Tom Bulford explains why small-cap companies can rocket past their better-known competitors. And below, he picks his six favourite shares.
Perhaps Adair Turner’s recent report on the dire state of our pension savings will be the wake-up call we all need. Perhaps we will give up instant gratification and start saving for tomorrow. But we need more than just the will to save. We need to find a place to invest our cash – and that’s not easy.
There isn’t a lot of enthusiasm for big company shares, and the property market is past its peak. We could trust our money to managers in the City. But just when we need a reliable savings industry, its reputation has been battered by broken endowment promises, the Equitable Life disaster, and the split-capital trust scandal. We are entering an era of financial self-help. I don’t think many of us will want to rely on the state or the savings industry to provide for the new set of golf clubs and world cruise.
Fortunately, there is a corner of the stockmarket that has always offered great returns, will continue to do so, and is the natural haven of the DIY investor: small companies. These have a long history of outperforming their big brothers. There are several explanations, not least of which is that it is a lot easier for a £1m turnover firm to double its sales than a £10bn giant. Small firms are altogether a different species to those giants. They are not weighed down by the burden of corporate governance. They don’t pay their directors excessively. They are not persuaded by self-serving investment banks to make ‘strategic’ acquisitions that they then come to regret. They are often still run by their founders, who combine entrepreneurial flair with belief in their product. Above all, they are the companies of tomorrow. All our largest firms started out on a piece of paper on the kitchen table, and once were small, thrusting businesses. Now, most of them struggle to grow, and are often just trying to defend their position. If all the attention lavished on the inevitable decline of firms such as Marks & Spencer was devoted to the success of small firms, we might all have a rosier view of the stockmarket.
Academic studies covering the last 80 years by the likes of Dimson, Nagel and Quigley, and Ibbotson Associates, have all confirmed the long-term outperformance of small firms. Their superiority became accepted wisdom in the 1980s, only for them to enter a rare decade of underperformance. In the 1980s and 1990s, big companies were perceived to benefit from globalisation. And as index funds were born in an attempt to keep pace with the bull, they became a massive and mindless source of investment funds for large index stocks.
This period is now over. In the last two years, the FTSE Small Company index has risen by 44% and Aim by 62%. The FTSE 100 is up by just 15%. In their hearts, the big investment institutions know that small companies are going to outperform large ones. But for reasons of liquidity alone, they are obliged to stick with the big boys. There is no reason why individual investors should do the same. The internet has transformed the task of running a portfolio. Internet broking has slashed dealing costs, and those willing to do their own research can turn to the many free online services (my favourites are www.uk-wire.com, and the finance pages of Yahoo.com). Just about all firms now have a website, most of which are comprehensive and sometimes include broker research notes. In short, a private investor is at no disadvantage to the City professional.
Statistics do not tell the full story, because the small-company universe is changing the whole time. This year, 18 main market firms have voluntarily relegated themselves to Aim, drawn by lower costs, lighter regulation and the chance to attract private investors. But Aim has also welcomed 161 debutantes in 2004. Almost £3bn of new capital has been raised. The number of firms quoted on Aim is now 936 – three times as many as at the end of 1998.
While main market shares are bounced around by hedge-fund traders, Aim is becoming the natural preserve of private investors looking for genuine growth from comprehensible firms. There are tax breaks too. Aim shares are classified as business assets, which means that if you hold them for just two years, you will only pay tax on 25% of your gain.
Direct investment into successful small companies is the best way for private investors to make money. The hard part is to identify the best firms from this large and growing selection, which does, of course, include plenty that will fail – especially within the ranks of the many fresh mining exploration firms. But investment into small firms need not be risky. You can achieve a low-risk portfolio with just ten shares, so long as they are spread across different sectors and are financially sound. Risk is a consequence of weak profitability and a balance sheet full of debt. Such a structure can afflict any firm – size is not the issue. On these pages are my six favourite small-company shares. And with the exception of Deltex, I would not classify any of them as ‘high risk’.
Tom Bulford is the editor of Red Hot Penny Shares.
Investing in shares can lose you some or all of your investment. Never risk more than you can afford to lose. Small company shares can be illiquid and carry higher risk than other shares. Past performance is no guide to the future. Consult a financial advisor if unsure. Fleet Street Publications Ltd. 020 7633 3600