These small-cap growth stocks have been absolutely flying. Is it too late to buy in?

Paul Summers takes a closer look at two hot growth stocks. Are they now fully-valued?

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It would probably be fair to say that the majority of growth stocks have suffered over recent months, particularly those on fairly frothy valuations. And it’s not just the uncertainty over Brexit that’s to blame.

Even market darlings such as Boohoo and ASOS have been hammered after having failed to meet investors’ already-lofty expectations, despite raking in the cash. 

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Notwithstanding this, some companies — and their share prices — have bounced back hard. The question, however, is whether there’s any more upside ahead. 

Unlocking growth

I’ve not looked at small-cap challenger law firm Keystone Law (LSE: KEYS) since October. Back then, I was bullish on the minnow’s future. Three months later, I’m just as positive. 

To recap, Keystone’s goal is to become a leading mid-market firm. It aims to attract both lawyers and clients using its “distinctive platform model“. Rather than operate from a set of offices, the former can work from home and use the support and administrative services provided by the company, with Keystone taking a cut of their fees.

According to last week’s update, the AIM-newbie has “continued to trade strongly” in H2, so much so that management now predicts profits will be “comfortably ahead” of what the market was previously expecting when it provides full-year numbers in May. 

Keystone is clearly in a purple patch. Returns on capital employed are increasing and there’s no debt on the balance sheet. Despite ongoing investment, it even pays a dividend (the predicted 8.25p per share cash return in the current year equates to a yield of almost 2.1%). 

The only trouble with all this is that Keystone’s shares now trade on a pretty punchy valuation. Assuming the company is able to achieve the 15% rise in EPS expected in the next financial year (beginning February 1), the stock trades on 29 times forecast earnings. This clearly leaves little room for error. And if further upgrades don’t come, many investors will probably head for the exits and ask questions later. Such is the difficulty of managing expectations.

If you really must take a position now, scaling-in may be the way forward.

Still on song

Like Keystone, junior market peer Focusrite (LSE: TUNE)  can do no wrong at the moment. 

In a very short update released just before Christmas, the supplier of hardware and software products to musicians stated that revenue for the financial year to date was “now ahead of the comparative period last year“, following strong trading in November. This builds on impressive numbers from 2017/18, including a 13.7% rise in revenue to £75.1m and 18.1% rise in EBITDA to £15.5m. The firm is debt-free and had cash of almost £23m at the end of the last financial year. 

Headquartered in High Wycombe, Focusrite was my top pick all the way back in November 2017.  Since then, its share price has climbed a very satisfying 82%, highlighting just how profitable smaller stocks can be for investors over a short period of time. 

As a result of this, however, the shares are nowhere near as cheap to acquire as they used to be and currently change hands for almost 28 times earnings. When it’s considered that those in the city are still only expecting low single-digit EPS growth this year and next, I’m inclined to think that it might be best to wait for things to cool a little. 

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Paul Summers has no position in any of the shares mentioned. 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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