If your goal is to generate strong investment returns, it’s worth looking outside large-cap indices such as the FTSE 100 and allocating a little bit of capital to small-cap stocks. This area of the market can produce explosive returns due to the high-growth nature of smaller companies. Just look at one of my top small-cap picks from last year Gamma Communications – it’s up 70% in less than a year.
With that in mind, here’s a look at my top three UK small-cap stock picks for 2020.
Artificial intelligence-fused digital marketing
DotDigital Group (LSE: DOTD) is a fast-growing technology company that specialises in artificial intelligence-fused digital marketing solutions. Its key marketing platform, Engagement Cloud, which helps businesses connect with customers, is used by over 70,000 marketers in 156 countries.
DotDigital issued a strong set of full-year results in mid-October. For the year ended 30 June 2019, organic revenue from continuing operations climbed 15% to £42.5m, while adjusted earnings per share jumped 33% to 3.88p. Meanwhile, recurring revenue as a percentage of total revenue climbed to 86%.
Looking ahead, analysts expect revenue and earnings per share of £48.9m and 4p respectively this year. I believe there’s a good chance the group will beat these forecasts, given its strong growth in the US and Asia. This could send the share price significantly higher.
At present, DOTD shares trade on a forward-looking P/E ratio of 24.5. I see that valuation as very attractive.
Legal industry disruptor
Next up, Keystone Law (LSE: KEYS). This is an innovative, next-generation law firm that is disrupting the market by enabling lawyers to work from home or their own offices. It currently has over 300 lawyers on board (it believes its addressable market is potentially 47,000 lawyers), and its clients include Tesco, the BBC, and Siemens.
Keystone has grown at a rapid rate over the last few years (three-year revenue growth of 104%) and I’m expecting further growth in the years ahead. Directors believe the business model enables “rapid scalability” and if the special dividend of 8p that was declared in the group’s first-half results in September is anything to go by, management is certainly confident about the future.
Turning to the valuation, Keystone shares currently trade on a forward-looking P/E ratio of 37. That is a lofty multiple, however, given the exciting growth prospects here, I don’t see it as a deal-breaker.
Autonomous vehicles play
Finally, my last UK small-cap stock pick for 2020 is AB Dynamics (LSE: ABDP). It’s a provider of integrated test systems for the global automotive industry. Given that the group’s products are integral to the development of new vehicles, I see ABDP as a good way to gain exposure to the self-driving cars market. In the years ahead, manufacturers will need to evaluate their autonomous vehicles extensively under a large number of complex scenarios and ABDP is well placed to benefit.
AB Dynamics issued a great set of full-year results in late November. For the year, revenue climbed 56%, while adjusted diluted earnings per share increased 50%. The company also said that it remains confident that it will continue to deliver further growth in the coming year. However, since the results, the shares have pulled back from above 2,800p to around 2,000p.
I think this pullback has created an attractive entry point. Given the company’s strong growth, I think the stock’s forward-looking P/E ratio of 30.7 is quite reasonable.
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Edward Sheldon owns shares in dotdigital Group and Keystone Law. The Motley Fool UK has recommended AB Dynamics, dotDigital Group, and Tesco. 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.