You should be investing in small companies – here’s how to do it

Every stock-picker dreams of finding the elusive multi-bagger'. A retirement stock. The one great pick that makes your fortune.

Take one of the classic multi-baggers of recent years online retailer Asos. If you'd invested £1,000 when the company listed in 2001, your stake would now be worth £78,000.

Of course, sensible investing isn't about getting rich quick.' For every Asos, there are hundreds of duds. If you stuff your portfolio full of lottery ticket plays, you're more likely to end up in the poorhouse than the penthouse.

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But don't let that put you off the sector. Research shows that if you take the right approach investing in small caps can give your portfolio a real boost.

And with new tax rules making investing in Aim stocks far more appealing, there's never been a better time to go hunting

The government does us a favour for once

The government recently made changes to the tax rules, with the aim of making investing in smaller stocks far more attractive to individual investors.

The changes apply to the Alternative Investment Market, or Aim. This is largely made up of small companies, many of which aren't yet established enough to pass the more stringent listing criteria for the main market.

You can now put Aim stocks in your individual savings account (Isa). That means you won't have to pay capital gains tax on any profits you make. You won't have to pay income tax on dividend payouts either.

On top of that, most Aim shares are exempt from inheritance tax as long as the owner has held the shares for at least two years prior to death. (Do be aware that this exemption doesn't apply to property or investment companies, and it's not always easy to tell which are exempt so if your tax-planning strategy relies heavily on this, get professional advice.)

And from next April, you won't to have pay stamp duty if you buy an Aim share.

In short, these exemptions mean that you won't have to pay any tax on most Aim shares whether you're dead or alive.

So great tax breaks. But a tax break is pretty worthless if the underlying investment doesn't deliver any returns to pay tax on. The good news is that plenty of research shows that small stocks in the past at least have more than earned their place in portfolios.

Two academics at the London Business School Professors Paul Marsh and Elroy Dimson - have looked at the performance of smaller companies. Their research shows that, judged by total returns (so including dividends) the Numis Smaller Companies index has beaten the FTSE All-share index by 3.2% a year since 1955. That's a massive out-performance.

In fairness, the Numis index includes many shares that are listed on London's main market' Aim was only created in the 1990s but the point is, the figures show that small cap investing can deliver great returns.

How you can beat the City in the small cap sector

So why do these shares often outperform? It's partly because it's easier for small companies to grow at a rapid rate. If a large company is a dominant player in a particular market, it's hard for it to generate sales growth of, say, 50% a year for ten years. That's pure common sense it's always going to be easier to grow sales from £50,000 a year to £100,000, than from £500m to £1bn.

But this is also one of those markets where the canny private investor can beat the City. It's much easier to spot unloved stocks that are priced far too cheaply. In the jargon, the small cap market isn't efficient'.

Large companies tend to be followed by a large number of analysts and fund managers at any one time. So a large company's share price while far from being priced perfectly - is likely to represent a fair reflection of the company's prospects at any one time.

But with smaller companies, there are often very few followers, so the market can be inefficient. In the past, I've certainly seen small companies issue news releases that are dramatic breakthroughs for the companies concerned, but the share price barely moves. That's a sign of an inefficient market.

What's more, smaller companies are often family concerns, or the management team may have substantial stakes in the company. If the directors own plenty of shares, they're incentivised to do a good job.

Also, sheer scale can be a problem for institutional investors. Even if a fund manager spots a great opportunity, it's often impossible to put enough money into it for it to make significant difference to their portfolio. Warren Buffett has complained of this problem in the past.

All this means there can be exciting opportunities for savvy investors who keep a close eye on the small-cap world.

Of course, there are downsides too. Smaller companies are more likely to go bust. The share prices can be very volatile, which means they can give you more sleepless nights. And you have to watch liquidity there can be a big gap between the price you buy at and the price you can sell at (the spread'). But overall, the potential returns are worth the added risks.

How to invest in small cap stocks

If you don't fancy hunting for small cap bargains yourself, you could always invest in a fund that focuses on the bottom part of the market. I particularly like the Fidelity UK Smaller Companies Fund, which has beaten pretty much all its peers. Another option is The Throgmorton Trust (LSE: THRG), an investment trust with a solid long-term track record.

Just be aware that while you can put either fund into an Isa, you won't benefit from the exemption for inheritance tax. My colleague David C Stevenson wrote in more detail about his favourite ways to invest in UK small caps in MoneyWeek magazine a few weeks ago.

As for individual stocks, my colleague Phil Oakley tipped a couple of small alcohol-related stocks last month, one of which has already performed very well. If you're not already a subscriber, you can subscribe to MoneyWeek magazine.

And if you want to keep a closer eye on what's happening in the small cap sector, you should sign up for my colleague David Thornton's free email, Penny Sleuth. David spends his time looking for exciting opportunities in the small cap or penny share' market.