How to find big profits in small companies

For many people, the term "small-caps" conjures up images of dodgy penny shares hawked over the phone by people in boiler rooms. In truth, depending on the precise definition you use, the small-cap universe can include stocks with market capitalisations of up to £1bn, while even so-called "micro-caps" can be as large as £250m. The sector includes some of the most dynamic and fast-growing companies in the UK and around the world. If you're prepared to do some basic research and be patient, they can prove very lucrative.

Hidden gems

There are two main reasons that it makes sense to eye up smaller companies. Firstly, unlike their larger counterparts, they are generally ignored by most financial professionals, with many fund managers barred outright from investing in them. As a result there are also fewer investment analysts researching them, says Eustace Santa Barbara, who co-manages the Marlborough Special Situations fund with Giles Hargreave. That creates "more opportunities for investment teams... to uncover hidden gems with growth potential that hasn't yet been priced in by the wider market". Smaller companies also have much more scope for growth. Sales and profits can rocket off a low base, while it is extremely hard for a blue chip's figures to rise by a similar percentage.

The universal size effect

Given these factors, it should come as no surprise that small shares have historically outperformed their larger counterparts. According to research by Elroy Dimson, Peter Marsh and Mike Staunton of the London Business School, £1 invested in large-cap UK stocks in 1955 would have been worth £1,225 by the start of last year. The same amount invested in small- caps would have soared to £8,200. And had you opted for micro-caps (as defined by the smallest 1% of listed companies) you would now be sitting on a portfolio worth £33,011.

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The UK isn't the only market to experience this size effect. Micro-caps have outperformed both large caps and even smaller companies in the United States, with annual returns of 12.7% over the last 92 years, compared with 9.9% for the largest companies. While this is a more modest gap than in the UK, this still means that $1 invested at the start of 1926 would have grown to $60,276 if you had put it into the smallest companies, compared with only $5,767 for blue chips. Overall, Dimson, Marsh and Staunton found that the smallest firms had the highest returns in virtually every major stockmarket around the world (the one exception being Norway).

Of course, long-term averages only reveal part of the picture. The flipside of high reward is high risk; many small companies go down in flames. Even if they don't, they will be more volatile than their large-cap counterparts since they are small enough for even minor purchases or sales to shift the price significantly, while they are also less liquid. In addition "transaction costs are higher and small-cap portfolios are costly to manage", as the London Business School's Paul Marsh points out. This can be a major drag on returns if you buy and sell them frequently. Still, these negatives have the advantage of keeping prices low, thus keeping a lid on valuations and implying robust long-term returns. There is "good reason" to expect them to "continue generating larger returns over the long run". Indeed, the FTSE SmallCap index has beaten the wider market over the last three, five and ten years.

How to spot winning smaller companies

One big micro-cap enthusiast is Gervais Williams, author of The Future Is Small: Why Aim Will Be the World's Best Market Beyond the Credit Boom; he is also managing director of Milton Group. Given the risks involved with small- and micro-cap shares, investors should insist on a strong balance sheet before even thinking about investing. Williams also likes the companies to have "good management and staff". The quality of management is crucial to smaller companies because their management "tends to be closer to the coalface than in larger companies".

Williams also likes firms that can productively reinvest a large portion of their profits. His ideal firm "is one with a high rate of reinvestment, as well as evidence that the money is having an impact on the bottom line". A good rule of thumb is that any reinvestment should start producing cash within three years, so investors should be sceptical of projects that will take a decade, especially since anything can happen over that timeframe. Annual reports and investor presentations should make the timescale of any projects clear.

Dominating a niche

Investors should also seek out market leaders in a particular niche. In contrast to the perception of small firms as powerless minnows, "a surprising number are leaders in their specific area, it's just that these areas tend to be relatively small," says Williams. One of the big benefits of having a niche where there are few if any competitors is that their customers will have limited alternatives. So not only can they maintain high margins, but they can also pass higher costs on to their customers, notes Santa Barbara.

One micro-cap that met these criteria, and has proved to be a great investment for Marlborough Special Situations, has been Somero Enterprises, which makes equipment used in the construction industry. Santa Barbara started buying into the company in 2012 based on the "dominant market position", high returns on capital employed and "excellent" cash generation. Since 2012 Somero has maintained its leading position, grown sales in its core market of North America, and expanded globally. This has propelled its share price from 11p to more than £3 a near-30-fold rise.

Diversify widely to temper volatility

The higher volatility of small- and micro-caps also means that it makes sense to diversify your portfolio more widely than when dealing with the shares of larger companies, though this strategy won't necessarily eliminate all the excess risk. Hargreave and Santa Barbara usually start by taking a small stake in a company that they think looks promising before gradually increasing their holdings, while Williams thinks micro-caps should be combined with other, less risky investments. However, it's important to note that spreading your investments between shares in too many different companies can lead to increased trading fees and create a portfolio that is too large to monitor effectively.

Companies you should avoid

While diversification can help make small- and micro- caps less of a rollercoaster ride, avoiding some of the obvious traps is also key. One type of company you should steer clear of are firms that are likely to need to raise additional cash, either through borrowing more money or issuing additional shares. It can be very dangerous for a company to have to sell more shares before it breaks even. It is in danger of going broke if market sentiment shifts so much that issuing more equity becomes impossible.

Given that the quality of management will determine success or failure, it's particularly important that directors' interests are aligned with those of shareholders. The most obvious way they can do this is by owning shares in the company themselves. This means that a management team who are reluctant to hold shares in the company they run is a particularly negative sign, especially since it also implies that they lack confidence in their firm's future. Treat companies where management aren't shareholders themselves with extreme caution.

Another thing to watch out for when it comes to small- and micro-caps is sudden price falls. Santa Barbara thinks these are more of a warning sign than when they happen to larger companies. "While it can be tempting when a stock suddenly becomes a lot cheaper, often there's a very good reason for the share price going south, which means there's further to go." Only buying shares that are increasing in price is arguably closer to trading than investing, but they suggest that you should "look very carefully" before investing in companies that have seen the value of their shares plunge.

Aim now looks less hit-and-miss...

While there are plenty of small-caps on the main market of the London Stock Exchange, Aim is seen as the home of micro- caps. Aim was set up in 1995 to make it easier for smaller companies to raise money on the stockmarket. However, despite some spectacular successes, such as Asos, admitted to Aim in 2001, the market as a whole has failed to live up to the hype. Indeed, £1,000 invested in Aim when it was set up would have failed even to keep pace with inflation, compared with the fourfold real return from investing in the FTSE All-Share Index.

Nevertheless, there are signs the market may finally be starting to take off, with Aim outperforming the FTSE over the past three years. Those who have been investing with Aim for a long time also point out there has been a big improvement in the quality and range of Aim companies. For example, at the turn of the century a lot of companies were dotcoms, while the exchange proved a magnet for resource companies between 2003 and 2008. In contrast, there are now companies from a wide range of industries on offer.

... and its companies' profitability is improving

Another positive sign is the increase in profitability of Aim companies. In the past it was awash with red ink. There were many young companies "with limited financial histories that were not yet making much, if any, profit or paying dividends," says Santa Barbara. As late as 2008, only slightly more than a third of Aim companies paid dividends and only slightly more than a half made a profit. However, last year firms comprising more than 60% of Aim, by value, were paying a dividend and 75% making a profit.

Aim companies also seem to have a more global focus. In the 1990s, a lot of Aim companies "had most of their sales in the UK", say Richard Power and Paul Latham of Octopus Investments. Today, those companies "have started to expand internationally, and have been joined by others that already have a global strategy as part of their business plan". However, despite this maturity, there are still plenty of opportunities for more adventurous investors, as it "continues to see a healthy flow of much smaller, earlier-stage companies, which in turn will provide the stars of the next decade".

A tax-efficient market

Changes to tax rules have played an "important role" in Aim's resurgence. Under current rules, most Aim shares benefit from business relief, which means that they are exempt from inheritance tax if you hold them for two or more years. What's more, six years ago the government allowed investors to hold them within an Isa (individual savings account) and also abolished stamp duty on them. This means that you combine the benefits that come with putting shares in an Isa (such as no capital gains tax and no tax on dividends) with the other advantages.

Of course, it's never a good idea to invest in a company solely for tax reasons. However, it's something those thinking about handingover their investments to their children or grandchildren should bear in mind. The only catchis that some types of stock (such as property companies) are excluded from IHT (inheritance tax) benefits. As a result, this may be one of the few occasions where it might be worth paying extra fees for a specialist adviser or wealth manager who knows which shares offertax advantages.

The most promising small-cap plays

Somero Enterprises (Aim: SOM), which provides concrete-levelling equipment to building companies, allowing high-quality concrete floors to be installed faster, flatter and with fewer workers, has been a very successful investment for Malborough Special Situations. Hargreave and Santa Barbara remain bullish thanks to the group's patents and "commitment to innovation".

They also like the fact that, while the core market remains North America, "it's steadily grown sales elsewhere". Despite more than doubling sales over the last five years, the company trades at just 10.5 times 2020 earnings.

Another smaller company worth investigating is Caretech Holdings (Aim: CTH). This provides specialist social-care services, supporting adults and children with a wide range of complex needs. Caretech was recently given the go-ahead by the Competition and Markets Authority to take over specialist residential schools operator Cambian. The company is now hoping to improve Cambian's services and reduce staff turnover. With Caretech trading at a 2020 price/earnings ratio of only eight times 2020 earnings, Santa Barbara thinks thatthe shares "are attractively priced and the stock offersa pretty compelling risk/reward proposition".

Renew Holdings (Aim: RENEW) is a contractor providing essential engineering services to maintain andrenewcritical infrastructure networks, notably those related to energy, transport and the environment. Sales have doubled over the past five years and are expected to keep on growing thanks to growing awareness that the UK needs to invest more in capital projects. At present the group earns a return on capital invested of 14%. Although it has a relatively high level of debt, it generates more than enough cash to meet its interest payments, even if rates rise, and trades at only 9.5 times 2020 earnings as well as yielding 3%.

For those who prefer to spread risk through a fund, one with a very successful track record is Liontrust UK Smaller Companies, run by Anthony Cross and Julian Frost. Despite a relatively high ongoing charge of 1.65% a year, it has returned a total of 1,051% since it began in 1995, compared with 233% for the FTSE Small Cap Index, and has outperformed the index over the last one, three and five years. While it includes some mid-caps, nearly three-quarters of the fund is invested in Aim-listed shares. Those interested in even smaller companies should also consider the Liontrust UK Microcap Fund, run by Cross and Frosh, with Matthew Tonge and Victoria Stevens. This fund has an ongoing charge of 1.41%.

Another successful fund focused on smaller companies is Marlborough Special Situations, run by Giles Hargreave and Eustace Santa Barbara. This fund focuses on smaller companies with high growth potential; 75% have a market cap under £1bn,and 17% under £250m.Over the past ten years it has returned a total of 449%, compared with 336% for the FTSE SmallCap Index, and it has beaten the index over the last three and five years. The largest holdings are Burford Capital and Fevertree Drinks. Its ongoing charge is 1.54%.

A lower cost way to invest in small companies is through the iShares MSCIUK Small CapUCITSETF (LSE: CUKS). This exchange-traded fund (ETF) tracks the MSCI UK Smaller Companies Index, which is roughly divided between smaller mid-caps and genuine small caps.

The ETF has a total expense ratio of 0.58%, which is relatively high for an ETF, but much cheaper than most actively managed small-cap funds. A more globally focused counterpart is the iShares MSCI World Small Cap UCITS ETF (LSE: WSML), which tracks the MSCI World Small Cap Index. This ETF has an ongoing charge of 0.35%.