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David Kuo: Small wonders make big profits in these uncertain economic times

Investment Insider

In a fragile recovery, small is most definitely beautiful. Those investors who have recognised the resilience and growth of small- and medium-sized enterprises have been rewarded.

In 2010, the FTSE Small Cap index gained 16 per cent while the FTSE 100 index increased 9 per cent.

Unfortunately, there is no precise definition of a small cap, which makes identifying them a little tricky. But we can still have a go. The FTSE has three different indices. These are the FTSE 100, the FTSE 250, otherwise known as the mid caps, and below them the small caps. In the mid caps, the smallest company is valued at about £300m, and in the small caps, the largest company is between £300m and £350m. You could say that small caps are any companies with a value of less than £350m, but the figure is not set in stone.

Small caps tend, though not always, to focus on the domestic market. Consequently, they can be seen as good bellwether shares for the UK economy.

Latchways is a good example of a small cap company that has significant exposure to the UK economy. It has carved out a lucrative niche by focusing on a small segment of the construction industry. It makes safety equipment for people working at height. More specifically, it makes carabinas that let construction workers attach themselves to the outsides of tall buildings or bridges. Latchways shares slumped to 412p in 2009 in anticipation of tough times for the construction industry. But, they rebounded last year to 1,060p, rewarding investors with a 157 per cent increase.

Fuller Smith & Turner is a brewer that punches well above its weight. It has a market value of £350m, so it's dwarfed by the likes of SABMiller, which is valued at £33bn. Shares in Fuller Smith & Turner, as expected, fell in 2008 to 304p but have recovered steadily to 619p. Austerity has clearly driven us to drink.

What is the secret behind these two companies' success? It is quite simple. Both have products which continue to be in demand. It also helps to have a balance sheet that is well protected with cash and little in the way of debt.

What's more, too many bosses jump from one company to the next, spending more time managing their careers than the businesses. It is important to identify those with significant shareholdings and modest compensation deals. Their interests are more likely to be aligned with ordinary shareholders like you and me.

David Kuo is director of financial website Fool.co.uk