It's every investor's Holy Grail. The small company with the potential to become the next BHP - or at least the next Worley Parsons or ABC Learning. The company set on a skybound trajectory with the likelihood of growing its earnings year-in and year-out. The company that currently trades for peanuts but with the potential to increase its share price many times.

The company, in short, that could turn your investment portfolio's performance from merely respectable to shoot-the-lights-out fantastic.

Welcome to the world of the small companies funds. The enormous returns reported by these funds in recent years are proof positive that there are rich pickings outside the top 150 or 200 stocks.

Over the past financial year, Australia's top-performing small companies funds returned more than 50 per cent. The top three - Macquarie's Small Companies Fund, Pengana's Emerging Companies Fund and Challenger's Microcap Fund - returned 82.23, 70.78 and 68.46 per cent respectively, according to researcher Morningstar.

Small companies funds have been some of the best performers in the market over recent years. According to Morningstar, the best small companies funds have returned more than 30 per cent each year for the past five years, meaning investors who got in early have multiplied their money.

But this is not a market where finding rich pickings is easy. Over the past 16 years, says Macquarie portfolio manager Neil Carter, the Small Ordinaries Accumulation Index has returned just 11.6 per cent a year. By comparison, larger companies have returned 12.3 per cent.

Carter says the median small companies manager over that period has returned 21.9 per cent but if you were with a poorly performing fund, or merely a mug punter, your returns could have been much less. "It's like looking for a needle in a haystack," he says.

Michael Courtney, the smaller companies portfolio manager at Challenger, says he would be thrilled to have just one ABC Learning or Worley Parsons in his portfolio each year. Both were listed on the Stock Exchange as minnows and have grown into billion dollar enterprises. But even a company that can grow from $100 or $200 million to $500 million or more can be a tasty proposition.

The reason that small companies funds can outperform is the same reason it's dead easy to lose money at this end of the market. Few small companies attract the attention of brokers. On the plus side, this means good companies can be bought inexpensively. For those prepared to do their research - and most good small companies managers visit hundreds of companies each year - there is a great opportunity to identify growing companies and get in before the crowd.

But the lack of independent research also means investors are reliant on their own homework. Retail investors, in particular, can't just stroll into a managing director's office and start asking questions. Good information can be hard to come by. And while the occasional hot tip might pay off, just as many are likely to fail.

Carter says he has found companies that make a fabulous investment story have three things in common:

* They operate in a large and growing market.

* They have an unfair competitive advantage.

* They have the business model needed to turn the first two criteria into sales and profits.

Steve Black, Pengana's small companies fund manager, says his approach is to start by eliminating resource companies, loss-making companies and property trusts. This leaves it with 800 to 900 companies it can research aggressively.

Like most small companies funds, Pengana is a stock picker and relies heavily on understanding each company's business and finances. Black says he values stocks on their future cash flow and looks for companies that are undervalued relative to their likely future earnings.

Quality of management is also important. "There's not a lot of depth in management among companies worth $100 to $600 million," he says. "So the chief executive will have a large part to play in determining its success."

Like Carter, Black says it is critical to understand management's strategy for growing the company and to be confident they can deliver on those plans.

"We look for companies with a good earnings profile for a least three years and we have to like the guys running the business," says Don Williams, portfolio manager with the boutique Platypus funds management company, which manages the Australian Unity Acorn Microcap Trust - one of last year's 50 per cent-plus performers.

"If a company doesn't have those two qualities, the rest is irrelevant."

Unlike many retail investors, small companies funds are wary of speculative investments, preferring solid earnings and a strong business franchise to lots of blue sky.

"We could play uranium stocks and make 50 per cent easily," Courtney says. "But we don't like losing money. [Good returns] have been easier to get over the past three or four years but historically it's been quite easy to lose money in smaller companies."

So what are the fund managers tipping as the next big growth stories?

A peek into their portfolios reveals some lesser-known gems, and an insight into how the managers choose them. Here are their picks:

Arasor International (ARR)

One of Neil Carter's picks, Arasor is a technology company manufacturing optoelectronic chips - a combination of silicon chips with fibre optics that provide greater access to bandwidth, faster speeds and richer content. Carter says these chips were not previously able to be produced in large volumes at a reasonable cost but Arasor has developed that capability and is supplying markets such as China and India as they leapfrog the old copper wire technology and roll out wireless networks based on fibre optics.

Carter says the company is also active in consumer electronics where its chips can be used in products like laser TVs and digital projection. He says Arasor plans to roll out digital projection through cinemas and there are also opportunities for its use in mobile phones. At last week's prices of about $3.20, Arasor is expected to move from a loss in 2006 to a profit in 2007 and revenue is expected to rise from $29.6 million in 2006 to $120 million in 2007.

Austar United Communications (AUN)

Challenger's Michael Courtney has been invested in Austar for about four years and reckons it still has plenty of growth potential. He says the regional pay TV provider has a monopolistic position in the market and the penetration of pay TV in Australia is still relatively low compared to other countries. "[Penetration levels] are about 25 per cent and growing 1 to 2 per cent each year," he says. "At the same time, prices are increasing every year and the company is selling add-ons such as personal recording devices."

Courtney says Austar can deliver double-digit earnings growth every year for at least the next three to five years and is well positioned in a growth industry. "We like to focus on industries with good growth potential," he says. "Regardless of how good management is, if you're in a declining industry it's hard to make money."

As it happens, Courtney says, Austar has "very good management" that is also good at managing the company's capital base. It has been able to add value to shareholder through capital returns. At last week's levels of about $1.60, Austar is trading on a forecast 2008 price-to-earnings ratio (P/E) of about 21.

Blue Freeway (BLU)

Carter says this is a "pretty exciting" company in the online digital media industry. "There's a big structural shift happening, especially among younger people, who are watching less TV and picking up their entertainment on YouTube, Facebook and so on," he says. "There are big changes happening but advertising is a long way behind. Our question is, how do we play that? If you look at companies like Wotif, they are very expensive, so we're taking more of a picks-and-shovels approach."

Carter says Blue Freeway is a specialist online advertising agency that is developing very powerful campaigns for online and digital use - including mobiles. It is one of the few players in this market and, as the traditional ad agencies are all geared up to create TV ads, it is able to position itself as a specialist and attract good talent.

Carter says Blue is taking market share from traditional ad agencies and operating in a high-growth part of the market. Its last guidance to the market indicated it would generate organic revenue growth of 60 per cent in 2007 and 100 per cent profit growth.

He says it has "very good management" and a strong acquisition model - it is adding acquisitions around the world, which should also generate growth. At last week's levels of about $2.25, it is trading on a 2008 P/E of about 18.

"We would expect it to continue to grow at very impressive rates for the next few years as advertising dollars catch up with what eyeballs are doing," Carter says. "Plus, everyone wants the prized younger demographics."

Cabcharge (CAB)

With a $1.5 billion market capitalisation, Cabcharge probably doesn't qualify as a minnow any more. But Pengana's Steve Black believes it still has good growth potential. He says the company is Australia's largest provider of electronic payment terminals and is benefiting from the strong migration to electronic payments. It's estimated only 25 to 30 per cent of taxi fares are paid electronically, though this number is growing.

Black says Cabcharge also recently joined up with Singapore's ComfortDelGro, which has a strong position in private bus ownership in that country. The two have bought up a lot of Sydney's private bus operators and have developed a strong presence in Newcastle. Black says this is a low-risk business as contracts with the Government mean the private operators don't wear the risks of seats not being filled to the extent that they normally would.

At last week's prices of about $13, he says Cabcharge is trading on a 2008 P/E of 20 to 21 times and is expecting to grow profit by about 40 per cent in 2007 and more than 20 per cent in 2008.

Mineral resources (MIN)

Black says Mineral Resources is one of the services companies riding the mining boom. It owns and operates large ore-crushing machinery for companies such as BHP and Rio, on long-term contracts where the companies agree to crush a set volume.

"It's contract mining," Black says. "Most of the crushers are targeting the iron ore industry, which is projected to grow dramatically over the next three to five years. They're going to need crushers to extract the ore from the ground."

Black says Mineral Resources is the largest player in the Australian market and crushes about 30 million tonnes a year. But such is the size of its crushers that a single new contract could add 5 million tonnes - and the company is bidding on a number of contracts at present. He says Mineral Resources also operates fines recovery and pipeline infrastructure businesses and recently entered into a long term contract with the Chinese investment house CITIC in the fines recovery area.

Black says the company's growth is contingent on contract wins but it has grown its profits by more than 20 per cent a year over the past four years. He says he expects this "to at least continue".

At last week's levels of about $3.50, Black says it is trading on a 2008 P/E ratio of about 14 times and has no debt.

Neptune Marine Services (NMS)

Carter says Neptune is a good example of a company with an unfair competitive advantage. Neptune has developed a patented technology for underwater dry-welding, which has huge potential in applications such as oil rigs, underwater pipelines and shipping.

Traditionally if an oil rig in, say, the Gulf of Mexico, needed repairs, its owners had two choices. An underwater wet-weld could be used as an emergency measure but moisture and salt would be welded into the repair and it would only last for a matter of weeks.

The alternative was to dry dock the rig and weld it there which could prove time consuming and expensive.

Carter says a Gulf of Mexico rig could take six months to decouple, tow to port, dock, repair, and get back into action. In the meantime, production that could be worth millions of dollars a day was halted.

Neptune's Nepsys system allows the repair to be done in situ while the rig is still operating. Lloyds of London is prepared to issue a certificate that these repairs are as good as a dry dock weld.

"The potential market is the shipping, oil, and gas industries," Carter says. "The market is absolutely enormous and they're only starting to scratch the surface."

In Australia Neptune is active mostly on the North West Shelf but has not yet penetrated the Timor Sea or Bass Strait. Carter says the company has the potential to double its Australian operations and has bought a dive operation to gain entree to the Gulf of Mexico. A further plus is that the company has recently changed tack to offer a full-service inspection, repairs and maintence offering so that its customers can outsource the lot. Carter says Neptune's revenues were $1.5 million in 2006 when it was merely a technology company trying to license its technology but revenues are now expected to grow to $27 million this year and $70 million in 2008.

At last week's prices of about $1.06, Carter says he has it on a 2008 P/E of 14.1, with the potential for more upside.

Reckon (RKN)

Courtney bought shares in Reckon after dipping his toe into the accounting software market by investing in competitor MYOB. He says MYOB and Reckon (through its Quicken software) have about 95 per cent of the accounting software market. "It's basically a duopoly and they're good places to make money," he says.

Courtney says Reckon is debt free and benefits from the large number of small businesses that start up each year. "One of the first things they do is buy an accounting software package. Sales of those packages have been growing every year for the past 10 years."

As well as its traditional product, Courtney says Reckon has been developing software for the professional services industry. "It had 20 to 25 per cent growth last year and has made a few acquisitions in other areas. We say it has potential to grow by expanding its offering to clients. The more you can offer your existing clients, the more they tend to rely on you, so you tend to keep your customers longer."

At last week's levels of about $1.25, Reckon is trading on a 2008 P/E of about 15.

Reverse Corporation (REF)

Platypus's Don Williams says telecommunication service provider Reverse still has good growth potential, though it has moved from trading on a P/E of 12 when he bought it to about 21 on 2008's forecasts. Reverse's main business is owning and operating reverse charge calling services. It has a growing mobile reverse charge business and Williams says much of its growth will come from its ability to take its products into other geographic areas.

"Its main market is Britain and its main customer BT," he says. "But it is also in Australia and it's starting up in Ireland, and the next major market is Spain. If it can get Spain it will add $1 or more to the stock but getting into each new area takes years."

RR Australia (RRA)

This is Radio Rentals, the household names that rents out everything from plasma TVs to furniture, computers and exercise bikes to "cash or credit-constrained" consumers. Listed in December last year, Pengana's Black says its appeal to the fund manager comes from a new management team that is setting out to reinvigorate the business. He says management is now much more client-oriented and has been trying to build awareness through advertising.

But Radio Rentals is not your traditional retailer. It has shop fronts but Black says about 70 per cent of its enquiries and sales come by telephone. "They don't need to roll out new stores to grow their business," he says.

"So long as they increase awareness that can generate growth without a large increase in costs, so they get a stronger drop-through to profit growth from an incremental increase in sales."

At last week's levels of about 85 cents, Black says RR is trading on a 2008 P/E of about 10.5, which "is pretty cheap". Its first profit report exceeded forecasts and Black says Pengana is strongly attracted to its strong operating leverage and the quality of its new management.

Technology one (TNE)

Williams says he invested in Technology One when it listed in 1999 and has seen it fall from $1.50 to 20 cents, before recovering to recent levels of about $1.20. At the top of the tech boom, Willliams says the software company became "horribly overvalued" but he says it has always had good earnings.

Technology One's specialty is developing and distributing financial management and accounting software solutions. It has also developed software for specific industries, such as education and local government. After five years of research and development, it is gaining traction in higher education and set up a fledling operation in Britain.

Currently capitalised at about $375 million, Williams says it has a great core business and is "transitioning from a small, small company to a large small cap". Whether it becomes a $2 billion company, he says, will depend on its success in entering the British market. At last week's share price of about $1.25, it is trading on a 2008 P/E of about 22.

ABC LEARNING CENTRES
Listed                  March 2001
Share price then                40�
Share price now         $7.02
Earnings per share then 9.4� (2002)
Earnings per share 2006 27cents
Market capitalisation now       $3.3 billion
WORLEY PARSONS
Listed                  November 2002
Share price then                $1.74
Share price now         $35.40
Earnings per share then 17.1� (2003)
Earnings per share 2006 67.9 cents
Market capitalisation now       $8.1 billion