One fast-growing small-cap stock I’d buy right now, and one I’d avoid

Edward Sheldon explains that the key to small-cap success is finding highly profitable companies.

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One of my rules when investing in small-cap stocks, is that I only invest in companies that are actually profitable. I’ve found that this strategy tends to minimise big losses. With that in mind, here’s a look at one company that meets my criteria and one that doesn’t.

Earthport

£115m market cap Earthport (LSE: EPO) is a financial services company that provides cross-border payment services to financial institutions. The company’s global payment network powers transactions for some of the world’s largest financial institutions, e-commerce companies, money transfer organisations and payment aggregators. Earthport claims that it is “uniquely positioned to act at the centre of fundamental change in global financial services.” That certainly sounds like an interesting story, however, there’s one thing that turns me off investing here – the company appears unable to make a profit.

While sales have risen quite spectacularly in recent years, from £2.5m in FY2011 to £22.8m for FY2016, an analysis of the company’s profits reveals a less glamorous picture. Indeed, over the last three years, Earthport generated net losses of £6.7m, £8.7m, and £8.2m. Full-year results for FY2017 released today reveal a similar pattern. Revenues increased by 33% to £30.3m, while net losses climbed by 47% to £12.1m. The market is clearly unimpressed, with the stock down 5% at present.

Earthport could go on to be a great investment in the future, given the increasing demand for global payment services, but for now, I’ll be avoiding the stock simply due to the fact that profits are elusive. 

dotDigital Group

One stock that I do rate quite highly at present is email marketing specialist dotDigital Group (LSE: DOTD). I first bought shares in this small-cap tiddler almost four years ago, at a price of just over 20p. Today, the shares change hands for 89p, so I’m pretty happy with the return on my investment. Having said that, I believe there could be further gains to come for long-term investors.

Its core product ‘dotmailer’ is a nifty piece of software that enables clients to effortlessly construct marketing emails. The software is used by clients such as Barbour, Converse and Fred Perry, and the popularity of the platform has seen sales surge in recent years. Indeed, over the last three years, sales have almost doubled, rising from £16.2m to £32m. Earnings per share have more than doubled, increasing from 1.19p to 2.42p.

Recent final results for the year ended 30 June were excellent, with revenue rising 19%, profit before tax increasing 30% and earnings per share climbing 32%. Revenues outside the UK surged 48% and the company signed some key new clients during the year including The Premier League, Superdry and CNBC.

Looking forward, City analysts predict dotDigital’s strong growth to continue, with revenue growth of 24% forecast for FY2018, along with a 14% rise in earnings per share to 2.77p. That earnings estimate places the stock on a forward P/E of 31.9, which clearly isn’t the cheapest valuation around. Yet given dotDigital’s consistent growth, it doesn’t look unreasonable, in my view.

A glance at the long-term chart reveals that the stock is clearly trending upwards, and for that reason, I won’t be selling my shares yet. As they often say in investment circles, “the trend is your friend.”

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Edward Sheldon owns shares in dotDigital Group. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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