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A small-cap growth stock I’d buy with £1,000 today, and one I’d sell

With interim results released Tuesday, dotDigital (LSE: DOTD) is in the business of providing software services to the digital marketing business. At around 86p today, the share price has more than five-bagged in five years, and the latest figures show why.

Revenue in the six months to 31 December grew by 25% to £18.8m, with adjusted EBITDA up 8% to £5.7m. The acquisition of Comapi in November caused a cash outflow of £10.7m, but that still left the company with cash of £10.5m at the halfway stage.

Software can be a fickle business. But dotDigital’s approach is to provide software as a service, expand its offering (the Comapi acquisition apparently “provides further progress towards fully-fledged omnichannel offering“), and build long-term customer relationships.

That should hopefully provide both stability and a grounding for long-term growth, as CEO Milan Pate said the firm has “further cemented our partnerships with Magento, Shopify, Microsoft and our other partners.

Cash prospects

That strategy leads to recurring revenue streams and strong cash generation, and I think we could be looking at one of tomorrow’s big cash cows here. Dividends are currently only yielding under 1%, but that’s covered more than four times by earnings, and it’s progressive. From 0.1p per share in 2013, a dividend of 0.68p is forecast for the current year.

It does lead to my one caution that’s common with growth stocks. When a company starts to reach maturity and the transition from an all-out growth story to the beginnings of an income investment, the growth investors often dump it and the share price takes a knock.

But I like the long-term look of dotDigital, and I don’t see a 2019 P/E of 24 as too demanding.

Bigger risk

An example of a ‘jam tomorrow’ lossmaker that I’d steer clear of right now is Verona Pharma (LSE: VRP), but I want to start by telling you what I like about it.

Verona focuses on “developing and commercialising innovative therapies for respiratory diseases,” and 2017 results looked promising — for a start-up still in its cash-burn phase, at least.

Clinical studies sound impressive, with two having recently completed ahead of schedule. The firm’s RPL554 treatment for COPD, when used alongside Tiotropium, gave positive results including “significant and clinically meaningful additional improvement in peak lung function” and faster onset of action. It was well tolerated too, which is a key achievement.

Verona also raised £70m in the period, from a combination of a successful IPO on the Nasdaq Global Market, together with a European private placement and a shareholder private placement. That, especially the Nasdaq launch, suggests that some serious investors see great promise here.

Risky finances

I was bullish a year ago, but finances put me off now. A reported operating loss of £29.8m was due to the costs of these clinical trials and to pre-clinical activities, and the firm did end the year with £80.3m in cash and equivalents on the books.

But net cash used in operating activities ramped up to £20.7m (from £5.6m), and there are pre-tax losses of more than £30m per year currently forecast for the next two years.

That increases the likelihood of further cash being needed before profits come around, and with the pitfalls that can beset the pharma business right up until the last minute, the risk is too great for me.

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Alan Oscroft has no position in any of the shares mentioned. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. The Motley Fool UK owns shares of and has recommended Shopify. The Motley Fool UK has recommended dotDigital Group. 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.