Three small cap stocks with big potential

Each week, a professsional investor tells MoneyWeek where he'd put his money now. This week Paul Harwood, director at Unicorn Assest Management.

Stockmarkets around the world have been depressed by slow or no growth, financial and banking risk and burgeoning government fiscal deficits. The mainstream media focuses on any negative story from international (Greece) to local (Clinton Cards) to prove' that equity investment is unattractive.

We know that even modest rates of inflation will damage the real value of savings. So anyone who buys low-risk assets, and therefore accepts low cash interest rates and bond yields, is tacitly acknowledging that a slow real loss of value is acceptable. And yet it seems plenty of investors are prepared to do just that.

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Part of the problem is that risk is being defined rather narrowly. It is often seen purely as day-to-day volatility. Equities score badly here compared to other investments. But when so much short-term volatility is a function of speculative manipulation, can it really be regarded as pure risk? To a longer-term equity investor, who focuses on finding growth and decent real returns, this sort of short-term volatility is just noise. But where should we look for such growth?

Over the last year or so we have seen the value of past favourites amongst the quoted utilities (predominately water and electricity suppliers) rising strongly. These are now valued on mid-teens price/earnings (p/e) ratios, yet they are unlikely to grow in real terms, carry the risk of tighter regulatory control and have high levels of debt. So our hunt for growth needs to focus elsewhere in the smaller companies sector. Here are three businesses that I think offer decent long-term growth opportunities.

Acal (LSE: ACL) is a European electronic component distributor. With new management it has focused on more specialist areas where it can add value for its customers, often through assisting in the design process. Sales will be flat in the short term because of the European recession. However, trading profit margins are less than half those of the major operators and can be raised as the business gains traction.

Acal's shares sell on a single figure p/e and offer a yield of more than 4%. An added bonus is that there is no debt on the balance sheet. Downside risk is also limited by the clear attraction this company would have for an America acquisitor who requires greater European exposure.

My second tip is VP (LSE: VP), a British plant-hire company with a difference: it hires into specialist fields, from North Sea oil equipment to rough terrain site vehicles for housebuilders and contractors. VP should be viewed partly as a bank in circumstances where its customer base may not have sufficient access to credit lines to finance short-term equipment. Last year the company raised turnover by 16% and seems confident of further growth. The p/e is around eight, with a yield of 4.3%.

Lastly, I like Castings (LSE: CGS), which manufactures engineered cast products, mostly for the global truck and off-road vehicle industry. It is highly efficient and has a long-term record of (cyclical) growth. The balance sheet is extremely strong and new contracts should offset some of the short-term cyclical downturn. The p/e is also around eight, with a yield of 3.9%.