Three cheap small-cap shares to buy now

While the economic outlook remains grim, professional investor Mark Niznik believes the smaller-companies sector will produce good rewards for investors over the next three to five years. Here, he picks three cheap small-cap shares to buy now.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Mark Niznik, co-manager of the Artemis UK Smaller Companies Fund.

After turning more positive towards the end of last year, even we've been surprised by the speed of recovery in smaller-company share prices in the first half of 2009. Our best-performing stocks so far this year have been mostly those which were hardest hit in 2008. This bounce was built on a 'relief reaction' to a slowdown in the pace of economic decline coupled with some very cheap valuations. And the benefit was felt most by some of our resource holdings, such as Kenmare, Aricom and Salamander Energy, along with Alterian (a marketing services software firm) and REA Holdings (an Indonesian palm-oil grower).

However, we see scant evidence of a return to sustainable growth and we are cautious about near-term prospects. Although smaller-company ratings are cheap by any historic measure, the economic outlook is also still pretty grim. It is hard to know what will change that. Nonetheless, we believe investors will be well rewarded by the smaller-companies sector over the next three to five years. A banking system returning to order will help. And investors will seek to take advantage of the gap between the high free cash-flow yields of smaller firms and the low cost of borrowing.

Stock selection remains key. We look for companies with strong records of cash-backed earnings growth, and that are leading business franchises in their field. We also like them to have modest (or even no) debt. This makes them well suited to surviving what may be one of the worst recessions yet. We also want them to be reasonably priced. Three of our newest holdings which fit these criteria are Xchanging, Chemring and Babcock International.

We bought Xchanging (LSE: XCH) on a current year price/earnings ratio (p/e) of 11 and a free cash-flow yield of 7%. These are attractive for a business which we think will grow at 15% a year over the next three to five years. It also enjoys recurring revenue from processing claims and settling trades as an outsourced partner. The result is a 30-40% cost saving for its clients. We think any company that can demonstrate this level of savings for its customers should do well.

We bought Chemring (LSE: CHG) on a p/e of 9 and a free cash-flow yield of 9%. The shares had been underperforming a rampant small/midcap market earlier this year. That's partly because investors wanted cyclical recovery plays which Chemring isn't and were worried about cuts in defence spending. We were comforted, though, by the company's strong order book of over £600 million. We also noted the US defence secretary's recommendations in April for the Congressional budget. The result was more money going to the Joint Strike Fighter programme, to which Chemring is a supplier.

Like Chemring, our final stock, Babcock International (LSE: BAB), underperformed early this year, because investors were worried about cuts in government spending. That allowed us to buy the group on a p/e of nine and a 10% free cash-flow yield. Yet this is a company with a huge £5.7bn order book, giving it 90% recurring earnings from a monopoly on maintaining the UK's nuclear submarine fleet. While we think huge cuts in UK government spending are inevitable after next year's general election, Babcock will be well placed to cope.

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The stocks Mark Niznik likes

12-month high12-month lowNow
Xchanging275.75p157.75p191.5p
Chemring2,426p1,527p2,032p
Babcock International619.5p306p477p

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