Forward Diary

Stocks & Shares - Investing in Small Caps

The Holy Grail of stock-market investment for many enthusiasts is the ‘ten bagger’, a share which rises to ten times its original price or more. In the UK, ASOS, the internet fashion retailer, has been one of the greatest stories of recent years. Ten years ago, it was trading at around 46p and now the shares are each worth about 615p. It is no coincidence that technology stocks figure strongly on the horizon of investors looking for small-cap minnows with the potential to become large-cap whales one day. Some of these companies may fall by the wayside, and many did when the late-90s tech boom came to a sticky end, but this is part of the risk-reward equation we have already discussed. Ten baggers may be recovery stocks – basically sound companies that have bounced back after falling out of favour with the market for one reason or another. Or they may be great growth stories that were so small it took a long time before anyone took much notice of them. If one such stock in the portfolio takes off big- time, it can make up for a lot of disappointment from other holdings – but there is no guarantee of hitting the jackpot. Sifting the small company wheat from the chaff can be a daunting task, as there are a great many of them and information is not always easy to come by. Fortunately, magazines such as Shares provide a wealth of research and opinion for private investors, often covering quite obscure companies. Bulletin boards on websites such as allow you to chat with other private investors about the shares you are interested in. As a guide to the potential of a small company, check out its PEG – price/earnings to growth – ratio and its cash flow and cash burn. PEG is calculated by dividing the company’s prospective PE ratio by its estimated future growth rate in earnings per share. A potential ten bagger will tend to operate in a growth market, have a strong cash position and a PEG below 1. The main hunting ground in the UK for potential ten-baggers is the LSE’s Alternative Investment Market, AIM. Its listed stocks include a wide range of businesses including early stage, venture-capital backed companies as well as more established businesses seeking access to growth capital. ‘AIM is the London Stock Exchange's market for small and growing companies,’ says Marcus Stuttard, the LSE’s Head of AIM. ‘You can use it to buy shares in ambitious new firms which may be at an earlier stage in their development than big established companies, but which potentially offer higher rewards. Since its launch 15 years ago, investors have shared in the growth of thousands of companies from all over the world through AIM; companies like Majestic Wine and Domino's Pizza [now listed on the Main Market] which have developed into successful businesses worth hundreds of millions of pounds.’ An AIM listing is less expensive for companies than one on the LSE’s main market, and the requirements are not as onerous. However, AIM companies are generally of less interest to the big institutional investors and apart from the largest – for example those that make up the FTSE Aim 50 index – tend to be thinly researched by stock market analysts. One disadvantage of AIM is that although it is run by the LSE it is not classed as a ‘recognised stock exchange’ for ISA purposes. Unless a stock is also listed else- where on a recognised exchange, you will not be able to include it in an ISA and benefit from the tax break on any capital gains that this provides. Qualifying AIM stocks may, however, be eligible for Inheritance Tax Relief. More recently, we have seen the launch of PLUS, a new small & mid-cap stock exchange, which is a recognised exchange. Not a bad thing Lack of attention from major institutions and analysts is not necessarily a bad thing. Often the most profitable openings among small-cap stocks are to be found in companies that operate under the radar of big investors. With less coverage from brokers and analysts, everyone has a chance of discovering a few hidden gems. Small-cap stocks can appreciate dramatically once they get going. This is because a sizeable order may well encourage the market-makers to move prices quickly to tempt investors to trade. However, if there is no catalyst, lack of liquidity–cash provided by willing buyers and sellers – can leave prices static and investors may end up paying a wider spread. The risk with trading really small stocks is that if the liquidity dries up it becomes costly to trade because spreads (the difference between buying and selling prices) widens. As long as you are trading within Normal Market Size, you can deal in small caps via your broker’s online platform in the same way as you would deal in the blue chips. These systems generally poll a network of market makers to see if any will improve on the best bid and offer prices, which usually produces a small saving. If trading in large size or against a wide bid-offer spread, it is worthwhile telephoning the broker’s dealing desk to try and negotiate a better deal. When it comes to spread betting and CFD platforms, coverage of small caps varies. Some go down to companies worth as little as £10m, but even if a stock is not on the platform the provider may be prepared to trade via a phone call. Smaller companies have traditionally been much more open to private investors buying in at flotation and some brokers offer investors the opportunity to buy stock in a company before it has joined the stockmarket, known as pre-IPO. Such opportunities may be pretty sparse when market conditions are difficult, however. Traditional brokers will generally buy stock in a company that is about to float at a discount, and then offer this to clients. This stage can be risky, as a company’s lack of trading record and unproven business model can result in investors losing out. Institutional placings Private clients may be offered the chance by their brokers to participate in what are often institutional placings, rather than rights issues, to which they would other- wise have no individual access. Investors may also find themselves dealing with so-called small-cap specialists that will recommend shares after buying a cheap line of stock. The results from such services could be described generously as mixed. A number of specialist ‘penny-share’ dealers were subject to FSA action in 2009 following com- plaints of high-pressure sales tactics. Finally, a word about cash shells. These are companies with money but no trading operations, perhaps because they have sold their only business. There are a number of them listed on both AIM and PLUS. Under AIM rules, shell companies need to complete an acquisition or make a reverse takeover within a certain period to remain listed. Such companies can provide an alternative route for entrepreneurs seeking a listing, avoiding the trouble and expense of an IPO. Cash-shell situations can be a boon, offering investors in a company holding a small amount of cash the prospect of favourable participation in a new listed entity when decent assets are reversed into it. Equally, you could be buying a pig in a poke – a company that is under pressure to do something with its cash just to stay listed. A penny for them Penny shares are investments with a low market price and not traded on the main stock exchange. They are high-risk and difficult to sell on. The FSA has four tips for anyone thinking of buying penny shares from a dealer: Challenge the advice a broker gives you. Ask why a particular share is suitable for your particular circumstances. Research and verify that advice. Make sure you know the risks attached to the shares Ask what commission the broker will get for arranging the sale   This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements.   The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance.   You should get professional financial advice before making any investment decisions.


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