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Do British American Tobacco plc & Avon Rubber plc Make A Great Combination?

Sometimes I find it a good idea to blend a few big-cap shares with smaller, higher-risk and potentially higher-return shares in my portfolio.

A steady big cap can deliver solid dividend gains and maybe a little capital growth to stabilise the foundations of my investment strategy, while a growing small cap can spice up returns when the underlying business clicks.

With such a strategy in mind, I’m looking at British American Tobacco (LSE: BATS) and Avon Rubber (LSE: AVON) to see if they can make a great combination when held together.

Strong growth

Avon Rubber ticks the box for excitement and strikes me as a good candidate for the small-cap side of this investment strategy. The firm reckons it has transformed itself over recent years into a design and engineering group specialising in two core markets of Protection & Defence and Dairy.

That sees the firm making and supplying respiratory protection systems (think gas masks) for the military, the fire service and other first responders, and to the industrial sector. Today’s breathing systems are far more advanced from those we might have seen in Dads’ Army, and Avon Rubber is into many aspects of their design and manufacture. The firm earned around 71% of its operating profit from its protection and defence division last year.

The remaining 29% of operating profit came from the dairy division, earned by making and supplying liners and tubing and several other bits and pieces needed to get the white stuff from udder to churn, or holding tank.

Business has been good, as the firm’s financial record shows:

Year to September

2011

2012

2013

2014

2015

Revenue (£m)

108

107

125

125

134

Profit after tax (£m)

7.12

7.83

8.84

10.81

15.17

Net cash from operations (£m)

7.53

13.55

12.11

21.79

17.11

This steady, cash-flow backed growth in profits drove the shares from 310p at the end of 2012 to today’s 1,084p. The company pursues growth organically and through a lively acquisition programme.

City analysts following the firm expect earnings to ease (4%) during the current year to September 2016. Meanwhile, the forward dividend yield runs at just under 0.9%, and forward earnings should cover the payout almost six times. That’s a healthy level of cover, which suggests to me that the directors see plenty of potential for further growth, otherwise they might return more free cash to investors through the dividend rather than reinvesting it into the business.

Avon Rubber’s forward price-to-earnings (P/E) ratio sits just over 20. That’s quite rich, but could be justified if the firm continues to deliver on growth. Overall, I think the company is well worth further research.

‘Defensive’ consumable  products

With the shares up more than 200% over the last ten years, British American Tobacco has not left much for investors to complain about. The consumable, cash-generating nature of the firm’s product has served well and I would not like to bet against further good performance down the line.

At today’s 3857p share price the forward P/E ratio is just over 17, and City analysts following the firm expect earnings to grow 7% that year. The forward dividend yield runs around 4.2% and those forward earnings should cover the payout about 1.35 times.

Cigarette firms tend to make ‘defensive’ investments so British American Tobacco and Avon Rubber make a good pairing for this two-pronged investment strategy and, as such, both seem worth watching for a better-value entry point, or to buy on the dips.  

I also think it's worth researching another small-cap company, one that our analysts uncovered. In a special wealth report, the investment team highlights a little-noticed small-cap share with great potential. You can find out more, free of charge, by clicking here. 

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.