How to search for the Google of tomorrow

For big returns, think small. Small cap investments are risky, but finding the firm that could prove to be tomorrow's Google is potentially far more profitable than betting on large, established operators. There's greater scope for a small firm and its share price to grow rapidly than there is for a giant with a massive market capitalisation to notch up spectacular profit and stock-price gains.

Why small caps make good investments

Small-cap returns over the past few years, and over the longer term, highlight their massive potential. In 2006, as in the previous three years, small firms "were winners and by a handsome margin", say Elroy Dimson and Paul Marsh of the London Business School in their annual report on the Hoare Govett Smaller Companies Index, published with ABN Amro. The HGSC index, which encompasses the bottom 10% of UK stocks by market capitalisation, posted a total return of 25.1% in 2006, 8.4% ahead of the FTSE All-Share. The HGSC has gained at least 20% for four successive years and has outstripped the All-Share by at least 5% over the same stretch, an unprecedented feat. And calculating the HGSC index back to 1955 shows that it has notched up annual gains of 16.6% to date, against the All-Share's 13%, while the HGSC 1000 index, covering the bottom 2% of the market, has done even better, with annualised returns of 18.6%. So a £1,000 investment in the HGSC and HGSC 1000 indices in 1955 would now be worth almost £3m and £7m respectively, with dividends reinvested. Adjusted for inflation, the figures are £155,000 and £370,000.

The risks of small cap investments

Can the HGSC's run continue this year? Its p/e of 19.6 is now at an all-time high relative to the overall market, but Richard Rae of ABN Amro points out that this still looks reasonable given that smaller companies' estimated earnings growth rates have been revised upwards of late; small caps are expected to grow profits by 16% this year, a figure almost double that of FTSE 100 firms. The key now, as Jonathan Davis says in The Independent, is whether these forecasts can be met or whether the US slowdown and higher UK interest rates lead to profit warnings. Smaller firms tend to be more exposed to the domestic economy and because they are relatively illiquid they can fall further in a downswing than their established counterparts.

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Stock screening is essential for small cap investors

Still, it's clear from the data that no long-term investor can ignore small caps, says Davis, although investors should be wary of Aim stocks. The FTSE Aim index has returned just 0.3% a year over the past decade, and "the quality of some of the companies coming to the market has been a real dog's dinner". Throw in small caps' volatility and the fact that every year "an inordinate number" of small caps, and especially microcaps, vanish without trace, and it's clear that "tried and trusted" stock-screening investment strategies are essential, says David Stevenson in Investors Chronicle.

One approach Stevenson suggests is the "Tiny Titans" strategy, developed by fund manager James O'Shaughnessy in the US. It seeks cheap small caps with upward price momentum, and the strategy has delivered a total return of 2,658.9% over the past nine years. It uses a screening system to find stocks with a market cap between £10m and £150m, a price-to-sales ratio of less than one, and then narrows the search to the 25 with the greatest relative strength over one year.

Two small cap investments to consider now

Another successful strategy, Stock-screening News (published by Investors Chronicle), has demanding criteria, including a net profit margin in the top quartile of the market, a share price over 10p, earnings-per-share growth over the past three years in the market's top quartile and of at least 25% in the current year, and a return on capital employed of at least 15%. Two stocks that stand out from the screen result are IT business services specialist Axon Group (AXO) and SMC Group (SMC), a fast-growing architecture company.