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Little treasures

Lack of scrutiny means there are some real gems waiting to be unearthed in the small-cap market.

It is becoming something of a tradition at the beginning of each year to write off the small-cap market and recommend an increased allocation to large caps. It seems nonsensical to forecast the demise of an asset class purely on the basis that it has had a good run. On that basis, an investor should disregard any asset that has appreciated for, say, three years. That is a sure route to become overweight in underperforming asset classes.

The 20.1 per cent return in the FTSE Small Cap index in 2006 may have surprised some. The index rose by 8 per cent in December alone. Frenetic merger and acquisition activity, particularly private-equity buyouts of midand large-cap companies, pushed shares higher and helped the FTSE 250 to rise by some 27 per cent last year. The speculation and activity spilled over into small caps and placed a substantial premium on some stocks.

If there was a real surprise, it was that Aim stocks failed to catch the tail of the shooting star, returning 0.8 per cent. One of the reasons is there has been a lot of new issuance on the market, particularly in 2005 and the first half of 2006. Once the indigestion has passed, this factor should no longer hold sway.

A longer-term structural issue is that Aim-listed stocks are outside the benchmark of many investment funds and most managers are forbidden from going off piste. This is inextricably linked with the dearth of analyst coverage of the 2,000 or so small-cap stocks that lie outside the FTSE small-cap universe. The top 300 biggest companies in the UK have 15 to20 analysts studying their every move but many Aim companies are lucky if there are more than one or two analysts looking at them in a serious way.

This lack of research means there is fantastic potential to unearth superb investments. When mainstream investors finally catch up with the good news, share prices can have a momentum all of their own.

Take Carter & Carter, a vocational training company which benefits from Government backing. When it came to market in February 2005, the company was not well understood but it has a predictable earnings’ stream, is well managed and has made a series of attractive-looking acquisitions. Its shares rose by 130 per cent last year.

Then there is OMG, a technology provider which gained a new chief executive a year or two ago and migrated its technology into new and profitable areas. Its shares were up by 140 per cent.

Not all Aim companies offer similar attractions. The gambling groups lost out badly last year and there have been mixed fortunes for the spate of secondary listings that Aim has attracted in recent years. The share-price drivers of these companies are usually offshore and you may wake up and find prices have moved considerably without obvious explanation.

What are our predictions for the coming year? There is likely to be value in software and hardware. Many of these companies fell off the radar after the dotcom crash but the survivors often have plentiful cash, good dividend yields and strong growth potential.

Manufacturing is another attractive sector. Firms that survive the onslaught from emerging markets should be efficient and well managed.

Aim stocks also provide significant rerating potential. They are increasingly moving to the main market, providing an instant jump in price. The risk/reward ratio for such companies is alluring, to say the least. The wider universe of small-cap stocks also offers returns that are uncorrelated to the main stockmarkets.

Of course, equities in general could suffer in the event of economic retrenchment but with economic growth good, interest rates rising only marginally and inflation in check, we do not see too many clouds on the horizon this year. The Bank of England has room for manoeuvre if the economy seems to be flagging.

A stable environment should provide a strong platform for Aim stocks this year. Even if the economy takes a turn for the worse, these stocks should hold up given their already depressed valuations and low gearing.

Gervais Williams is head of UK smaller companies at Gartmore.

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