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Three small-cap stocks with big potential

There are three key attributes that smaller companies must have to outperform larger ones, says professional stock picker Ed Beal. Here, he explains what they are, and tips three such stocks to buy now.

Each week, a professional investor tells moneyWeek where he'd put his money now. This week: Ed Beal, manager, Dunedin Smaller Companies InvestmentTrusts.

Small companies are often regarded as riskier investments that outperform during periods of above-trend economic growth. So why might smaller companies have done so well recently, returning over double the performance of the FTSE 100? There are three reasons.

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Firstly, investors should realise that not all small firms are inherently riskier than large ones. Many are global market leaders in their niches, with high barriers to entry, quality management teams and a shareholder-friendly approach to corporate governance. They also have balance sheets that are sufficiently robust to allow them to weather the economic cycle.

Secondly, many small firms are largely immune to trouble here in the UK as they derive a big portion, sometimes even a majority, of their revenues from overseas including emerging markets.

Thirdly, these sorts of small firms are well placed to grow their dividends.

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Which smaller companies offer these attributes? Here are three that I like.

Devro (LSE: DVO) is the global leader in the production of collagen casings for sausages. This is a growing market as a rising population consumes more protein. Collagen also offers performance advantages when compared to traditional animal gut, so growth is also being driven by substitution.

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Almost half of the firm's sales come from the Asia-Pacific region and the Americas, and it has a low level of gearing, with a net debt to earnings before interest, tax, depreciation and amortisation (Ebitda) ratio of just 0.4. Devro grew its dividend last year by 6.2% and trades on an earnings multiple of 15.5 with a 2.7% yield.

Elementis (LSE: ELM) is a leader in the production of rheological products, which alter the characteristics of liquids. These are speciality chemicals that are often critical to customers, yet represent only a low proportion of the company's costs. As such, this business has pricing power.

Elementis also owns the only domestic American chromium manufacturing facility. The movement of chromium is regulated in America and Elementis's ability to produce it in an easily transportable, liquid form provides the firm with a cost and service advantage over competitors who have to import it in more hazardous powder form. Moreover, the company also owns the world's only commercial grade hectorite mine.

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Hectorite is a clay used as a thickening additive in certain speciality products. Clearly, mine ownership is a big barrier to entry. Britain represents less than 5% of sales, the balance sheet is cash rich, and the final dividend was increased by 14%. The firm has even announced a special dividend. Trading on 15.7 times earnings, the shares yield 2.7%.

XP Power (LSE: XPP) designs and makes power convertors. Once built into a product, it is difficult for a competitor to displace them. The design process gives good order visibility and, because XP Power doesn't sell via the consumer electronics market, it has been able to avoid that market's savage downswings.

More than 40% of revenues are derived from Asia and America, the company is highly cash generative and the latest results saw a 43% reduction in indebtedness, with gearing down to 17%. The final dividend has recently been increased by 13%, while the shares trade on 12 times earnings with a 4.4% yield.

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