Learning to separate promising small-cap shares from penny stocks is a vital skill for active investors to develop. The former, consistently growing revenue and profits, have the potential to make you rich, in time, especially if they’re held within a tax-efficient Stocks and Shares ISA. The latter, driven by little more than hype, will very likely make you poorer.
With this in mind, here are three examples from the small-cap space that have been doing the business for those already invested.
EKF Diagnostics (LSE: EKF) specialises in manufacturing point-of-care (POCT) devices and tests. These are used in hospitals, clinics and doctors’ surgeries to provide measure hemoglobin, glucose and lactate levels. As you might expect, increased demand since the emergence of Covid-19 hasn’t done business any harm at all.
In a short-but-encouraging update, the firm stated that “strong trading” last month and a packed order book for the remainder of the year would likely lead it to exceed market expectations on its full-year performance. It’s worth noting that analysts had already adjusted their expectations several times in 2020.
EKF’s share price is up almost 300% since March’s market crash. That said, I think it’s far more likely to hold on to these gains compared to your typical ‘pop and drop’ penny stock. A valuation of 36 times earnings for FY21 is high but unsurprising.
Everyone knows Harry Potter. Ask who prints the boy wizard’s tales, however, and many people will draw a blank. Just in case you’re one of them, it’s Bloomsbury Publishing (LSE: BMY). Based on recent trading, it’s a name worth remembering.
A beneficiary of the first lockdown and the move to remote learning, Bloomsbury recently reported record earnings for the six months to the end of August.
All told, revenues climbed by 10% to £78.3m. Year-on-year profits grew 60% to £4m, exceeding even management’s expectations. The shares have understandably rallied.
Will this momentum fall once we’re released from lockdown round 2? It’s possible. Then again, true investors rarely concern themselves with short-term fluctuations. It’s the underlying business that matters, and Bloomsbury looks sound. So sound, in fact, management has reinstated its dividend policy.
Shares currently trade at 23 times forecast earnings. That’s not cheap, but a bulletproof balance sheet (£44.1m in net cash at the end of August) helps justify this valuation.
A small-cap treat
Last on my list of top small-cap buys would be global ingredients specialist Treatt (LSE: TET). In its most recent trading update, the £375m-cap reported that FY20 pre-tax profits were likely to be “in line with pre-Covid-19 expectations” of around £14m, despite a slight dip in revenue.
Clearly, the outlook remains foggy due to the coronavirus. According to CEO Daemmon Reeve, however, Treatt is “strongly positioned to benefit from key consumer trends including the preference for natural products, a growing interest in health and wellness, and premiumisation.”
A price-to-earnings ratio of 31 for FY21 is, again, undeniably punchy. Even so, I’d argue that a company with a market-leading position like Treatt is worth paying more for.
Like EKF and Bloomsbury, its finances are in good order. At the end of FY20, the business had £1m in net cash (excluding lease liabilities) in its coffers.
It’s also still paying out dividends. You won’t find many penny stocks doing that!
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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has recommended Bloomsbury Publishing and Treatt. 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.