-out fantastic.

Welcome to the world of the small companies funds. The enormous returns reported by these funds in recent years are proof positive that there are rich pickings outside the top 150 or 200 stocks.

Over the past financial year, Australia's top-performing small companies funds returned more than 50 per cent. The top three - Macquarie's Small Companies Fund, Pengana's Emerging Companies Fund and Challenger's Microcap Fund - returned 82.23, 70.78 and 68.46 per cent respectively, according to researcher Morningstar.

Small companies funds have been some of the best performers in the market over recent years. According to Morningstar, the best small companies funds have returned more than 30 per cent each year for the past five years, meaning investors who got in early have multiplied their money.

But this is not a market where finding rich pickings is easy. Over the past 16 years, says Macquarie portfolio manager Neil Carter, the Small Ordinaries Accumulation Index has returned just 11.6 per cent a year. By comparison, larger companies have returned 12.3 per cent.

Carter says the median small companies manager over that period has returned 21.9 per cent but if you were with a poorly performing fund, or merely a mug punter, your returns could have been much less. "It's like looking for a needle in a haystack," he says.

Michael Courtney, the smaller companies portfolio manager at Challenger, says he would be thrilled to have just one ABC Learning or Worley Parsons in his portfolio each year. Both were listed on the Stock Exchange as minnows and have grown into billion dollar enterprises. But even a company that can grow from $100 or $200 million to $500 million or more can be a tasty proposition.

The reason that small companies funds can outperform is the same reason it's dead easy to lose money at this end of the market. Few small companies attract the attention of brokers. On the plus side, this means good companies can be bought inexpensively. For those prepared to do their research - and most good small companies managers visit hundreds of companies each year - there is a great opportunity to identify growing companies and get in before the crowd.

But the lack of independent research also means investors are reliant on their own homework. Retail investors, in particular, can't just stroll into a managing director's office and start asking questions. Good information can be hard to come by. And while the occasional hot tip might pay off, just as many are likely to fail.

Carter says he has found companies that make a fabulous investment story have three things in common:

* They operate in a large and growing market.

* They have an unfair competitive advantage.

* They have the business model needed to turn the first two criteria into sales and profits.

Steve Black, Pengana's small companies fund manager, says his approach is to start by eliminating resource companies, loss-making companies and property trusts. This leaves it with 800 to 900 companies it can research aggressively.

Like most small companies funds, Pengana is a stock picker and relies heavily on understanding each company's business and finances. Black says he values stocks on their future cash flow and looks for companies that are undervalued relative to their likely future earnings.

Quality of management is also important. "There's not a lot of depth in management among companies worth $100 to $600 million," he says. "So the chief executive will have a large part to play in determining its success."

Like Carter, Black says it is critical to understand management's strategy for growing the company and to be confident they can deliver on those plans.

"We look for companies with a good earnings profile for a least three years and we have to like the guys running the business," says Don Williams, portfolio manager with the boutique Platypus funds management company, which manages the Australian Unity Acorn Microcap Trust - one of last year's 50 per cent-plus performers.

"If a company doesn't have those two qualities, the rest is irrelevant."

Unlike many retail investors, small companies funds are wary of speculative investments, preferring solid earnings and a strong business franchise to lots of blue sky.

"We could play uranium stocks and make 50 per cent easily," Courtney says. "But we don't like losing money. [Good returns] have been easier to get over the past three or four years but historically it's been quite easy to lose money in smaller companies."

So what are the fund managers tipping as the next big growth stories?

A peek into their portfolios reveals some lesser-known gems, and an insight into how the managers choose them. Here are their picks:

Arasor International (ARR)
Austar United Communications (AUN)
Blue Freeway (BLU)
Cabcharge (CAB)
Mineral resources (MIN)

Neptune Marine Services (NMS)

Carter says Neptune is a good example of a company with an unfair competitive advantage. Neptune has developed a patented technology for underwater dry-welding, which has huge potential in applications such as oil rigs, underwater pipelines and shipping.

Traditionally if an oil rig in, say, the Gulf of Mexico, needed repairs, its owners had two choices. An underwater wet-weld could be used as an emergency measure but moisture and salt would be welded into the repair and it would only last for a matter of weeks.

The alternative was to dry dock the rig and weld it there which could prove time consuming and expensive.

Carter says a Gulf of Mexico rig could take six months to decouple, tow to port, dock, repair, and get back into action. In the meantime, production that could be worth millions of dollars a day was halted.

Neptune's Nepsys system allows the repair to be done in situ while the rig is still operating. Lloyds of London is prepared to issue a certificate that these repairs are as good as a dry dock weld.

"The potential market is the shipping, oil, and gas industries," Carter says. "The market is absolutely enormous and they're only starting to scratch the surface."

In Australia Neptune is active mostly on the North West Shelf but has not yet penetrated the Timor Sea or Bass Strait. Carter says the company has the potential to double its Australian operations and has bought a dive operation to gain entree to the Gulf of Mexico. A further plus is that the company has recently changed tack to offer a full-service inspection, repairs and maintence offering so that its customers can outsource the lot. Carter says Neptune's revenues were $1.5 million in 2006 when it was merely a technology company trying to license its technology but revenues are now expected to grow to $27 million this year and $70 million in 2008.

At last week's prices of about $1.06, Carter says he has it on a 2008 P/E of 14.1, with the potential for more upside.