Some of the UK’s most successful investors — such as ISA millionaire Lord Lee — are known for their ability to spot high-quality small-caps with long-term growth potential.
Today I’m going to take a look at two, including one of Lord Lee’s current holdings. I believe both firm have the potential to outperform the market over the coming years.
Rising profit margins
Software testing specialist SQS Software Quality Systems (LSE: SQS) gained 13% this morning, after revealing a sharp increase in profit margins during the first half of the current year. In its half-year trading update, it said increasing automation of its services had lifted the group’s adjusted operating margin to 7.5%, up from 6.9% for the same period last year.
The company said that it expects second-half revenue to be higher than for H1, thanks to “a number of known business wins starting later in the year”. Management says it has a “stronger pipeline” of sales opportunities than in 2016 and expects to benefit from “a range of emerging growth opportunities”.
In the medium term, SQS expects to be able to deliver an adjusted operating margin of 9% and a corresponding improvement in cash flow. This sounds appealing to me, especially given the stock’s modest valuation.
Investor confidence in the firm was shaken in March and the shares fell from more than 600p to less than 500p. Investors were alarmed by a drop in revenue in the Managed Services division that had showed up in last year’s results.
However, today’s update suggests to me that the steps taken to address these changing business conditions are working well. Evan after today’s gains, the shares are still trading on a modest forecast P/E of 12.7 with a prospective yield of 3.1%. That looks cheap enough to me.
A ‘sticky’ specialist
One of the stock holdings listed by Lord Lee in his parliamentary register of interests is electronics group Concurrent Technologies (LSE: CNC).
This is a specialist business that makes computer boards for critical applications, such as use in harsh environments. Many of the firm’s customers are in the defence sector, but Concurrent products are also used in other markets, including aerospace, telecoms, transportation and industry.
The shares have risen by about 30% since March, when the company reported a 6.2% increase in pre-tax profits and hiked the dividend by 10.5% to 2.1p per share, giving a yield of 2.6%.
The shares now trade on about 17 times trailing earnings, so they aren’t obviously cheap. Despite this, I think Concurrent could remain a smart long-term buy.
The group’s profits have been variable in recent years, perhaps due to the lumpiness of new product introductions and major customer orders. However, the trend in earnings has been upwards and dividend growth has been very consistent, averaging 6% per year since 2011. Net cash rose by 32% to £7.8m at the end of last year, accounting for more than 10% of the company’s £60m market cap.
I believe this business offers good long-term growth opportunities and appears to have a capable and prudent management team. In my view, the shares are definitely worth a closer look.
