Where to find big profits in small companies

A professional investor tells us where he’d put his money. This week: Edward Wielechowski of Odyssean Capital chooses three overlooked minnows.

At Odyssean we attempt to apply in-depth research to stocks to identify promising long-term stories that are poorly understood and therefore undervalued by investors. We believe such bargains are most frequently found among smaller companies. Stocks in this segment of the market tend to get limited coverage from brokers, so few investors are fully familiar with them.

As a result, price movements can become disconnected from company fundamentals. What’s more, small caps are more likely to be able to deliver a sharp improvement in performance than their larger counterparts. A new market opportunity or management team can drive meaningful change in returns .

A defensive firm in transition

One firm where we see value is Chemring (LSE: CHG), a maker of military countermeasures and threat-detection sensors. The short-term impact of an explosion at its manufacturing facilities has obscured an exciting opportunity.

In 2018, the group’s sensor divisions secured a significant boost from long-term US military programmes. These new contracts have the potential to transform the profitability of the group. Furthermore, the recently installed CEO instigated a strategic review, discontinuing volatile and less profitable ammunition supply operations.

It is slowly becoming a higher-margin, more predictable business, focusing on products that help save lives. With peer Esterline recently sold for around twice sales, and Chemring currently trading on approximately 1.4 times earnings, the shares are highly attractive.

Navigating the cybersecurity landscape

We also like the story for NCC (LSE: NCC), a global expert and US and UK market leader in cybersecurity and risk-mitigation services. This market is growing rapidly and NCC is well positioned to help companies navigate the fast-evolving cyber-threat landscape. The shares have been buffeted by historic mergers and acquisitions missteps and recent operational challenges.

However, the new management has identified significant margin and cash-generation improvement potential through internal efficiencies as well as opportunities to accelerate growth in the key US market. These measures have started to deliver and have further to go, presaging strong earnings growth over the medium term. Given all this, we believe the current valuation of about 12 times earnings is too cheap.

Skin in the game

Another tasty opportunity is Devro (LSE: DVO), the leading global producer of collagen sausage casings. Its expertise and large manufacturing footprint make it difficult for potential competitors to break into the market, which is growing steadily as the global population expands.

A period of investment in new production facilities is now beginning to bear fruit. Furthermore, management has identified cost savings through integrating a historically globally disparate group and trimming costs. Improving cash generation and increasing profitability supports a dividend yield of around 6%. The market has overlooked the stock or dismissed it as boring, but we see a real opportunity here for long-term investors.