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Small talk

Small companies are never dull. This is one thing that can be said with certainty.

Whether they are in or out of favour, there is always a story and this makes fund managers involved in the market passionate about what they do. You can be tramping round a building site in the morning and talking about a revolutionary technology in the afternoon.

It allows investors to be involved in the development of a young, exciting business, to build direct relationships with the management rather than the PR department and to watch the ideas of entrepreneurs come to fruition – or not, as the case may be.

But never mind why fund managers like smaller companies – what is the investment case?

The main opportunity in small companies revolves around what is often called the small company effect – the idea that investment in small companies can provide high returns for the amount of risk undertaken.

This is because the small companies market is under-researched by brokers and therefore less efficient than the main market.

Many brokers have found it unprofitable to research small companies, particularly when the market capitalisation is under £100m, as there is often not enough commission or corporate fees to justify the costs.

Certainly, broker coverage of companies seems to increase markedly with rising capitalisation. The fund managers who do spend time researching the market should be able to find anomalies in valuations.

There is ample scope to do this, given the sheer volume of small quoted companies. At the end of December 2003, there were 263 constituents of the FTSE Small Cap Index exc investment trusts – a key benchmark for investors. Then you can add on the stocks in the Fledgling index and on the Aim and even the smaller part of the FTSE 250 index for some funds It is easy to identify an investment universe of around 1,500 companies but finding an undervalued company is not enough. If no one else thinks it is cheap, then the share price will not move.

It is even more important to identify the catalyst that is likely to bring the company to wider attention and encourage the stockmarket to value more efficiently.

Another important attraction of the small company end of the market is that it can be seen as a hot house for growth stocks and it tends to contain the fastest-growing businesses. A float is the next logical step for businesses funded by venture capital, so many are at a relatively early stage of development when they first list. There are some notable examples of companies which started in the small companies arena and have grown strongly through to the mid and large-cap market, such as Capita, Serco and Enterprise Inns.

It is easier to grow rapidly from a small turnover than from a bigger, less flexible base. As someone once said “Elephants can&#39t gallop.”

However, there are some issues that must be taken into account when investing in small companies.

Liquidity can be a problem. In many of these companies, the number of shares traded on a regular basis is very low. Matched bargains are much more important here than in the main market.

This does mean that you need to be doubly sure of your investments as a fund manager, as once you are a shareholder it can be very difficult to exit again quickly, particularly if something goes wrong.

You also have to be patient when building a position and disciplined to walk away if the price moves against you in the process.

Share prices can be very volatile as a result of low liquidity and the dealing spreads very wide. Prices can move sharply on modest volumes of shares traded. It is important to distinguish between fundamental changes in the outlook for your investments and background noise affecting the share price, such as ill-informed scare stories with no material impact on underlying value.

Small companies are perceived to be higher risk than their bigger brethren but this is a simplification of the issue.

It is true that growing a business can be risky and progression may not be smooth. Equally, management may also be less experienced and the businesses can be quite narrowly based.

However, for every higher-risk business, there is a long established “dull but worthy” company, so within a portfolio it is possible to manage the risk profile to an appropriate level depending on the requirements of clients.

The last year has seen strong performance from small companies in the UK and around the world.

Over the year to the end of February this year, the FTSE Small Companies index exc investment trusts rose by 64.5 per cent. This compares with 27.2 per cent for the FTSE100 and 31.9 per cent for the FTSE All Share.

A period of underperformance had led to small companies looking cheap on a price to earnings basis relative to big companies while offering faster growth.

Small companies are the purest recovery play, with high levels of exposure to the domestic economy.

With comparatively lower focus on the US than big companies, they are also less at risk from the adverse movement in the dollar.

The sector make-up of the index has attractions too at this time. It has a stronger growth and cyclical recovery bias than the FTSE 100 with, for example, nearly 12 per cent of the FTSE Small Companies index exc Investment Trusts being in information technology – a sector which had been massively out of favour until recently.

A clear sign of positive sentiment towards small comp-anies is the resurgence in fund-raising activity that is taking place.

For the last few years, the IPO and secondary placing market has been all but dead. As equities in general returned to favour, the backlog of companies wanting to raise capital has started to come through, inundating the market. The bulk of activity has been at the small end of the market with a bent towards growth stocks.

It is worth noting the popularity of the Aim market which has been the home for many of these new issues, reinforced by the new accelerated float format.

Aim companies can raise money much more cheaply and, despite the lighter corporate governance requirements, have been no more prone to scandal than fully listed stocks.

It has been stimulating to see so many new opportunities but, as always, the key is picking the long-term winners.

After a period in the doldrums, the small companies market has come back to life in dramatic fashion. Some of the easy gains have now been made but we believe it is set for a period of buoyancy.

Company management seems re-energised, balance sheets are strong, trading is improving and there is a solid base of investor interest in the market.

As ever, proper research and good stock selection are the keys but for those willing to spend the time, we believe that the small company market offers a rewarding investment experience.

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