Little gems: what are the attractions of small caps?

F&C manager Catherine Stanley on why small companies are more appealing than their large-cap counterparts.

In the 1990s, the small company arena could readily have been described as a very under-researched and under-broked area of the market, therefore offering great inefficiencies and many undiscovered gems if you were prepared to carry out a little bit of groundwork.

Additionally, small company stocks were previously very domestically exposed and were highly dependant on the outlook for the UK economy.

The landscape has changed markedly during the noughties. While there are still undiscovered gems, particularly at the micro cap end of the market, it could in fact now be argued that the reality is the small cap market is over-broked with plenty of research widely available to investors. Nonetheless, the quality of this information can vary and there is still a requirement within the small cap universe to undertake thorough research to sort the wheat from the chaff.

Whilst remaining more domestically exposed than large companies, they are equally far more international now than they ever have been and are therefore in a position to take advantage of global trends. This is clear with the rise in importance of resource stocks which are exposed to a variety of geographies, but also true across all sectors.

Good prospects

With the small company market arguably more efficient than it once was and a wider variety of investment options on offer in general, what opportunities are available in small companies now? Well, there are plenty of opportunities which are exciting and interesting with the possibility of potentially dramatic returns. The small cap market can be more volatile, meaning investors may run the risk of being impacted negatively during periods of risk aversion and there clearly are value traps where companies never reach their potential. However, investors also have the ability to gain significantly and can find investments to appeal, regardless of individual portfolio styles.

There are four key areas where we believe small companies currently offer something harder to find in large company counterparts:

1. Choice. There is a far broader choice within the small companies market in terms of sectors, diversity of businesses, types of management style, strategies and sheer number of stocks.

Investors can certainly consider the bald headline numbers in terms of an examination of the asset class valuation relative to large companies, but this kind of data hides such a wide range of diversity within that it actually tells you very little. Small companies may look cheap or expensive in relation to large cap stocks at a particular point in time but the comparison is never ‘apples with apples’; the great joy of smaller company stocks is that investors should be able to uncover companies offering returns and risk appropriate to most portfolio strategies.

2. Income. Small companies have traditionally been perceived as an area of the market for mainly growth investors. Over the last 12 months or so, it has become quite clear, particularly since the cuts in dividend income from large companies, that small companies can also offer investors very attractive yields and there is in fact plenty of income to be found. Whilst some is at that value end of the market where there may be very little capital growth - and paying a dividend may well be a lifestyle decision on the part of either management or shareholders – there is equally a multitude of solid companies which are yielding above the market average, are strongly cash generative and can pay progressive dividends. Certainly, the yield on FTSE Small Companies Index is about in line with FTSE 100 and more attractive when compared to the FTSE 250.

The quality of that dividend income can of course be very variable, but given the number of stocks on offer, there are companies that can offer both attractive income and growth characteristics. Companies such as Domino Printing pay an attractive and well covered dividend as well as offering good scope for capital appreciation. Other examples would be distributors such as Brammer and even some consumer stocks such as Restaurant Group. This area of the market is increasingly attracting income fund managers seeking out income where dividends have been cut from large cap sources, such as the financial sector and the likes of BP.

3. Greater exposure. Small companies can offer much greater exposure than large companies to world leading science and technology in a pure form. The weighting of the IT sector in small companies is much higher than in large companies and there are also plenty of electronics, engineering and healthcare businesses which have fantastic science within them such as machinery component manufacturer Renishaw, optical technology expert Gooch and Housego and SDL, which provides software and services for global information management. Such companies are world leaders in their particular field. Their niche may not yet be big enough to propel them into the FTSE 100, but they nevertheless offer high margins, good growth and a leading edge in technology.

4. Unique stocks. Small cap offers access to many forms of exciting E&P and mining stocks that are not available in large cap. Investors are offered the opportunity to buy into to unique and interesting parts of the world from Vatakoula’s exposure to gold in Fiji to London Mining’s iron ore in Sierra Leone.

Risky businesses

A great deal of these types of companies, by the very nature of their business, require funding and refinancing on a fairly regular basis to make progress, however a meaningful number of them will offer significant upside and attract very entrepreneurial and highly experienced management teams. This is of course at a riskier end of the small company universe but can offer huge returns to those comfortable with investing in an area which is hugely more exciting and rewarding than some of the larger resource plays.

Overall, smaller companies are now far more diversified than they used to be. Regardless of whether they appear cheap or expensive relative to large or mid cap stocks, certain characteristics unique to the small company area of the market point to the fact that there will always be something interesting within this space for investors.