Small caps with big potential

Well-managed smaller companies offer plenty of growth potential, says professional stock picker Mike Prentis. Here, he tips three small-cap growth stocks for the medium term.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week: Mike Prentis, portfolio manager, BlackRock Smaller Companies investment trust.

Our investment approach is most simply described as trying to find and invest in companies which have the potential to become much larger over the medium term. We ensure our portfolios are mainly composed of our highest-quality core holdings most have fared well in widely differing economic conditions. We have stringent criteria for our core holdings.

They must all have: proven, trustworthy management; strong market positions giving them pricing power; a clear record of earnings growth; good conversion of earnings into cash; and a sound balance sheet.

Examples of our larger core holdings include Oxford Instruments, Aveva, Ashtead, Howden Joinery, Senior and Booker. We supplement these with smaller holdings which have the potential to become core; our positions in each individual company are much smaller than in a core' company, until our confidence levels have increased.

We recognise the differing economic growth rates of emerging markets, North America, and western Europe, and seek to gain exposure to companies which are selling into strong geographical end markets.

Three companies with market caps below £100m which we believe have considerable medium term attractions are Corin, Gooch & Housego and Brainjuicer.

Corin (LSE: CRG) designs and makes a range of orthopaedic implants, with the emphasis on hips and knees. Sales of metal-on-metal hips have fallen dramatically in recent years, but Corin introduced a new range of non-metal-on-metal hips, which now represents about 60% of sales. Legacy metal-on-metal hips are now down to 5% of total sales. Total hip sales grew 41% in 2011 and are expected to continue to grow well.

Corin has also developed a new knee product which looks to have considerable competitive advantages and is due to be launched next year. Given the success of the hip product, hopes are high for the new knee. In 2011, Corin achieved sales of £47.9m and operating profits of £2.5m. In a few years, we would hope to see total sales growing at 10% plus per year, and operating margins moving to and above 10%. Currently Corin has a market cap of £23m and debt of £5m.

Gooch & Housego (LSE: GHH) is a world-leading designer and manufacturer of precision optical components and subsystems. Its historic success has been built around the Q-switch, a product used in lasers which enables a powerful light pulse to evolve. Sales are closely linked to the semiconductor sales and so are very cyclical.

In recent years, the company has sought to diversify its product range and to move more into systems and other related areas, in particular aerospace and defence, and life sciences. Whilst there had been some delays of certain major contracts, these have now all come through, and the pipeline of other prospects is encouraging.

Brainjuicer (LSE: BJU) is at the forefront of thinking in psychology and behavioural science and its application to market research. It has developed a range of juicy tools' which aim to understand how individual consumers think, rather than how they say they think. It is run by a very strong, inspirational, management team. Customers include Coca-Cola and Proctor & Gamble. Revenues and earnings have grown strongly over the last five years, and we expect this to continue.

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