How small-cap stocks can supercharge your portfolio

Here's an eye-opening statistic: if you'd put £1 into the UK market in 1955, and reinvested the dividends, then by now it would have turned into £1,000.

That's a nice return.

But if you'd put the same £1 into the smallest 10% of stocks on the London Stock Exchange, you'd have done a lot better than that. Rather than £1,000, you'd have nearly £5,000 today.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

That's a really nice return.

I've pulled that figure from a recent book The Future is Small by successful fund manager Gervais Williams. Williams is a big fan of micro-cap and small-cap stocks. And when you can generate returns like that, who can blame him?

But what's the best way to invest?

How you could have turned £100 into a life-changing sum

If you're looking for small stocks with big potential, one of the main hunting grounds for UK investors is the Alternative Investment Market (Aim).

The legendary success story that every penny share investor wishes they had invested in is online retailer Asos.

When it bottomed out in August 2003, after the internet bubble had burst, you could have bought the shares for 3p a pop. Earlier this year they peaked at more than £75, over 2,000 times higher. Even today, at a much lower price of around £25, they are still more than 800 times higher than their initial price.

Even if you'd put just £100 back when it bottomed in 2003, and had somehow managed to hold on through the thrills and spills of the last 11 years (which is another question altogether), you'd now have roughly £80,000.

A more recent success story is Fitbug, which soared 15-fold in a week and is up five fold since last September (my colleague David Thornton wrote about this one recently).

Overall, in the past year, 52 companies have at least doubled in value. Another 46 have gone up by more than 50%. By contrast, the top performer in the FTSE 250 is up by 86%.

It shows the potential that small companies have for rapid gains. Of course, the flipside is that many, many small companies either plunge in value or go bust. And there are also a few Wolf of Wall Street'-type frauds.

But the reason that Aim can make such a good hunting ground as long as you have your wits about you is that fewer fund managers and analysts cover the sector. So if you are prepared to do your homework, there should be a greater chance of finding a hidden bargain.

Why small investors can get one over on the City pros

It's one of the few areas where private investors can enjoy certain advantages over the City. One problem for the professionals is that small-cap shares tend not to be traded that frequently. This means prices can stay static for days, or even weeks. It also means that there are often big differences between the buying and selling prices (the spread').

The tendency to wide spreads makes Aim a poor choice for short-term trading the share will have to go up by more than the spread before you start making any money. And the relatively small numbers of buyers and sellers means that if you need to dump them all at once, this could hit the company share price.

However, if you are willing to hold for an extended period, the rewards could be substantial. Studies have suggested that, to compensate investors, less liquid shares tend to have higher long-term rewards, irrespective of size.

And as Williams points out, the law of small numbers also works in favour of smaller companies. Many entrepreneurs have created successful firms with just one good idea, or by stealing customers from more established competitors. So they can grow at a fast pace from a low base.

It can be much harder for large, established firms to grow quickly. It may involve culture change, or moving into new business sectors, which is always tricky - particularly if they are fending off upstarts at the same time.

Tax isn't a reason to buy but it is a nice extra

Aim has also become more attractive in terms of taxes.

In this year's budget speech, George Osborne announced that Aim shares would be exempt from stamp duty (currently 0.5%). And investors were last year allowed to put Aim shares in a tax-efficient Individual Savings Account for the first time.

Certain types of Aim share but not investment trusts and property-related companies are also exempt from inheritance tax as long as you hold them for two years or more.

Of course, you should never make an investment just because it looks attractive from a tax perspective. However, it is clearly a nice little bonus.

How to invest in small-cap stocks

Because small-cap stocks are generally riskier, you do need to own a wider spread of companies than you might if you were just buying blue chips. You can invest in a fund or investment trust (there are plenty of small-cap ones out there) but if you'd rather do it yourself, the key is to get a good grasp of analysing companies. You can't just follow tips from the bloke down the pub you need to be able to understand a set of accounts.

It's also a good idea to stay on top of trends. If you're not sure where to start, have a look at our small cap expert David Thornton's latest ideas. He's a former fund manager and small-cap expert, who's the perfect companion to guide you through the most exciting areas in small company investing right now. You can find out which shares he believes have the biggest potential here.