Small companies hold big potential

Many small companies hold more cash and have less debt than bigger firms - but investors should look for quality and pick companies that have the potential to double their size.

There are not many trends in the market that can be clearly identified. Amid the uncertainty, many investors are battening down the hatches and heading for “safe havens” such as large company stocks and gold. The strategy being that large caps, while affected by volatility, are better able to stay in business. Increasing weightings to the smaller company sector is not a wildly popular strategy, yet it is something investors should consider.

Reason is often lost during episodes such as this, but where visibility is reduced is it not rational to invest in assets where you can really see what is happening? In small-cap – that is genuine small-cap of the sub-£100m variety – it is possible to drill into companies, meet and get to know the managers, talk to their customers and find out how they are likely to react to adverse market conditions. Can such information really be extracted from GlaxoSmithKline or BP? Did anyone have genuine insight into Northern Rock before this summer?

Yet the small cap sector is ignored by most fund managers and investors. By doing so they are ruling out the 70% of British quoted companies that have a market cap of less than £100m. That is not to say that all these companies have intrinsic value – far from it.

But several are cash generative, profitable, dividend-paying companies that trade on a single-digit price-earnings ratio. Not only are they often as well run as large caps, but more importantly, they have the potential to double or triple their share prices.

The huge potential upside is mainly the result of inefficiencies in the sector that are absent from large caps. Consolidation among brokers and a reduction in the number of analysts means there are fewer eyeballs on small caps at a time when the number of stocks is expanding rapidly. So, unlike large caps where there is a mass of information, small cap investing allows a manager to discover something the rest of the market does not know.

A typical example of a good small cap company is Tanfield. This is a Newcastle-based systems engineering business that was turning over £20m in 2004 with a profit of a few hundred thousand pounds.

Tanfield acquired a milkfloat manufacturer and broadened its business to provide electric vehicles to global delivery firms such as TNT. Its orderbook swelled and its shares now trade at about 170p (see graph).

Indeed, when all the building blocks are in place, small cap can be an effective safe haven. Many companies are better prepared than they were for the last downturn by holding more cash and less debt while companies with high gearing have been de-rated by the market. At present chief executives seem overwhelmingly reassuring about their relationship with their banks and the answers. But, either way, it is only possible to get that level of visibility with small caps.

Investors are prone to search for bargains in times of volatility. The best approach, however, is to take the same view as venture capital and look to find the right products and services, while looking at both the buyout value and the potential downside. The advantage of this approach is that if a stock is likely to treble in value, stockmarkets falling 10% does not affect the decision to buy.

Small cap is a long-term environment and quality will out. At the same time, the larger small cap universe may start to suffer as bid premia unravel. Whereas the possibility of a private equity buyout was built into most of these companies’ prices, this is no longer the case.

A common sense approach to investing is vital. The best strategy is to look for companies that have the potential to at least double their market cap. This needs a proper understanding of what the company does and who its customers are. It is important to know how critical its service is in bad times as well as the good ones.

The classic small cap trap is the surplus capacity providers that are just feeding off scraps from the top table. Recruitment firms sometimes fall into this category.

Alongside proprietary products and services, management is also critical. Small companies can struggle to make the transition to publicly owned entities. Therefore it is necessary to see evidence of the requisite management experience and appropriate structures such as an executive compensation model.

In terms of specific stocks, an example of a sector offering value is business services. The share price of Education Development International, a £20m training business, has risen from 24p to 34.5p in seven weeks.

This kind of business is appealing – small cap, owns intellectual property in the form of a qualification certificate, trades at 7.5 times next year’s earnings, and holds £2.5m on its balance sheet for acquisitions. Other companies of note include CBG, an insurance broker and Elektron, an interesting turnaround story.

A market downturn in the disasterous style of 2000-03 is unlikely. While the coverage of small caps stays low – and there is no reason to think it will not – investors who are seeking the opportunity for growth and a haven from economic or geopolitical risk should move down the capitalisation scale.