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Why I’d consider buying this top small-cap stock instead of this FTSE 100 giant

Having performed admirably since late 2015, it’s been a rather disappointing last few months for holders of defence, aerospace and security behemoth BAE Systems (LSE: BAE). From a peak of 675p back in June, the stock has now dived around 20% in value as some traders have become skittish that the company’s intention to cut almost 2,000 jobs hints at possible changes to UK defence spending rather than a restructuring of the business.

If you believe what the company is saying however, this drop feels overdone. In its most recent trading statement in October, BAE declared that trading has been in line with expectations and that it has not altered its outlook for 2017 as a whole (a 5% to 10% rise in earnings per share on that achieved in 2016 is predicted). Moreover, the US defence market outlook “remains positive“, according to the company, with the ramp-up in production on a number of its programmes “progressing to plan“. 

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With the shares now trading on a price-to-earnings (P/E) ratio of 12 for the current year, BAE looks good value. At its current price, the £17bn cap also yields 4%, with dividends fully covered by profits. Although hikes tend to be modest, the FTSE 100 constituent now has a long uninterrupted history of raising its bi-annual payouts. The fact that free cashflow has improved greatly over the last couple of years also gives management far more wriggle room to return cash to shareholders.

Notwithstanding the recent reversal in its share price, I think BAE remains a solid choice as part of a suitably diversified portfolio. That said, if you’re fortunate enough to have a sufficiently long investing horizon over which to build a sizeable amount of wealth, I think there’s a far better option lower down the market. 

A better bet

Thanks to its tempting valuation, £330m cap gas mask maker Avon Rubber (LSE: AVON) was my top share pick back in September. Today’s encouraging set of final results make me even more bullish on the Melksham-based firm’s future.

Ignoring currency fluctuations, orders in the year to the end of September jumped 22.2% to just under £174m. Revenue also rose 14.2% to £163m with adjusted operating profit coming in ahead of expectations at £25.8m.

Possessing a closing order book of £34m — up 45% on FY2016 — Avon now believes it has “excellent visibility going into 2018“. Its suitably buoyant CEO, Paul McDonald, also reflected that there were “significant” opportunities ahead for both of its businesses. As a result of an expanding Military product and customer base, Avon Protection has a “very positive growth outlook” for next year “and “subsequent years“. The “more positive market” for the company’s Dairy segment is also expected to continue.  

Since the beginning of September, Avon’s shares have been on a roll, rising 18%. That said, the stock still looks remarkably good value at just under 16 times trailing earnings, particularly when you consider the consistently high returns on both sales and capital employed achieved over the years.

In addition to its finances being in great shape (the company had a £24.7m net cash position at the end of this financial year), Avon’s habit of increasing its payouts to shareholders by double-digits continues with today’s final dividend of 8.21p giving a final payout of 12.32p for the year — a 30% increase on 2016.

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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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