Pick wisely and small cap firms could prove a real goldmine

INVESTING in small companies has traditionally been seen as a risky business, reserved only for those with plenty of experience and deep pockets. But with global diversified blue-chip stocks running into trouble, it is no surprise that investors have started to see the lower echelons of the FTSE index as more attractive. <br /><br />Indeed, only last week, Nick Williams, European small-cap fund manager at Baring Asset Management, said he was bullish on the prospects for European smaller companies and that they would continue to outperform the larger firms for some time to come. <br /><br />The FTSE small cap index has risen nearly 38 per cent since its 2009 low in March compared to the FTSE 100&rsquo;s 25 per cent rise. And while fund managers are remaining optimistic about the outlook for small-caps, talk of a double-dip recession is holding blue-chip stocks from making a significant rebound in the third quarter.<br /><br />The Hoare-Govett Smaller Companies index, which measures the performance of the lowest tenth by value of the main UK equity market, has risen 30 per cent so far this year, whereas the index for the FTSE 100 has risen only 1.1 per cent. <br /><br />Smaller companies tend to be more cyclical and therefore will be better placed to profit from an upturn, if and when it comes. In contrast, the FTSE 100 has more defensive stocks, which will not benefit as strongly from green shoots and an improvement in economic conditions. <br /><br /><strong>LEANER AND FITTER</strong><br />And among the small-caps it has been a question of survival of the fittest during the recession, says Jeremy Martin, chief executive of Horizonte Minerals, an exploration and development mining company that focuses on Brazil and Peru. This means that those remaining are leaner, fitter and more robust, which is good for investors, who should be exposed to good quality companies.<br /><br />But out of the 1,413 stocks that are still listed on the FTSE&rsquo;s junior Aim market, how should investors go about picking growth stocks that will be successful? Firstly, plenty of patience and hard work is required of anybody looking at small-caps. These are not guaranteed to return a quick profit. <br /><br />Also, these stocks are often relatively new companies that are looking to expand their reach and may also be biotech or mining companies that are dependent on new drugs being approved or a new discovery of a deposit or oil. <br /><br />Richard Smith, fund manger in charge of UK smaller companies equity fund at Invesco Perpetual, says that investors should look at UK companies that are particularly well-placed to benefit from the fiscal tightening that is likely to come into effect after the next general election.<br /><br />&ldquo;Companies such as business-processing company Xchanging or services group Connaught stand to benefit from the government outsourcing, as a result of the future cuts to public sector spending,&rdquo; he adds.<br /><br />Bob Foster, chief executive of gold and base metals exploration and development company Stratex International which operates in Turkey, says: &ldquo;The key thing for investors to look for is the right technical expertise at the top driving the company, as well as cash in the bank and an ability to risk manage.&rdquo;<br /><br />Horizonte Minerals&rsquo; Jeremy Martin agrees, saying that investors need to know the quality of the management team. &ldquo;If you have got sound guys who have worked in the major companies and know how they work, then that obviously feeds through,&rdquo; he says.<br /><br /><strong>JOINT VENTURING</strong><br />For Martin, a clear business strategy is a sign of a company with good prospects. His own company is focused on generating and advancing exploration projects before joint venturing them with a major mining company for further development and to provide mid-term cash flow, which can then be fed back into the business and its other projects. <br /><br />So far this has been a successful business strategy and has left Horizonte with a strong enough balance sheet to pick up new projects at lower prices and not ask the market for more investment in what has been a difficult period. <br /><br />&ldquo;What you don&rsquo;t want to be doing as a company is changing your business model all the time &ndash; it&rsquo;s difficult for investors to follow and you need to keep adding value through your existing business model.&rdquo;<br /><br />It is clear that research is crucial to picking successful growth companies and if you choose your stocks correctly, you can see substantial gains if they do discover that next wonder drug or find a large gold deposit. <br /><br />But if picking the winning growth companies sounds like more research than you have time for, then you could consider a small-cap fund such as Invesco Perpetual&rsquo;s UK smaller companies equity fund, which focuses on companies that display characteristics such as a high degree of recurring revenues, attractive valuations and good-quality management. Over the past three months, the fund&rsquo;s performance has been 16.8 per cent. <br /><br /><strong>BROADER EXPOSURE</strong><br />Although you will have to pay, you entrust the investment decisions to professionals who are watching the market all the time and you also get a broader exposure to small-cap companies, rather than picking a few potential winners. An alternative for the private investor is to consider an exchange-traded fund which tracks a small-cap index, such as the Powershares FTSE RAFI Europe Small-Mid fund. <br /><br />The outlook for small caps has been brightened by a revival in the economy, however slow. Interested investors will have to accept that returns may be slow in coming and hard work is needed in order to pick the businesses that do stand a chance of making it into a viable long-term company.<br /><br /><strong>SMALL CAPS AIM MARKET</strong><br /><br />&9679; The Aim market is part of the London Stock Exchange and was established in 1995. <br /><br />&9679; Its more flexible regulatory regime allows smaller firms to &ldquo;come to the market&rdquo; to raise the needed capital without having to go through the listing and disclosure requirements that firms listing on the main market have to undertake.<br /><br />&9679; The more successful companies have grown sufficiently in size to join the Main Market, although, given the decimation of stocks in recent months, more may be choosing to move the other way.<br /><br />&9679; Aim is officially classed as an exchange regulated market. <br /><br /><strong>SMALL CAPS PLUS MARKETS</strong><br /><br />&9679; Plus Markets is a relatively new stock exchange based in London for small and mid caps, which began in 2005, as a response to demand from brokers and financial institutions. <br /><br />&9679; 7,491 companies are currently traded on Plus, while 201 are quoted. The total market capitalisation of the Plus-quoted market is &pound;2.3bn.<br /><br />&9679; Nearly 50 brokers and 7 market makers are active on Plus, including Winterflood and TD Waterhouse. <br /><br />&9679; Plus has recognised investment exchange status which gives it the same rights and privileges as the London Stock Exchange.