Library | FAQ

Investing in Small Caps

Find out why investing in small companies could make you big profits. . .

What are Small Caps

Small Cap is a catch-all phrase to cover a wide variety of the smaller quoted companies (SQCs).

In stock market terms the size of a company is usually measured by its market capitalisation. To get to this figure you take the number of shares in issue and multiply it by the current price of each share. It is a sensible way to calculate the size of a company and it is used by markets around the world. However, defining which companies fall under the heading of ‘Small Cap' differs from country to country.

In the United States it is generally agreed that Small Cap means a company with a market capitalisation below $500 million. Here it is much more complicated than that. There are 700 companies with a market cap of over £56m quoted on the main market of the London Stock Exchange (give or take a few, the picture can change from day to day). The top 100 by market cap form the FTSE 100 and the next 250 companies in the league table are the FTSE 250. Collectively they form the FTSE 350 and the remainder of the quoted companies with a market cap over £56m form the FTSE Small Cap Index.

But when we are looking at UK smaller companies we must include those on the Alternative Investment Market (AIM) and OFEX, which is the other British exchange for SQCs. (These are probably the most well-stocked fishing grounds for those seeking younger companies with exciting plans and good growth prospects.)

The whole indices scene can be rather confusing and in fact it has been designed principally for stock markets to measure performance rather than to help the private investor. Our advice is to forget the confines of the indices. Set your own parameters, for example companies with a market cap of between £10m and £200m and mine for gold nuggets in all the markets that contain such constituents.

Why Small Caps are important

Every cloud has a silver lining, and for those investors who survived the holocaust of the dotcom and TMT boom-and-bust the upside is that they have become wiser and more accomplished investors. And all the signs are that they are also more ambitious and are prepared to seek out companies with real potential rather than sticking to the safety of the FTSE 100.

Evidence for this entrepreneurial flair that his infused investors came from figures published for 2003 trading activities. Here in the UK money flowed into the market and the FTSE 100, which measures the performance of the top 100 companies, rose 16.7 per cent. That's a pretty impressive figure until it is compared against the FTSE Small Cap Index, which went up a whopping 57 per cent.

And the statistical picture was pretty much the same around the world. The smaller companies were the darlings of the stock market as far as private investors were concerned.

Interestingly, the change of heart came in the second half of 2003. Whereas at the start of the year investors were demonstrably risk averse by autumn there was a move toward more volatile and cyclical stocks in the autumn. Indications are that the trend has continued.

The risks and rewards

Private investors have a distinct advantage over their bigger and richer brothers, the institutional investors, when it comes to investing in Small Cap stocks (the smaller quoted companies on the stock market).

The investing rules of the institutions often prohibit them from investing in minnows. There are two main reasons for this: The belief that small means risky and the worry that buying and selling stock in Small Cap companies can present problems.

It is fair to say that both reasons have some validity. Smaller companies usually do not have the strength in depth that is enjoyed by their bigger cousins and so are more vulnerable to commercial setbacks and economic downturns. Large companies can survive cash problems by living off their fat; newer businesses may not have the wherewithal.

Small capitalisation can also mean restricted availability of stock and institutions and mutual funds usually want to buy and sell in big quantities. Not only is it sometimes difficult to bundle together enough shares to satisfy a big requirement but there is further hassle when a substantial holder wants to sell out. A major percentage sale could adversely affect the share price and therefore jeopardise the company.

However, despite the inherent risks, investing in Small Caps can have some big advantages for the private investor.

The absence of heavyweight competition leaves the profit field open to the savvy private investor or investment club. He or she should mitigate the risk factor by doing the right research, and that means making sure that the company has enough money available to survive the bad times.

Meanwhile the share liquidity problem - not enough stock around to attract the big traders – will not be a concern to those who do relatively small trades.

In short, the fact that larger institutions often turn their back on the Small Cap sector can be an advantage rather than a disadvantage to private investors. By doing careful research into overlooked stocks you can spot the diamonds in the rough.

Small can be beautiful – but do your homework

If, in 1955, you had invested your savings in a tracker fund that covered the whole of the equity market, each £1 you put in would be worth in excess of £486 (to April 2004).

However, if you had restricted your investment to a tracker fund that bought only minnows, the smallest 2 per cent of companies measured by market capitalisation, each £1 would today be worth £8,123.

It would seem to be a no-brainer then to restrict your investments to the tiddlers that swim around on the bottom of the pond. But, as with all decisions based on such statistics, that would be a dangerously wrong conclusion. Because there is no doubt that if you cast your bait into such murky waters, while there will certainly be a few fine catches, they will be eclipsed by the huge number of tiny fish who, despite their best efforts, are not strong enough to make it to the surface.

By all means do your researches in order to identify possible winners. But a good idea and an attractive prospectus are not enough. Make sure you dig deep and examine such areas as:

- The management. Are the people at the top of the company tree the right people to be running the business? There's a world of difference between the entrepreneur who is adept at starting a business from scratch and the person who can successfully develop a publicly quoted company.

- Are there weaknesses in the staffing structure? All too often new companies have not fully developed all their strengths, probably in such vital sections as research, quality control, sales strategy or marketing.

- The competition. Unless it has a unique product – and such a phenomenon is almost unheard of nowadays – a new business will have to fight for an increasing share of its market. Is the appeal of your company strong enough to break up long-term relationships between its competitors and their customers?

These and many other challenges face new companies. Some will survive and thrive. Many will wither and die.

Beating the tax man

As well as the potential to unearth bargains the institutions have overlooked, investing in Small Caps can help you save tax.

AIM is the London Stock Exchanges junior market and tends to attract younger companies looking to expand.

Investing in AIM stocks has significant tax advantages for the private investor. The individual has the benefit of tax breaks that are not available to funds.

In particular the Capital Gains Tax (CGT) treatment is particularly generous. We all have a CGT allowance of £8,200, which means that we can – and should – realise cash profits to that amount during the tax year (April 6 th to April 5 th ).

If you realise more than £8,200 profit from main market shares during the year you will normally have to pay 40 per cent capital gains tax on the additional amount. However, AIM stocks are classified as ‘business assets' and therefore, although you will have to pay 40 per cent if you have owned the share for less than a year, there is a tapering system in place which means that the rate falls to just 10 per cent after two years.

Shares in new AIM companies may also qualify for an Enterprise Investment Scheme, which is available to businesses which have gross assets valued at less than £15m before flotation and less than £16m after. In this case you can defer CGT on profits made in the 36 months prior or the 12 months following your purchase of the new shares. You also get 20 per cent income-tax relief on up to £200,000 when you hold the stock for three years or more.

And finally, AIM shares become free from inheritance tax once you have held them for two years.

A note of caution: Don't invest in AIM shares simply for their tax breaks. The market is a haven for fledgling companies that are striving to prove themselves and that means they are riskier than well-established businesses. Be sure to balance risk with reward.

Conclusion

This introduction to Small Caps is just that – an introduction. As part of our exciting plans to help educate and grow the investor community in the UK, Digital Look (www.DigitalLook.com) is creating a much broader Small Cap research centre to allow investors to find the latest Small Cap news and price movers.

Also watch out for our new Small Cap Fantasy Share Game brought to you in association with City Equities and offering a range of fantastic prizes.

 

 






www.bolsamania.com – www.sharecast.com – http://www.proshareclubs.co.uk/ – www.digitallook.com