Four small caps that will stay small – and that’s a good thing

Anna Croze tips four quality small companies.

The benefits of economies of scale are often overstated and under-analysed, especially when it comes to companies.Size doesn't always correlate to economic gain bigger isn't necessarily better. Sure, some successful small companies are small simply because they are still relatively young, and haven't yet grown big.

But others make a virtue of being small, with clients and staff drawn to them precisely because of their size. And there are other small companies that probably won't grow much in the long run, but still have the ability to generate fantastic returns for shareholders. Below, I've taken a look at four prime examples of these sorts of quality small companies.

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Small companies, big ideas

Large companies have complicated supply chains, and use products and services from several other organisations, both large and small. Often the 'game changer' that can differentiate these big players from their rivals in a specific area of their business comes from a small company's big idea. Take dotdigital (Aim: DOTD). This £100m market capitalisation firm was founded in 1999, and is now the UK's largest provider of email marketing. It's also a leader in providing intuitive 'Software as a Service (SaaS)' technology (software that companies effectively rent rather than buy outright, in exchange for ongoing assistance and updates) and tools for digital marketing professionals.

Dotdigital helps its clients to grow their online businesses and has been particularly effective at innovating and constantly developing and improving its service. But its main strength is that it provides a core expertise that its customers don't have in this case, email marketing. A typical client will start off trying to do their own email marketing. But it eventually becomes unmanageable and unwieldy. Sensible companies realise that when things get technical or tricky in an area that's outside of their core sphere of interest, it's better to buy it in.

By doing the job better than the clientcan do it themselves, dotdigital creates value for both itself and its customers.A company's ability to profit from mutually beneficial relationships like this are a sweet spot for anyone seeking sustainable profits. It means that a small company like dotdigital can generate repeat revenues from big clients that the market can't easily compete away (its blue-chip client base includes Old Mutual, Santander, Barclays Capital, Danone and Fidelity Investments). This helps maintain solid profit margins, at least initially.

Here's an example. Cinema chainOdeon wanted to target its customers more effectively, but this was provingboth difficult and time-consuming.So Odeon outsourced its email marketing to dotdigital. As a result, membership of Odeon's loyalty club grew by more than 20%, and 19,000 extra bookings were generated from customers who had signed up. Better still were the huge efficiency gains. It used to take Odeon four days to run profiles and import the relevant data to its existing email platform, using an external agency. Now this process is automated and it takes just six minutes to build a list. The above campaign targeted 200,000 guests, cost £3,000 and generated more than £13,000 of ticket sales.

In terms of performance, dotdigital doesn't have many direct peers to compare to, but set against the general market it stacks up well it's profitable, generates a good amount of cash flow, is reasonably valued and even pays a small dividend.It will always need to invest to stay at the cutting edge of technology, but I see good potential to grow further geographically and across different market segments.

Stifled by the corporate machine

Sometimes being small can help companies attract staff and clientsfrom larger rivals, where creativity can feel stifled by the corporate machine.For example, £242m market cap advertising agency network M&C Saatchi (Aim: SAA) is growing both by buying other companies and through rolling out its own model to new markets and specialists. It is still a minnow compared to the 'big four' of WPP, Publicis, Omnicom and Dentsu, but this gives it two big advantages.

On the recruitment and expansion side, employees at big agencies are sometimes drawn to the idea of joining a smaller network and having more autonomy, which better suits their creative and entrepreneurial spirit, while still having the clout and expert services of a well-respected, established agency like M&C Saatchi behind them. For example, the firm has increased its reach in emerging markets as teams from larger agencies have set up under the M&C Saatchi umbrella. Staff ownership of shares is substantial and new teams coming in retain plenty of equity in the business, which further drives their motivation and commitment.

From the client perspective, small canalso be attractive. The big theme of agencies is the provision of the full gamut of services advertising, media buying, design, etc. In very large agencies, different teams tend to work on each of these aspects, but they may not be well integrated. M&C Saatchi has the necessary scale to offer a full service, but is also compact enough to offer a service where each of the disciplines work well together. This has helped to attract some big clients, with a top-ten list of Boots, Celcom (a Malaysian telco), Commonwealth Bank, Ferrero, Ikea, Jaguar Land Rover, O2, Optus, Pernod Ricard and RBS.

These top ten provide 31% of revenue between them, which does leave the company vulnerable to any large client losses, but I think that risk is outweighed by the potential for further improvement in profit margins as a driver for earnings growth. The shares yield more than 2%, and growth in the UK economy bodes well for the group, with nearly half of its revenues coming from the domestic market. A further 30% comes from emerging markets, which are currently suffering, but the long-term potential in these markets remains.

Dominating your niche

Keywords (Aim: KWS) is a 'game localisation' company. What does that mean? It provides a niche service that helps to ensure that video games can be successfully launched outside of the territory where they were first designed. This includes things like translating text and audio, or amending characters, brands and locations so that they are culturally appropriate for their export markets. The more complicated games become, the more expensive they are to develop (the global games industry is now significantly larger than the film business in terms of revenues), and the more important it is to outsource localisation services to ensure the launches go smoothly.

That's good news for Keywords, which listed inlate 2013 and now has a market cap of £74m. This remains a very fragmented market its market share is only 5% yet every one of the ten largest video-game publishers use Keywords' services. The company aims to grow via bolt-on acquisitions, which will broaden its geographic footprint and range of services. A typical, earnings-enhancing example is video games art services provider Liquid Development, which Keywords bought a few weeks ago.

Keywords' workforce is passionate about gaming. Staff see the chance to be first to play and test these games as a real benefit, with serious cachet, which means the workforce is young, keen and highly motivated. They're flexible too, which is useful given the "lumpy" nature of game and console launches only 120 staff are permanent and the rest are freelance.

In 2013 total spending on gaming localisation was estimated to be around $600m, two-thirds of which is outsourced, so it's a decent-sized market. Keywords' acquisition strategy seems to be going well, the shares are attractively valued given forecast earnings growth, and when Microsoft slashed its localisation suppliers from 14 to two, Keywords made the final cut. That's some vindication of the company's expertise.

When staying small is good

And for a company that delivers fantastic shareholder returns, but won't grow its current scale too much? A good example is £219m market cap Manx Telecom (Aim: MANX), the original phone operator on the Isle of Man (which was spun out from BT, and passed on via Cellnet, Telefonica and a private equity group before floating). It operates in fixed-line, data, mobile and broadband. It has 100% of the fixed-line market (it owns all copper loop and almost all fibre on the island), 87% of data, 75% in mobile and 81% in broadband.

Manx Telecom generates robust cash flow, and has a dividend yield of 5.6%. There is some growth potential from expanding its data centres among the biggest customers aregambling firms. There are more than 100 listed e-gaming websites on the island, including PokerStars and Full Tilt Poker (the world's two largest online poker sites), as well as Paddy Power, Europe's largest bookmaker.

Otherwise, most of its business is in lower-growth areas, such as fixed line and mobile, which comprise two-thirds of revenues. While there are threats from competition, rivals haven't shown much interest in entering what is a small market for example, no one took up the third 4G licence offered by the government.

This is a well established, conservative company. It has steadily grown profits organically, the barriers to entry to its core business are high, and it has some modest growth opportunities. The Isle ofMan has an attractive economic backdrop and imposes no corporation tax. It's solid and unexciting, but it's also a reasonably valued, cash-generative income stock.

Anna Croze is executive director ofAdam Investment.