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How far should you go down the market cap scale?

After a sustained run for UK smaller companies, is now the time to look even further down the small-cap scale for under-researched, better-value Aim stocks?

Data from FE Analytics shows that smaller companies continue to power ahead of both the wider market and Aim shares, with the FTSE All Share Small Cap index returning approximately 21.3 per cent over one year compared with 18.6 per cent for the FTSE Aim index and 8.2 per cent for the FTSE All Share.

A combination of the improving economic outlook for the UK and the ongoing hunt for value amid expensive-looking equity markets has boosted the appeal of micro-cap companies for some equity managers in recent months.

Old Mutual Global Investors UK smaller companies manager Dan Nickols has been increasing exposure to what he describes as “smaller small-caps” in the £963.3m Old Mutual UK Smaller Companies fund.

He says: “If we compare where we are now with where we were a year ago there is a greater prevalence of smaller small-caps than there would have been this time last year.”

This end of the small-cap scale should see benefit from investors’ increased appetite for risk, according to Nickols, as well as the recent improvements in the
UK economy.

He adds: “The combination of reasonable economic growth where monetary policy is still loose should be quite positive for risk appetite over the medium term.

“This gives us sufficient confidence to look at big swathes of the market that would have been out of bounds to us because previously you would not have felt sure enough of your ultimate ability to sell names in that space.”

Miton small caps manager Gervais Williams argues that micro-cap companies are capable of delivering growth “irrespective of the economy at large”, something he believes is crucial when growth is becoming increasingly important to investors.

He says: “What we have seen recently is that it is getting really difficult for companies to get turnover growth now and with economic conditions having struggled, growth is becoming really valuable for investors. Of course, this is where smaller companies are going to be in fashion over the next five to 10 years. Smallness has a huge advantage in that some, though not all, of the smallest small companies can grow irrespective of the economy at large.”

Williams reckons that compared to the small cap index and wider market, the Aim index currently offers the best value and the broadest set of opportunities.

He says: “There are over 600 companies quoted on the ISDX and the Aim indices at below £25m market cap. 

“The bottom line is there is plenty left for us to select from within the smallest small companies.

“Yes, the market has recovered, the All-Share index is up and the main small cap index has done well and actually outperformed the main All-Share index. But the Aim market is still full of companies which have not moved enough, and there is great opportunity for us to get involved in businesses that are growing faster than the market overall and are at sub-normal valuations.”

The £17.2m Miton UK Smaller Companies fund, managed by Williams, at present has 80.5 per cent of its portfolio invested in Aim stocks compared to 9.6 per cent from the FTSE Small Cap index.

Cartesian Partners UK equity managers Jeremy Hall and Andrew Kelly also point out the Aim market is currently a good hunting ground for stockpickers because of the lack of analyst research in the space. 

Kelly says: “One of the reasons why the smaller end of the small-cap scale is a good area to operate is because of the lack of research, which means we often get to meet a company that many other people don’t get access to.”

Hall adds: “This fits with our preference for finding opportunities that do not have good market coverage. The nature of the UK market is that these types of opportunity are further down the cap scale.

“We will go down the market cap scale as far as £100m companies and when we look at this area of the market we tend to watch for stocks that we can hold for a long time.”

Fibre optics company Gooch and Housego is an example of a successful Aim stock that has yet to receive much analyst coverage, according to Hall. 

“This company has found a very strong fast-growing niche in opto-electronics,” he says. “It has already performed very well and can continue to grow its business handsomely, and step into new types of industry and new geographies to sustain this growth but it has hardly had any coverage.”

Worldwide Financial Planning IFA Nick McBreen notes that while micro cap companies may be well positioned to benefit from the current market, investing in Aim stocks is not for the inexperienced investor.

“Clearly, small caps are better able to respond in what appears to be the UK economic revival and the smaller you go the more nimble they get. But stock-picking at that kind of micro-level is a specialist area and it is not is for the faint-hearted.

“Micro stocks really are a different ball game, after all. That is why it is called the Alternative Investment Market. As long as investors go with their eyes open and have skills in that area then there is definitely fat to be found.”

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