Special Free Report From The Motley Fool

Here at The Motley Fool, we're big fans of the wealth building opportunities that exist by investing in shares.

Our co-founders, brothers David and Tom Gardner, started The Motley Fool because they were convinced – and the data supports the view – that shares could be one of, if not the best, single way for the average individual investor to build their wealth.

Indeed, index fund manager Vanguard regularly produces a chart comparing the returns from the various asset classes, and over the last 30 years Australian shares comfortably beat all other asset classes hands down.

Of course, Vanguard's data compares the average returns of each asset class and doesn't guarantee every investor will necessarily receive that return. Still, by investing in a low-cost index fund, the individual investor can almost exactly match the return provided by the index with a minimum of fuss and almost no work.

That approach is an entirely appropriate one for many people. Indeed, if more Australians simply did that, they would be much, much better off than they otherwise are.

At The Motley Fool, we not only want to achieve the average market return, but beat it.

To do that, we spend all day trying to find companies that fulfil a simple criteria. We look for great ASX companies trading at attractive prices.

Despite what you will hear elsewhere, successful investing needn't be complex, nor should it require daily trading or high fees.

Successful investing – Foolish investing – is simple, but that doesn't make it easy.

The last five or so years have been tough for investors. The global financial crisis that was created by the sub-prime mortgage debacle in US had far-reaching ramifications for investors, as did the European sovereign debt mess that followed.

Individual investors deserted the sharemarket in droves, finding the going too tough, and lacking the stomach for volatility that followed. That distaste finally wore off in the second half of 2012 as investors purged themselves of the fear that held them back, and the ASX 200 started a strong bull run.

That wasn't the whole story, however. Since early 2013, investors didn't exactly embrace growth stocks in the sharemarket, instead selecting the safety of household, dividend-paying blue-chip names. Read on for more of what we're calling the Blue Chip Bubble.

Trees Don't Grow To The Sky

We mentioned earlier that we think successful investing is about finding great companies and paying attractive prices.

That's true, but finding great companies – at least as far as investing goes – is far more than just selecting household names or even businesses with strong track records.

There's an old saying in the sharemarket – "trees don't grow to the sky".

When you invest in shares, the job is not to find the tallest tree, or even the tree that may become the tallest. Your job is to assess businesses for their growth potential. Yes, a strong track record and attractive profit growth are important predictors, but extending our metaphor they are the roots of our tree, not the tree itself.

Knowing that a tree may grow to over 100m tall is one thing. However, if that really is already 99m tall, the opportunity for additional growth is relatively small. If you can find a tree with similar potential that is only 10m tall, the scope for growth is – obviously – much greater.

So it is in investing. While some of Australia's biggest and best businesses are indeed great companies, many of them have their best days behind them. They are already dominant players in their industries, and the growth opportunities are relatively limited.

Australia's big four banks have somewhere in the vicinity of 90% market share between them, and their industry is growing at a mediocre pace.

Our three largest grocery players – Woolworths (WOW), Wesfarmers (WES) and Metcash (MTS) – have an estimated 75 to 85% of the market between them, and there are only so many cans of baked beans Australians can eat!

Similarly, our major telecommunications providers have the market between them, and while they still may be able to achieve reasonable levels of growth, each will struggle to significantly outperform the market.

Of course, if a company's shares are cheap enough, you don't necessarily need stellar growth for that investment to be successful.

The Great Blue-Chip Bubble

However, the wall of money that has entered the stock market since the middle of 2012 has predominantly gone into these so-called "blue-chip" companies, pushing their valuations to eye watering heights in many cases.

Not only are many of these companies' growth prospects somewhat subdued, but their valuations appear stretched at best.

When the equation requires us to buy great companies at attractive prices, (remembering that great companies, in this context at least, need bright growth prospects), our "blue chips" fail on both counts.

Woolworths and BHP Were Once Small Companies Too

It wasn't always thus, however. Way back in the early 1980s, Woolworths and Coles had somewhere in the vicinity of one-quarter of the market between them.

Once upon a time, BHP Billiton (BHP) operated a single mine in the west of New South Wales.

It was also not that long ago that Carsales.com (CAR) and REA Group (REA) – the company behind Realestate.com.au – were fledgling online classifieds with high hopes but small revenues.

The best time to invest in these businesses was not once they had cemented enormous market shares and achieved market capitalisation in the billions of dollars, but when they were much smaller and had bright futures ahead.

Of course, we're not suggesting speculating mindlessly on every microcap company you can find. The ASX is littered with the shells of companies that ended up being little more than hopes and dreams. That's especially true of the resources and energy sectors, where there is no shortage of blue sky and high hopes.

Instead, we think judicious research and careful consideration can help investors unearth some of tomorrow's big winners today.

Looking Where Others Aren't – Small-Cap ASX Stocks

The best part about looking for small cap opportunities on the ASX is that the sector has largely been left behind by the bull run of 2012-13.

Indeed, while the ASX 50 index (XFL) of the biggest companies on our market raced ahead by more than 23% in the three years to March 2015, the ASX Small Ordinaries index (XSO) of some of the smallest companies on our market has headed in reverse by more than 14% over the same time period, as you can see in the chart below.

Source: Google Finance

We think that provides enterprising investors with a great opportunity – particularly when you consider that several of the biggest performing stocks in the past year have been small cap stocks. Liquefied Natural Gas Limited (LNG) is up 586%, Audio Pixel Holdings Limited (AKP) is up 215% and Vita Group Limited (VTG) 190%.

Know What You're Buying

First though, a quick comment on risk. The smaller companies can be both more volatile – their share prices can move around more often and more severely than larger companies – and riskier. That extra level of risk comes from often being younger, smaller, and less entrenched than their larger brethren.

That brings more risk, but also potentially higher returns. As with any investment, it's important to understand your own risk tolerance, and stomach for volatility, as well as your personal goals and objectives.

With that in mind, we've scoured the smaller end of the market for attractive options, and have found two companies we think have a good chance of outperforming the market in the years ahead.

iProperty Group (IPP)

Company Snapshot (data as of June 19, 2015)

Market Cap: $475.5 million

Recent share price: $2.50

Cash/debt: $11.8 million/$0

Trailing P/E: N/A

Why Buy:

An early mover with a strong head-start
An attractive and growing market
Management and owners we want to partner with
3 out of 5 countries' operations now profitable

iProperty runs market leading online real estate classifieds businesses in some of the largest and most promising markets in Asia. It operates iProperty.com in Malaysia and Singapore, GoHome.com.hk and squarefoot.com.hk in Hong Kong and rumah123.com in Indonesia, ThinkOfLiving.com in Thailand as well as property magazines, seminars and market reports.

The Asian real estate classifieds market is a little different to what we're used to in Australia. For example, three-quarters of all real estate marketing (valued by the company at more than $1 billion) is spent by developers (as opposed to real estate agents) in the company's mainstay markets of Malaysia, Hong Kong, Thailand, Singapore and Indonesia. iProperty's own business follows a similar trend, with a little over half of revenues coming from developers.

Both the market and iProperty's revenues are growing strongly. The company continues to deliver strong revenue gains. That doesn't make an investment case all by itself, but it's an important milestone and a sign that the company's promise is starting to be realised. iProperty continues to impress.

Management

Chairman Patrick Grove holds a similar position at iCar Asia (ICQ). Grove was previously the executive chairman through to 2010 and was a co-founder of the business. He owns over 31 million shares in iProperty.

Georg Chmiel is new to the CEO role, having taken the reigns from Shaun Di Gregorio in early 2014 (Di Gregorio moving to a new role within the broader Catcha group). Chmiel is however no stranger to the business, and indeed the industry, being a former non-executive director of iProperty and CEO and Managing Director of LJ Hooker and former CFO and General Manager of International Operations at REA Group. He holds over 170,000 shares in iProperty. REA Group (REA) holds a 19.4% stake in iProperty too.

Strong financial growth

We mentioned earlier that revenue growth has been strong — and indeed it has! iProperty expects revenues of between $32.5 million and $36 million in the 2015 financial year.

That sales number is a very small number in the scheme of things, and belies both the reason iProperty is higher risk, but also the size of the prize should it get things right!

On an operating level, the company is forecasting earnings before interest, tax, depreciation and amortisation (EBITDA) of between $3 and $6 million, up from previous guidance of between $2 and $5 million. Given that guidance was for just 5 months of trading, we wouldn't be surprised if guidance is lifted again later this year.

However, the recent numbers aren't much use when it comes to valuation or making the investment case. It continues to be the future that matters. And iProperty's job for the next few years is to ensure it remains at the top of the classifieds pile.

Success in the interim won't be measured by pure financials. We have the luxury of knowing that the leaders in online classifieds are (and will be) immensely profitable. So an investment in iProperty is necessarily a judgement that the company's leadership can be in the lead when the market reaches maturity (think REA Group (REA), Carsales (CRZ) and Seek (SEK) here in Australia).

In that vein, we're pleased to see the deep pocketed REA Group looming large on the company's share register and that iProperty had $11.8 million in cash in the bank last time it reported.

Risks

A slug of cash in the bank is a wonderful asset, but we'll need to keep an eye on the rate at which iProperty uses that cash, especially if it decides to be aggressive with its marketing (we think it should). A company short on cash can be vulnerable.

Similarly, the ownership stakes of Catcha and REA Group give us a lot of confidence, as does the current management team. When the industry is potentially so large, but still in its infancy, the person whose hands are on the tiller matters, greatly.

iProperty derives a decent chunk of its revenues from developers — and that can be a boom and bust business. If that business was to materially reduce permanently, we'd want to know the company was able to grow and prosper in its absence — so we'll be watching closely.

Foolish Takeaway

iProperty is a higher risk business, but it also has a very high potential return. We think that makes for an attractive trade-off as part of a diversified portfolio, and with the management and ownership pedigree, it's time to take delivery of the keys.

Nearmap (NEA)

Company Snapshot (data as of June 19, 2015)

Market Cap: $200 million

Recent share price: $0.56

Cash/debt: $21.8 million/$0

Trailing P/E: 30.6x

Why Buy:

A unique product with a clear first mover advantage
Highly scalable offering with several niche market opportunities
Strong balance sheet and positive operating cash flows

Every now and again a business comes along that offers something that is entirely new and — even rarer — of genuine value. Such is the case with Nearmap (NEA).

The business provides geospatial map technology. In plain English, what it does is take ultra-high resolution aerial photographs which it then makes available to its customers via a sophisticated online interface.

Think of Google's maps service, but on steroids. Not only is Nearmap's imagery of a significantly higher resolution, but content is updated more regularly, can be viewed from varying angles, across different time periods, tailored for use by specific industries and contains a suite of online tools.

The value to clients is potentially immense. Time is money, as the saying goes, and Nearmap tools can save considerable time and as such drastically cut costs and improve efficiencies.

Take for example a solar panel installation company. In order to provide a quote, an installer would otherwise need to drive out to a customer, climb the roof and take measurements. With a Nearmap subscription, the client's house can be viewed online in high resolution, from multiple angles and time of day and measured with great precision — and all from the comfort of their desk and in a fraction of the time (and cost).

The Nearmap story has only just begun.

Google Maps… on steroids

Nearmap caters to a wide, and rapidly growing, variety of industries, including insurance, real estate, mining, solar, local government and rail. All of these leverage off the same underlying imagery, but are packaged in a way that is relevant to the end user.

Images are captured using proprietary photographic equipment mounted under light aircraft. Because the equipment requires minimal installation effort, the company does not need to maintain a fleet of its own aircraft — rather, it can lease equipment as and when it is needed. Captured imagery is then stitched together using unique software and added to the company's database.

Launching as a free service in late 2009, Nearmap began life as a subsidiary of a diversified technology and intellectual property group. High demand for the service led the parent company to focus its efforts entirely on the Nearmap business, which it took from loss to profit by converting to a paid subscription service. The value of the service is evidenced by the fact that take-up rates have remained high under the paid model and have delivered impressive sales growth.

As a subscription based online service company, earnings growth is all about retaining current customers and increasing user numbers (as well as price increases, where appropriate).

To date the business has shown extremely encouraging customer retention rates — last reported at greater than 90% — and is seeking to increase customer numbers in multiple ways. It boasts a large database of potential customers for its existing product suite, but is also looking to broaden its relevance by customising content for other industries. And this is key to Nearmap's strategy — by customising, promoting and pricing the product in a way that is tailored specifically to the targeted end user, the company hopes to maximise the value of its content.

Nearmap has also recently expanded into the US. Though this always carries risk, the ability to leverage of existing (and expensed) its intellectual property means a proven offering can quickly be brought to market as soon as imagery has been collected.

Part of Nearmap's beauty is that it is immensely scalable. If you can increase the number of customers you serve, and hence revenue, without a commensurate increase in costs, rising revenues translate into an even greater increase in profits.

Nearmap is also in an enviable competitive position. A competitor would not only need to capture its own images, they would need to be of a comparable quality, seamlessly stitched together and presented in an intuitive interface that is augmented with a host of online tools. That would require some serious development time (and cost), and when combined with the head start Nearmap enjoys, it would be difficult to steal market share. Moreover, the existing client base provides valuable scale and operational cash flow for Nearmap, giving it a distinct advantage over any newcomers.

Chief Mappers

The board and management of Nearmap have been in place for some time and are well suited to the business. CEO Simon Crowther has led the business since before it was the core focus and company namesake.

Though Crowther holds no shares in the business he does have 10 million options which expire in 2016, each with an exercise price of 7.5c. They are already comfortably 'in the money', and half are vested, but his financial future is clearly tied to Nearmap's.

The Chairman and founder of the original business, Mr Ross Norgard, does have serious skin in the game holding over 58.5 million shares.

One down, many more to come

Although the Nearmap business recorded its maiden profit of $7.1 million in 2014, there are plenty of impressive numbers to instill confidence.

The balance sheet is strong, with zero debt and approximately $22m in cash at most recent half. Nearmap became cashflow positive during the second quarter of FY 2013.

As mentioned, the business is extremely scaleable and the low variable costs provide wonderful financial leverage. Since 2011 the company's revenue has grown from roughly $3.7 million to $17.8 million last year. In the most recent half it achieved a sales growth of 44% over the previous corresponding period, locking in $11.4 million in revenue.

Expenditure on the US expansion is likely to see profits fall in the 2015 financial year, with Nearmap announcing plans to cover 150 million people with capital costs of around $8 million. While that might impinge on short-term profits, Mr Crowther recently reiterated revenue targets of $30-$50 million for Australia by the end of the 2015 calendar year, and the same rate in the US by December 2017.

Risks And When We'd Sell

If a competitor were to offer a similar or better product at the same or cheaper price, there is little to prevent Nearmap's customers deserting the company en masse.

Catching up to Nearmap could be costly and time consuming, but certainly not impossible, particularly for a goliath like Google, for example, which has much greater access to potential customers, expertise and capital strength, should it choose.

Another risk is that of poor capital allocation. Though international expansion holds great promise, the company needs to ensure it invests its cash flows wisely. A costly and ultimately unsuccessful expansion could hurt shareholders, even if the core domestic business continues to prosper.

Finally a lot of expectation is (we think, appropriately) already priced into the shares, and rather strong earnings growth is needed to justify the current market price. The success with which the business has transitioned to a paid subscription model, the growth in new sales and highly scalable nature of the business offer a lot of comfort, but we'll be watching closely to ensure that momentum is maintained.

Here's what we're looking for

With just its maiden full year profit under its belt, and a high cost US expansion under way, Nearmap is squarely in the higher risk category. The overseas opportunity potentially brings higher rewards, should it fulfil the promise we see in it.

Its share price has been — and will likely continue to be — volatile, but that's par for the course for promising businesses like Nearmap still in the early stages of life. We're never scared of volatility, but members should make sure they have the stomach for what will very probably be a bumpy ride.

Nearmap is a business with huge potential. Much of the investment case rests on its ability to maintain a rather robust rate of sales growth both here in Australia and the US. So far, a proven business model, high take-up and retention rate and lots of scope for further expansion give us plenty of cause for optimism.

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Last updated: 19 June 2015

This report was prepared by Mike King and authorised by Bruce Jackson. This report contains general investment advice only (under AFSL 400691). Please refer to our Financial Services Guide (FSG) for more information. Employees and contractors of The Motley Fool, may have an interest in any shares mentioned in this free report. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.

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Please remember that investments can go up and down. Past performance is not necessarily indicative of future returns.

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