Why small caps look set to rocket this year

The market's action in the opening weeks of January is a good guide to how the entire year will unfold.Fund managers for instance, will have spent December polishing their economic forecasts and setting out their strategy for the next 12 months. As soon as January arrives, they race to place their bets and the annual contest for bonuses is under way again.

The message this year is that they expect small companies to continue to outperform. While the 0.1% fall in the FTSE 100 share index in 2011 so far suggests an equivocal attitude to equity markets in general, the FT Small Cap and AIM indices are up 1.5% and 2.3% respectively.

Clearly, this is whereinvestors see value and the opportunity for real corporate growth, and I would be the last to disagree.

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The electric recovery of the AIM index

Down in Fleet Street, headline writers are preparing to herald the return of the AIM market index to 1,000. Having risen from the depths of 389 in February 2009 to todays 955 it just needs to keep going for a little longer to breach the four-figure mark.

For seasoned AIM watchers this will bring a sense of dj vu. 1,000 was the starting level for the AIM index when it opened in 1995. One glorious splurge took the index to the giddy heights of 2,745 in the dotcom boom - before the inevitable reaction reduced it to 540 in March 2003.

Other small-cap news

• Mobile Streams (MOS) shares gain 10% on revenue hike
• Shares in Mobile Streams (MOS) gain 10% after it reports a 40% increase in revenues in 2010
• Mobile Stream retails Apps, Games, eBooks, music and videos through mobile carrier partners and its Appitalism.com App store
• Chief executive Simon Buckingham is looking for "significant growth over the coming years"

A steady recovery took the index to over 1,200 in 2007 before the financial crisis brought it down once again. This time, if the index goes into positive territory once more, can it stay there?

Well, a rising index acts like a flame to the moths, and in this latest cycle the willingness of investors to back exploration companies has brought plenty of company promoters out of the woodwork. Today, about one quarter of AIM listed companies are involved in the oil and mining sectors, but they account for about half of daily share trading. Private investor participation in the mining sector is undoubtedly keen, and this sounds a warning bell.

But the AIM index looks less vulnerable now than it has after previous bull phases. Small companies are only just beginning to come back into fashion. The number of new AIM issues, even in the natural resource sector, is still a trickle rather than a flood. While confidence is returning, there is no sense yet that expectations have spiralled out of control.

With Chinese demand the main driver of commodity prices, there is no doubt that if China sneezes many small company investors will catch a cold. And yet profit forecasts for most mining and oil companies are based on product prices that are below today's levels, and enthusiasm for these stocks looks far more soundly based than the dotcom mania.

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Who will be the share heroes of 2011?

So it is no surprise to see natural resource shares amongst the early movers in 2010.Roxi Petroleum(LON:RXP), Beowulf Mining (LON:BEM), Amur Minerals (LON:AMC), Tertiary Minerals (LON:TYM), Namibian Resources (LON:NBR) and Atlantic Coal (LON:ATC) have already made strong gains.

Bio-energy play Viridas (LON:VIR) is amongst the leaders as is Third Quad Capital(LON:TQC), which has announced a possible sale of its software business. Distressed lender Davenham Group (LON:DAV) has seen its shares bounce on the back of a possible financial reconstruction while Crosby Asset Management (LON:CSB) is changing its spots to become an investor in natural resources.

Finally and intriguingly barging its way into the leading group is @UKLtd (LON:ATUK), whose software enables public sector bodies to both save money and prove their green credentials.

As ever, there are some unfamiliar names here. By the end of the year they could be on the lips of every investor. Or else, like frontrunners in the Grand National, they may fail to last the course.

But one thing is for certain - 2011 will bring a fresh crop ofpenny share heroes. And I'm not wasting any time placing my bets on who they'll be.

Most readers of my Red Hot Penny Shares will have been heavily invested in the oil and mining boom for some time. And I've also been recommending some stellar penny stocks for the year ahead.

These are companies that I think are poised to benefit from radical developments this year in metals, internet security and biotechnology. I personally see huge potential for penny shares at the forefront of these developments.

Red Hot Penny Shares is a regulated product issued by MoneyWeek Ltd. Past performance and forecasts are not a reliable indicator of future results. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Penny shares can be volatile, relatively illiquid and hard to trade. There can be a large bid/offer spread so if you need to sell soon after you've bought, you might get less back than you paid. This can make them riskier than other investments. Please seek advice if necessary. 0207 633 3780.

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.