Why I'm backing small-cap companies

Interest in small-cap companies is currently low - perhaps unsurprising given Britain's poor economic outlook. But professional investor Ed Beal thinks that to overlook smaller companies' investment potential is to miss a trick. Here he explains why, and tips three firms he thinks have what it takes to deliver despite the challenging economic headwinds.

Each week, a professional investor tells MoneyWeek where they'd put their money now. This week: Ed Beal, manager, Dunedin Smaller Companies Investment Trust PLC, Aberdeen Asset Management.

Many investors regard smaller firms as a proxy for the performance of the British economy. Given the poor outlook for Britain, it is perhaps unsurprising that interest in smaller companies is currently low. However, investors may be overlooking three important points.

Firstly, small firms derive a larger portion of their revenues from overseas than has historically been the case. We estimate that nearly half of our portfolio's revenues come from overseas.

Secondly, they bring an important element of diversification to investors who value dividends. Compared with large firms, the yields paid by smaller businesses are both less company-specific and less focused on particular sectors.

Lastly, it should be remembered that there is a low degree of correlation between economic growth and equity-market returns. Therefore, although Britain's GDP growth may be muted for some time, that need not necessarily mean equities will perform poorly. Three companies that we believe have the potential to deliver in the current challenging conditions are Chemring Group, Keller and McBride.

Chemring (LSE: CHG) supplies munitions to the armed forces. While the outlook for defence spending is difficult, it is important to recognise that not all areas will be adversely affected. Chemring's products are relatively low cost and are used in training as well as in battle. Being degradable, they must be replaced even if they aren't used and, as many of these items are designed to save soldiers' lives, politicians are less likely to cut budgets in this area. Finally, an increasing proportion of Chemring's sales go to markets other than Britain and America, and where there is less pressure on military spending.

The company is trading on an earnings multiple of ten and has a history of delivering dividend growth. The dividend was recently increased by almost 17%.

Keller (LSE: KLR) is a global leader in the provision of ground engineering and foundation works. The business is truly international, with operations ranging from Australia to America, Poland and India. The company's technological and engineering expertise means that it can command a margin which is a multiple of the margin typically associated with a construction company. Some parts of its business have been hit hard by the recession, most notably its American operations. Yet this is where the biggest opportunity lies. It has a sensible balance sheet and its eastern European and Asian businesses are performing well. The business is trading on a multiple of nine and yields 3.8%.

My final suggestion is McBride (LSE: MCB), a manufacturer of own-label household and personal goods, which it supplies to supermarkets across Europe. It has a dominant position in Britain and is also growing in less commoditised, higher margin areas. The business is susceptible to the impact of raw-material cost inflation in the short term. However, it has a demonstrable track record of recovering cost increases. Consumers are increasingly recognising McBride's quality and value for money. Meanwhile, the supermarkets want to see the firm prosper as this serves to reduce the influence of the branded fast-moving consumer goods operators. McBride trades on a 9.4 multiple and offers a 4.8% yield.

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