A guide to investing in small caps

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Written by:
28/05/2015
The term 'small cap' refers to stocks with relatively small market capitalisations.

However, defining ‘small’ is somewhat problematic; while some fund managers consider any company valued at under £1bn a small cap, others may consider that total too high – or, indeed, too low.

For the purposes of this guide, small caps are defined as any company listed on the FTSE SmallCap Index, FTSE Fledgling Index and the Alternative Investment Market (AIM).

Rewards

A significant number of small caps pay reasonable dividends – and in many cases, these dividends are rising. AIM-listed Sabien Technology (tipped by YourMoney.com in March) is just one example.

Furthermore, some small caps can be attractive reward prospects due to low valuations (when compared with the valuations of many blue chips and large chips), theoretically allowing investors to make sizeable profits if and when they grow.

“The small cap market is where up and coming, fast growth companies that have the potential to become tomorrow’s giants are to be found,” says Jason Hollands, managing director of Tilney Bestinvest.

Another positive is the notable acceleration in small cap IPOs recently.

“More than 100 new companies have come to market in the past year, expanding the universe of opportunities for funds to invest in,” Hollands says.

Gervais Williams, a fund manager at Miton Group, is positive about the asset class.

“As the small cap market isn’t crowded, there isn’t presently a backlog of investors trying to get in – and there won’t be a large exodus for the foreseeable future,” he says.

“Further to this, research has demonstrated that across most regions, smaller companies have delivered a return premium over the long term compared to the broader markets.”

Finally, in August 2013, changes to ISA rules meant that investors were able to add AIM stocks to their shares ISAs. This makes small cap investment potentially tax-efficient; profits made from AIM share price increases are immune from capital gains tax, there is no tax on interest earned on bonds, and there is 10 per cent tax cap on income earned from investments.

Risks

Investing in small caps can mean the constituent risks of large cap investment are magnified.

For instance, as with any income-paying investment, a fall in the company’s fortunes will result in dividends being reduced, or cut entirely, for an indeterminate period; the smaller a company, the more pronounced this risk may be.

Moreover, small cap success is typically predicated on a select number of key contracts, and a comparatively slight – but loyal – customer base. Losing a pivotal contract, or the customer base diminishing, can have severely damaging implications for small caps.

“Analysts also tend to focus more on the largest publicly listed companies, rather than small caps. Significantly less information on small caps is publicly accessible,” says Laith Khalaf of Hargreaves Lansdown.

“This can make a small cap’s true health opaque.

“Furthermore, small cap investment on the basis of value is potentially hazardous, as there is no guarantee that the market will eventually acknowledge a company’s true value.”

This is partially due to small caps having less access to capital compared to large caps; not only does this mean small caps are less able to pursue growth strategies, but a failure to secure financing during an economic downturn could sink a small company.

Williams, however, disagrees that this is necessarily an issue for small caps: “Small caps tend to have low to non-existent debt, due to being frozen out from borrowing – which makes for lesser balance sheet risk.”

Recommendations

Investors who do not want to invest directly in small cap stocks may prefer to access the asset class via funds.

As noted, analysts tend to focus on large, heavily traded publicly listed companies – and smaller companies tend to be under-researched.

“This is where active managers reveal their worth, as they have the resources to research and identify hidden gems,” says Hollands, who recommends Fidelity UK Smaller Companies.

This fund recently reopened its doors to new investors, having ‘soft closed’ in 2013 to limit size and protect flexibility.

“The window of opportunity to invest may be short lived; I expect it to soft close again in due course,” Hollands says.

Khalaf recommends the £116m AXA Framlington UK Smaller Companies fund. “I particularly like this fund as it is not yet on the radar of most advisers,” he says.

“If you’re interested in the smallest of small caps, I like the Marlborough UK Micro Cap Growth, which invests in companies with a market capitalisation of less than £150m.”

For income-seekers, there are several relevant small cap funds, such as the Unicorn UK Income fund.

“The fund focuses on companies which have low debt levels and strong free cash flow to support dividend growth, and offer a high return on invested capital. The fund is currently yielding 4 per cent,” says Khalaf.

However, investors do not need to select a dedicated fund for investing in small caps. Multi-cap funds invest across the cap spectrum.

Hollands recommends the Liontrust Special Situations fund. Currently, its portfolio is 38 per cent comprised of smaller companies, 30 per cent mid-caps, and 32 per cent larger companies.

“Despite the high small cap weighting, the fund has been less volatile than the FTSE All Share Index. Much like the Liontrust UK Smaller Companies fund, this fund focuses on companies with strong intellectual capital, distribution channels and brands,” says Hollands.

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