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Small wonders

In an economic downturn, the natural inclination for many investors is to seek cover by holding big and so-called defensive companies. This is because of their perceived relative financial strength while small caps are often, but not always, reliant on one product.

This would seem to be supported by the fact that the Alternative Investment Market, for example, fell in value by 60.24 per cent from May 1, 2008 to the end of February 2009, according to Financial Express. However, the current downturn has shown that big is not always best, with some notable international banks having particularly weak balance sheets.

The downturn has also demonstrated the danger of generalising about small-cap stocks. Amid the rubble, investors can still find plenty of smaller companies that are growing their earnings and profits.

An example is online retailer Asos which is listed on Aim and sells relatively cheap copies of clothes that have been worn by celebrities. The company’s profits grew from £3.3m in the year to March 2007 to £7.3m in the year to March 2008. Profits are expected to reach £13.7m in the year to March 2009. Its share price rose by 28 per cent from December 31, 2008 to March 5, 2009.

The key to identifying stocks like Asos is to evaluate whether companies have an economic advantage that is derived through intellectual capital. This is particularly pertinent during the current economic downturn as intellectual property is hard for competitors to replicate and therefore enables companies to sustain their profitability and pricing power and be rewarded with share price appreciation.

Pricing power is especially important as competition is intensifying and volumes are under attack. Focusing on intellectual capital also helps investors to avoid speculative unprofitable companies, of which there have been many listed on Aim.

There are three main measures of intellectual capital. The first is repeat business. A company with high recurring income (more than 70 per cent of annual turnover) may have long-term contracts (three to five years) or annual contracts where there is an inbuilt subscription or monthly element to billing. Such companies have an annuity type of income that enables them to undertake long-term planning.

An example is Craneware, a Scottish company that supplies financial improvement software solutions to the US healthcare market and whose share price rose by 4 per cent from December 31, 2008 to March 5, 2009.

Second is intellectual property which companies develop through many years of accumulated research and development spend. Intellectual property is captured via legally enforceable patents, copyrights and trademarks as well as less enforceable but more hidden knowhow.

Intellectual property creates a barrier to competition not only because it is frequently protected through law but as it also takes time and cost for a competitor to replicate as well as gain end customer acceptance of product quality.

An example is System C Healthcare through its provision of information solutions and services to the healthcare industry. Its share price rose by 16 per cent from December 31, 2008 to March 5, 2009.

Third, companies with their own distribution networks provide customer support at a local level as well as offering international customers a consistent service across multiple countries. Businesses with their own networks are able to get closer to customers and build up better local knowledge than when they use third parties.

Asos and courier company Business Post are good examples of companies with strong distribution networks that are hard for new entrants to replicate.

An ideal holding is a stock such as IT company Fidessa whose share price has risen by 56 per cent since the start of 2009 to March 5, 2009. It has recurring income, intellectual property and a strong distribution network. When a company such as Fidessa exhibits all three measures, it is leading to the development of a strong brand.

Anthony Cross and Julian Fosh manage the Liontrust intellectual capital trust

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