When it comes to stocks, it makes sense to buy small

Each week, a professional investor tells MoneyWeek where he’d put his money now. This week: Ed Beal, manager, Dunedin Smaller Companies Investment Trust.

Small companies have had another excellent year. During 2013 the FTSE Small Company (excluding investment trusts) index delivered a total return (in other words, including dividends) of 44.3%, compared with the 14.4% returned by the FTSE 100.

To understand why small companies as a group did so well, we need to reconsider some established investment wisdom, which dictates that small companies are inherently more risky than their larger rivals. The reality is that small companies have become steadily less reliant on the British economy. Indeed, many are global leaders in what they do.

Overall, balance sheets have strengthened, management teams have been improving and the small-company sector contains fewer highly speculative stocks. So investing should be considered on a company-by-company basis – it is no longer as simple as saying that small necessarily means higher risk.

Is last year’s performance likely to be repeated this year? Gains of 44% are exceptional by any measure. In some cases these gains were due to the share prices of lower-quality firms playing catch-up: the gradually improving economic environment helped those with weaker business models or balance sheets the most. Unsurprisingly, we expect returns to be more muted this year.

But that said, in the Dunedin Smaller Companies Investment Trust (LSE: DNDL), we have assembled a portfolio of good-quality businesses. Over time their fundamentals will be the main factor driving their share prices. The following three companies, selected from our holdings, exhibit many of the quality criteria we look for.

Domino Printing (LSE: DNO) is a market leader in the manufacturing of continuous inkjet printers, which are used for printing onto packaging. As the authorities impose more regulations designed to make products from pharmaceuticals to food easily traceable across the supply chain, more of this kind of printing will be needed.

Around 57% of Domino’s sales come from consumables and servicing and spare parts, meaning it benefits from a high level of recurring earnings, selling products that the customer can only source from the company itself. It trades on 20 times earnings, has net cash on its balance sheet and recently increased its dividend by 5%.

RPC (LSE: RPC) is the leader in rigid plastic packaging. Demand is growing as governments try to cut the packaging used in products. Often the simplest way to hit these targets is to swap glass or metal for plastic, making this another business that benefits from changing regulation.

RPC’s technical skills and intellectual property allow it to make packaging that its competitors simply can’t match. Many of its rivals are struggling financially, which offers RPC the chance to take market share and buy manufacturing capacity in areas where it lacks it. It trades on 14.3 times expected earnings.

Victrex (LSE: VCT) is the global leader in the production of a polymer called PEEK. PEEK has chemical, heat, weight and wear advantages over many metals and plastics, which mean it is increasingly used in high-value applications. Victrex remains the only operator capable of producing meaningful commercial volumes of high-grade PEEK.

The product is typically used in small amounts but in critical situations, so there is little incentive for customers to consider alternative sourcing, even if it becomes available. The company trades on 18.4 times expected earnings, has net cash on its balance sheet and grew its final dividend by 15%.

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