The small cap stocks set to deliver big gains

Every month, we invite the best investors we know to dinner and ask what they would and would not put their money into now. This month we look at Britain's small caps.

Annunziata Rees-Mogg: Let's start by defining what we mean by a small cap. Can we really just talk about them as a whole when clearly the smaller company market is made up of diverse sectors?

Patrick Evershed: That's true. It's an enormous area making up around half of all quoted companies. That means that different parts of the market move in different ways. Right now, for example, the resources sector has been doing well, but housing-related firms have been doing pretty badly.

Tom Bulford: I think I see there's a real divergence in the market now in terms of size. It seems to me that the smaller the company, the worse the performance has been this year. The bigger firms in the market and there are many worth a billion now have done better, but overall the Aim market is a bit of a problem: there have been so many initial public offerings (IPOs) that the supply of shares available exceeds demand.

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PE: Last year, there was a record number of listings on Aim, but this year has already more than doubled last year's record. There are about two listings a day I've got everything from Canadian to Chinese, Indian and Israeli firms coming to me to discuss IPOs. Everyone's trying to raise money, but there are so many of them that they are having to do it at half the price they were last year. Then, good growth companies were listing on p/es of 14 to 15. Now, it's more like eight times. So they are coming at cheaper and cheaper prices. It's marvellous if you're buying now you get super-growth companies on p/es of seven or eight with extremely good prospects. But it also means that half the firms that came to market last year on p/es of 14 or 15 have halved as cheaper new competitors have prompted reratings. So if much of your portfolio consists of things bought last year, you're having a rough time.

Giles Hargreave: For fund managers, this is all very hard work you have to meet all these companies to see if you want to invest in their listings. We're fully occupied day in day out seeing them.

Daniel Hanbury: We've got a policy of not doing IPOs for exactly that reason. It takes an enormous amount of effort to see all these companies and we just don't have the time to sift through them there's a lot of dross coming to the market as well as the super-growth companies that Patrick's referred to. We wait for them to trade for a year or two so that we can have confidence that they're a proper company before we buy.

PE: That's great. So you'd rather not buy on p/es of seven, but wait to buy on p/es of 14 next year? Well, it's people like you that markets need.

ARM: But why are there so many listings on Aim? Why do all these foreign firms want to list in the UK?

GH: Tax. The tax advantages of Aimare enormous. You only pay 10% capital gains tax after two years and no inheritance tax on shares after they've been held for two years. Very few people have cottoned on to the latter yet, but they will. We've just employed someone to do inheritance tax portfolios and I've persuaded my dad to do it. He's 92.

PE: That could be a problem, given you have to hold the shares for two years.

GH: That's very unkind and luckily he's very fit. Anyway, tax avoidance is a big reason, but the other is that listing firms is very attractive for corporate brokers. They charge a minimum of 3% of the money raised. That's a lot of money.

TB: I know of a firm that raised £1m gross, but, after they had paid all their lawyers and advisers here and in Hong Kong, got only £450,000 net.

ARM: A lot of companies are also re-listing from the main market, aren't they? What's going on there?

PE: There are now some huge companies listing on Aim, with market caps of up to a billion pounds. They're all after the tax advantages too. But this might cause problems. The tax advantages were put in place to help out minnow companies to compensate investors for the extra risks of buying them. But those same risks aren't there with £800m firms, so some people say that the rules are being abused. Gordon Brown may not like this. He could abolish the tax advantages, or abolish them for incomers with market capitalisations of more than £100m.

TB: We now have a situation where very mature companies are moving to Aim. That was never the idea.

PE: The other problem is that Aim shares aren't allowed to be put in Isas, so if a company you have in your Isa moves to Aim, you have to sell its shares. But you only get 28 days to do this and not all the shares are particularly liquid, so you can end up selling at a big discount, which is obviously damaging.

ARM: The size of the firms listing on Aim now suggests that we can't really think of it as only a small-cap market. So how do we now define a small cap?

PE: Some people say a small cap is under £500m. Others says under a billion.

GH: Liquidity is important here. I run three unit trusts. One is a big-cap fund and two are small-cap funds. On a bad day in the market, I bless the big-cap fund because it's completely liquid I can sell anything anytime. That's not the case with the others. The worse a market gets, the more illiquid they become. This is one of the places the smaller investor has an advantage over us. If we're putting, say, £100,000 into a stock and something goes wrong, we're stuffed. But an investor with, say, £5,000, can probably get out.

PE: This is currently a problem. New listings are being placed with only ten to 12 big shareholders, which means very low liquidity they can't all just sell at the same time.

ARM: A lot of recent listings have been in the oil and gas sector, which has been a major support for the market. Is that going to continue, or will another sector take the baton from here do you think?

DH: Every man and his dog is suddenly bearish on the oil sector, but I think it's still good for quite a period of time, for the medium to the long-term maybe, although in the shorter term you're likely to get a shake-out. How far it goes is open to question at the moment.

GH: In the last few weeks we've been reminded of some of the risks in oil exploration. A series of wells have been found to be dry and the cost of drilling and hiring rigs has soared. Rig costs have at least doubled. So although the oil price is high, so is the cost of exploring the cost of the risk. So I think all exploration companies need to be treated with considerable care.

PE: Still, some are extremely professionally managed and continue to grow. The problem is that too many people who know nothing about oil exploration have jumped on the bandwagon they don't know the first thing about how to find oil. If, instead of them, you back people who are really serious oil chaps and have experience and really good geologists, they'll keep on finding more oil.

TB: The trouble is that with so many foreign firms coming to Aim, it's hard to know who's got the experience and who hasn't. They all say they have the best geologists, and so on. Who's to know?

DH: The way we go about it is to make sure we see a track record of positive cash flow over the last two or three years as a minimum requirement before we invest. Do it like this and you can still get plenty of upside from a trend without setting quite as much risk. Even the mining companies we hold are typically profitable.

PE: On mining, you really want to go for people who have done the work already and are about to go into production. Now the sector's all been hit, you can get these cheap. You buy shares in companies that are already producing at a very low rating, so there's no need to look at the more dodgy stuff around.

ARM: The thing is that you professionals can talk to the analysts and find out what's for real and what's just talk, but the private investor can't do this. Private investors simply don't get as much information.

GH: I think that if private investors use the internet intelligently, they can probably get access to as much research as we can.

TB: I agree. In the US, small companies go so far as to communicate directly with their investors via their websites and, given how hard smaller firms can find it to get their voices heard, I think that it'll be interesting to see if we end up going down that route in the UK too. Of course, when companies present their own information they give it their own spin. But they do that when they take presentations around the City too.

GH: The difficulty is always finding independent research. You can't trust at least 90% of the research on smaller companies because it's written by the corporate broker who's being paid by the company. Good, bad or ugly, any report they write is going to recommend the stock and they also rarely do work on firms they don't represent. They aren't being paid to find research on other firms, so they just see it as wasting their time.

PE: This is partly the fault of stupid fund managers. We used to pay 1.25% commission when we bought or sold shares via the brokers. But since the Big Bang', we've driven those rates down to levels where the brokers can't afford to exist on commission alone, so now they have to earn money by charging their corporate clients retainers too. We prevented ourselves from getting the good advice we used to get by driving rates down. We'd be much better off paying more and getting better advice.

ARM: On a more general note, given that small caps tend to be more geared to the domestic economy than, say, FTSE 100 companies, should we be expecting underperformance from here?

PE: There are a lot of exceptions but yes, small caps tend to be exposed to the UK.

DH: On the plus side, there is so much diversity that you can be choosey. Many of the firms housebuilders and retailers, for example that did so well during the consumer boom and might do less well now, have moved into the mid-cap index, so you can avoid those too.

GH: It's true that the joy of small companies is that you can find decent businesses that will do spectacularly well regardless of economics, but the economy does have a major effect nonetheless. If I had looked at my portfolio a year ago, it was probably made up of 80% successes and 20% failures. Now, it isn't 20/80, but there are far too many failures in there. That's not so much company specific, it's to do with what's happening in the wider world.

PE: I spent £45,000 in the last election taking out ads saying that the Chancellor is reckless and the economy's going down the plughole. I think I've been vindicated day by day. I mean the whole economy is foundering on an enormous mountain of debt. There's a very large budget deficit, which whatever the Chancellor says about his Golden Rule is only supposed to happen in recessionary times. So God help us when the economy slows up now. There's also a record amount of personal debt. Then there is the fact that house prices aren't rising enough for people to feel good about and there is a huge pension problem. People just don't know how to cope.

GH: The pension problem has been mostly caused by Mr Brown.

PE: And taxes are going to have to go up to pay for the public sector's pensions. So individuals are going to have less, even though they need to save more. Whatever happens, there's going to be much less money to spend. I'm expecting retailers, housing and banks all to continue suffering.

DH: The Dutch market is a useful lesson in how housing affects consumption. Three or four years ago it stopped rising. It didn't drop off the cliff, it just stabilised. But the result was that consumption went through the floor and stayed like that for three years. That's what will happen here.

GH: I'm afraid I agree with all this.

PE: By the time Gordon Brown gets to be leader, the economy will have gone down the plughole.

DH: It'll be the same for Bush in the US. They have the same problems over there, but even worse than ours.

ARM: So we should keep avoiding retail, housing and banks. What should we buy?

DH: We still like the aerospace and defence sector. There is good earnings visibility and there are some very high-quality companies in the UK that are trading on huge discounts to their global peers. Petrodollars are important there. A lot of money is coming from the countries that have oil and they typically spend their money on airlines and defence.

ARM: What else?

TB: Security is an interesting area. There is Datong Electronics, which does airport baggage systems checking to see if there are explosives in suitcases.Then there is Eruma, which does shutters made of aluminium with a steel rod down the middle. If there's an explosion outside, they instantly create a sort of steel shutter across the window. They're a classic security play.

DH: I think gold is potentially a big thing. At the moment, the market is still viewing it as a commodity, but if at some point you get competitive devaluation between central banks and people start seeing gold as real money, then it becomes a very interesting proposition. I've got gold shares.

GH: Which ones do you like best?

DH: I've got Peter Hambro, which has done well.

TB: I'm also looking at technology. I feel there are some technology companies that are survivors. They faced the 2000 crash and are now beginning to demonstrate that they've got a business model that works.

PE: The great thing about the tech stocks is that they can only fall 100%, but they can go up tenfold or a hundredfold, so the risk/reward relationship if you look at them intelligently is absolutely fabulous. Still, a significant proportion will go down 100%. I'm absolutely stuffed with technology at the moment it makes up 30% of the portfolio. The uplift's absolutely enormous if you get the right ones. I'm also invested in firms that have got vaccines for the MRSA superbug, such as Neutec Pharma, which has gone through all its trials and is now going through the regulatory process. If you are looking at a cancer cure, you might come up with something, but whether it's better or worse than somebody else's cure can take five or ten years to work out. It takes two weeks with the superbug. Two injections in week one, two injections in week two. If the patient's up and running around after that, while the one who got the placebo isn't, you can reckon it works.

ARM: It seems that one of the themes here is that you've got to own a lot of shares if you are a small-cap investor?

PE: You must have an enormous spread. You must work on the basis that quite a lot of them could go bust. That's why I have got 180 stocks in my portfolio and I would never have more than 2% of the portfolio in one stock.

GH: I completely agree with that. It's exactly what I would do. I have 200 stocks and never have more than 2% in any one stock.

ARM: That's tough for a small investor to replicate. Should MoneyWeek readers just buy funds?

GH: That depends on how sophisticated they are and how much time they have. If you're going to buy individual stocks, you've got to put a lot of effort into it and diversify. Unless you're going to be very active, you should probably have funds.

PE: Or if you think you're going to die. You pay inheritance tax on a fund, but after two years you don't pay it on individual shares.

DH: The other thing to note is that you tend to see more consistent out-performance by good fund managers in the small-cap space than elsewhere. It's much harder to outperform with a large-cap fund because the market is so much more efficient, so if you are paying up for an active manager, you are better off doing so in small caps assuming you go for a manager with a good track record.

PE: We've just talked about the tax advantages of being in individual Aim stocks, but unit trusts also come with tax breaks the capital gains exemption is nearly £9,000 this year. So funds come with tax advantages too.

ARM: Let's talk about your favourite shares now.

DH: Okay, I'll give you a good one. XKO Group is a software firm that does deals to supply software to the utility sector to help them with their billing. I think that's very under-developed.

GH: I'm going to tip a resource stock, which I own and which has done hugely well for me. It has more than doubled, but I think it could go up another 20 times. It is now capitalised at £30m, but I think it could go to £600m. It is called Egdon Resources and is an onshore oil-exploration outfit that is going to do gas storage too they should have planning permission for this within a year. And something just happened that I have never seen before. The company secretary, a non executive, bought £140,000 worth of shares personally.

PE: I choose Clearspeed Technologies, which has developed a chip ten times more powerful than any other, but which uses 95% less power. There could be a phenomenal market for this and they're already getting the first commercial order in.

DH: I've got one to short D1 Oils, the biofuels company. Money doesn't grow on trees, nor does oil in my opinion.

PE: That one's already tripled since I told everyone it was complete rubbish.

TB: My buy would be ServicePower. It's an industry called field service scheduling, which means that if you've got a hundred men out there in white vans and you want to make sure that they do seven appointments in a day instead of six, you have software that automatically programs their daily schedule and adjusts everyone's schedule if somebody rings up. ServicePower are not the only company to develop this, but they've gone a step further than most to become an outsourcing company they actually schedule the jobs for companies such as GE in America, and you don't get much bigger than that. Next something to sell. I think the cracks are beginning to show in the oil exploration sector. I wouldn't discount the possibility of the oil price being down to about $40 next spring and the boom really fizzling out.

Our panel

Daniel Hanbury, Manager of Investec UK Small Companies fund

Giles Hargreave, Chief executive of Hargreave Hale and manager of Malborough Special Situations fund

Patrick Evershed, Manager of New Star Select Opportunities fund

Tom Bulford, Editor of Red Hot Penny Shares