Although small-cap stocks are generally considered to be riskier investments than more mature large-cap companies, they often deliver greater returns over the long term. Small-cap stocks are also more commonly mis-priced by investors due to behavioural biases and their perceived business risks, which enables investors to occasionally find some hidden gems.
With this in mind, I’m taking a look at two small-cap stocks with serious upside potential.
Buy and build
Scientific instrument specialist Judges Scientific (LSE: JDG) is a turnaround play which ambitious investors should keep an eye out for.
The core of the company’s business model is to buy and build a portfolio of scientific instrument businesses. Growth is being pursued by a combination of the pursuit of organic growth from existing businesses and through the acquisition of top-quality businesses with established reputations in specialist niches.
Although the past two years had been a tough time for the company, as growth in earnings and cash flow languished, the company is showing a number of signs that things could soon take a turn for the better. Despite a sluggish start to the year, trading picked up in the second half of 2016, with overall organic order intake up 2.9% compared with 2015.
Looking ahead, profitability is expected to improve as it addresses the production challenges in one of its businesses, which has primarily been the cause of the company’s recent weak financial performance. The company is also set to benefit from sterling’s relative weakness as the group earns a majority of its revenues from overseas, but its costs are predominately UK-based and are largely denominated in sterling.
What’s more, the long-term fundamentals of the scientific instrumentation sector remain intact, with demand likely to continue to grow due to increased investment in higher education and a growing trend towards optimisation across science and industry.
As City analysts expect the company to increase its earnings by 24% this year, investors would likely gain confidence in its turnaround prospects. Judges is currently attractively valued, with shares in the company trading at 15.2 times expected earnings this year (or 13.7 times expected earnings for 2018).
Infrastructure
Meanwhile, construction and engineering services company Renew Holdings (LSE: RNWH) could be set to benefit from an improving infrastructure spending outlook in the UK. The company has extensive expertise in the water, telecoms, transport and energy sectors and is well-placed to gain market share in the regulated infrastructure markets.
The company’s interim results this week show Renew is making solid progress. Revenue in the six months to 31 March 2017 increased 9%, while operating profit jumped by 14% to £12.1m. This enabled it to hike its interim dividend by 13% to 2.65p per share, giving its shares a current yield of 1.9%.
With management confident that it can lift the group’s operating margin to 4.5%, from 4.2% currently, I expect earnings to outpace revenue growth again this year. Renew seems reasonably priced, with shares in the company trading at 14.3 times expected earnings this year, which compares favourably to the sector average of 17.4.
