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Search for small-cap sparklers

Aim has seen a stunning 65% rise this year and there is still plenty of scope for finding the gems in the market

Giles HargreaveMarket View

The turbulent progress of the markets over the past two years has unfolded for me, in part at least, through daily updates on the triumphs – and in some cases tribulations – of those at the helm of smaller companies in the UK and overseas.

Each morning, company news printouts have told stories of the successes and difficulties of the managers and workers of these firms in the teeth of the most testing economic conditions in a lifetime.

Last year, these updates told a bleak story and the market reflected this.

By the end of 2008, the London Stock Exchange’s Alternative Investment Market was down by more than 60 per cent compared with 18 months earlier – fuelled in part by a flight to quality in testing times.

This year, however, has seen the small, young and growing companies that make up the Aim bounce back with a vengeance. From the start of 2009 to the beginning of November, the index is up by more than 65 per cent. That compares with a rise of just over 20 per cent by the FTSE 100 over the same period.

All this shows in the clearest terms the reality of small-cap investing. Yes, there is risk and it is certainly not a sector for the casual investor but the opportunities exist for returns that dwarf those to be found among blue-chip stocks.

What does the future hold for small caps?

Predicting where the market as a whole will take us is by no means an easy business.

Over the last six months or so, investors have recovered a lot of the money that they had lost so when the market wobbles, it is to be expected that there will be sellers who want to lock in their profits.

It will then be no surprise to see a shift into the perceived safety of defensive stocks with big names such as Tesco and GlaxoSmithKline reaping the benefits.

On a wider economic level, disappointing figures have prompted concern about a pretty anaemic recovery. To my mind though, a double dip is unlikely.

The evidence is that, having run down their inventories, firms are now beginning to restock, which is good news for those smaller companies that supply them, and there is genuine recovery in Asia, from which UK exporters can benefit.

Looking further ahead, the outlook for those investing in small caps is far from clear.

The strong recovery in the sector has brought an end to the days of an abundance of plainly undervalued stocks but value still exists. It is worth remembering that many companies worked hard to strip out costs last year and will enjoy greatly increased profitability when recovery does take hold.

The key for investors is to be selective. For my money, it is crucial for a small-cap fund manager and his team to spend a great deal of time getting out to meet managing directors and really understanding what they do.

This bottom-up approach is the key to finding the jewels in the small-cap arena – and they are out there – the excellent management teams, the innovators and the niche players insulated from the chill winds of rising unemployment and cuts in public spending.

Well over 1,000 companies are listed on Aim alone. The diversity is tremendous – ranging from Chinese cement companies to UK technology firms.

Yes, we are starting to see a few warning signs among those daily printouts on companies’ progress but, as ever, for those prepared to spend the time looking, the gems exist.

Giles Hargreave is manager of the Marlborough special situations fund and the Marlborough UK micro-cap growth fund

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