Size matters: Smaller firms can still make large profits

THE government is hoping to cast a spell over the banking sector with its Merlin deal with the banks. The growth of small and medium sized enterprises (SME) is thought to be vitally necessary to economic recovery, and getting the banks to lend to them necessary to promote their growth.

Smaller companies usually lead economies out of recessions, and the FTSE 250 index, which tracks the 250 biggest firms outside of the FTSE 100, has gained 31 per cent over the last year, outperforming the FTSE 100. But the FTSE All-Small index, which combines small and fledgling firms, is down 6.12 per cent over the same period.

Investing in smaller firms is distinctly riskier than larger ones, as shares tend to be a lot less liquid, while firms are less likely to be diversified, and so are more vulnerable to sudden shifts in demand. They are, however, also much more likely to produce fantastic growth. So with the economy gradually recovering, should investors be looking a little lower down the shares list to find value? And if so, how do they go about it best?

Charles Buckley, a partner at Gore Browne, an investment management firm, certainly thinks it’s worth it. “Some smaller firms have really done remarkably well,” he says, “and if a firm got through 2009 and 2010 successfully, it’s probably got a good underlying business.”

Buckley says that though economic growth is likely to be anaemic, there is an awful lot of value to be found in small businesses. But he also argues though that it is important to pick the right fund: “There’s a lot less research out there about small firms, and we don’t really try to pick stocks.” Instead, he advises investors to “follow the man.” In particular, Buckley recommends Harry Nimmo’s Standard Life Smaller Companies trust. “That fund has done staggeringly well – it’s up 47 per cent December to December. He’s really found some amazing stuff.”

Alex Wright, the manager of Fidelity’s UK opportunities fund, agrees about the importance of active management. “The further down the cap scale you go the thinner the analyst coverage becomes and the greater the chance of uncovering a gem that others have missed,” he says. Wright also says that small and midsized firms generally should do well, however, thanks to renewed mergers and acquisitions, as well as new projects. He is particularly bullish about the technology and media sectors, where the potential for rapid growth and interesting new projects is perhaps largest.

“We’re not expecting to see a return to 2007 style gearing up,” he says, “but as stability returns, firms ought to start spending a little more, restarting projects they had suspended or buying other firms.” Wright claims to spend a lot of time talking to small firms directly so as to find out what they are doing – and what might be interesting to the stock market.

But both will be hoping that their picks are the right ones. Ted Scott, UK market strategist at F&C Investments, argues that overall, large firms will be a better bet than smaller ones in 2011. Unlike large multinationals, smaller firms are still heavily exposed to the British market, which is looking weaker than expected right now, while difficulty getting funding is likely to continue. “It’s quite likely that GDP will undershoot expectations, and while many firms will undoubtedly still do well, small companies are a lot more vulnerable than big ones.”

Like the government, investors must be hoping that that vulnerability won’t be tested too severely. But that fear aside, there are profits to be had.