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These small caps could destroy wealth. Make sure it’s not yours

Small-cap shares can be wonderful vehicles for wealth creation. Jim Slater famously said, “elephants don’t gallop,” meaning it’s far harder for larger companies to rack up explosive growth.

That said, for every tiddler that soars, there are hundreds of doomed or overpriced operations that beguile investors with attractive predictions about the future. And even if you avoid the bad businesses, overpaying for quality could still destroy your wealth.

Today I’ll explain why I believe Koovs (LSE: KOOV) and AO World (LSE: AO) could destroy your wealth.

Cancel Koovs

Owning the ‘ASOS of India’ is an attractive prospect, especially when you throw in 151% revenue growth last year.

On the one hand, comparisons to ASOS seem apt, given Koovs’ strategy to sell own-brand clothing alongside popular international brands such as New Look, Lipsy and even pieces from UK success story Boohoo.Com.

Yet unlike ASOS, Koovs is burning through its dwindling cash-reserves at an incredible rate. The company has employed an aggressive strategy, heavily investing in infrastructure and marketing to drive sales. There’s nothing wrong with investing ahead of the curve – in fact it’s often essential for e-tailers, but I believe Koovs is getting carried away.

The company’s operations registered a cash loss of £12m in the first half of last year. The business model looks flawed to me and it isn’t even profitable at the gross margin level, with product costing £4.8m compared to £4m revenue in the last six months.

I believe the company has around £15m-16m cash currently. That barely covers the last six months’ cash-burn.

That’s not to say Koovs wont become the ASOS of India. It very well might. However, such a glamorous status doesn’t guarantee shareholder returns and investors are likely to be diluted heavily through further fundraising.

That risk, combined with the already demanding £81m market cap for an unprofitable business, in my experience, more often than not results in a painful ride for shareholders.

Great business, bad industry 

AO World is on a mission to become the best electrical retailer in Europe. Even if successful, I’m not sure this vision is compatible with creating shareholder value.

There’s a lot to like about AO World if you’re a customer. A wonderful focus on customer service, fast delivery and a vast selection makes the website a compelling place to shop. But I believe investors are paying a rather rich price for what is essentially a distributor.

The company reported 10.3% revenue growth in the third quarter, a solid result for a larger company but a little underwhelming considering the multiples the shares trade on.

The company has a market cap of £664m, roughly on par with sales in the last 12 months, yet the company still failed to generate an operating profit. It has already achieved considerable scale in sales. If it can’t yet make a decent profit, I’m worried it will never fulfil the lofty expectations demanded by its valuation.

That said, AO World has one major advantage over Koovs. It seems to be generating enough cash from operations to drive the majority of its own expansion, thus reducing the dilution risk for investors.

If you don't trust Koovs and AO World with your hard-earned money, you might find our top small-cap pick to be of interest. Unlike the aforementioned 'jam tomorrow' companies, it's soundly profitable and trades on a lowly PE of 7

When combined with double-digit earnings growth and an experienced founder-owner, we believe this business could go far. Click here to view this investment thesis in full. 

Zach Coffell 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.