Every investor dreams of being able to pick stocks that double or treble in value within a few months of being added to their portfolio. And while it's not impossible to find such good fortune among larger companies, you're infinitely more likely to find a bargain at the smaller end of the scale, where information is harder to come by, and there's a greater chance of a business being incorrectly priced by the market.
"In the small-cap universe, there's probably only one, two or maybe three analysts producing research on a company," says Dan Nichols, the manager of Old Mutual Asset Management's smaller companies fund. "Whereas in the FTSE 100 there are 40 or 50 analysts for each stock, so the chance of there being unknown information is pretty small.
"If you get it right in the small-cap arena, there's the chance to create a lot of value. Equally, of course, if you get it wrong, you can really destroy value too."
The lack of information, combined with the fact that fewer people are trading in smaller companies, means that they can be much more volatile, and are inherently much more risky for investors than larger companies. However, for those looking to mitigate some of this risk, there are a number of tax breaks which can help minimise losses if things go wrong.
Currently, investors who buy shares in companies listed on the Alternative Investment Market (AIM) qualify for so-called "taper relief", which means that if they hold the stock for more than 12 months, the tax payable on any capital gain is reduced from 40 to 20 per cent. If they hold it for more than two years, the capital gains tax (CGT) rate comes down to 10 per cent.
However, these rules are set to change in April, when the CGT rate will be set at 18 per cent, regardless of how long you hold the stock for. This will create a better tax regime for short-term speculators who want to sell out of a stock less than two years after they bought it but a slightly less advantageous one for those who hang on for the long-term. Hence, if you currently own an AIM share that you've held for more than two years, you may want to think about selling up before April, to take advantage of the 10 per cent tax rate.
The other tax advantage of investing in AIM stocks is that they are exempt from inheritance tax. Therefore, you can pass them on to your relatives free of tax, regardless of how big the rest of your estate is. While AIM companies are generally much higher risk than other larger, more established companies, there are still some relatively big businesses on AIM, such as Majestic Wines, which have a proven track record of delivering earnings growth, and which, arguably, are less risky than many much larger companies on the main market.
However, if you are investing directly in AIM or even smaller companies on the main market, it's usually well worth only putting down money that you can afford to lose. "A lot of our private clients like to have direct exposure to small companies in their portfolio," says Graham Spooner of The Share Centre, the stockbroker. "They want to get into something that is a fairly early-stage start-up, but they'll often use money they're willing to lose."
If you want exposure to the sector for a little less risk, it may make sense to let a professional choose the stocks for you, by investing in a mutual fund, such as a unit trust, investment trust or venture capital trust (VCT).
Nichols' fund is one of 59 unit trusts (and Oeics), and is the top performer in its sector over the past three years, delivering a return of more than 110 per cent during that time. In contrast, however, the worst performer over the period, the CF Canlife UK smaller companies fund, has only returned just over 1 per cent which represents a loss for investors, when you take into account inflation. Over 12 months, the CF Canlife fund has lost around 8 per cent of its value.
With many more companies to choose from in the smaller companies universe, Nichols says it is all the more important to pick a good manager, who has an eye for good value.
"A small-cap manager is looking at upwards of 1,000 stocks, compared to 100 or 250 with a blue-chip or mid-cap manager," he says. "So it's crucial to pick the right manager."
The advantage of investing in a unit or investment trust, is that you can put them into an ISA (up to 7,000 each tax year) where any gains or income will be free from tax.
Another alternative is to consider putting your money into a venture capital trust, where the tax breaks are even more generous. If you hold a VCT for five years or more, you qualify for a 30 per cent income tax kick-back which effectively means you are only paying 70p for every 1 you invest. Furthermore, all gains and income are also free from tax.
Ben Yearsley, an investment manager at Hargreaves Lansdown, the Bristol-based financial adviser and stockbrokers, says there are a number of VCTs which specialise in investing only in AIM-listed companies, while there are others which invest in unquoted businesses. The latter tend to be riskier propositions. He warns, however, that although the tax breaks on VCTs are generous, there are disadvantages.
"The problems with VCTs is that they have high charges, a lack of liquidity and they obviously slip to a discount to their net asset value," he says. "But if they're doing what they're supposed to, you shouldn't need to sell in a hurry."
Although most VCTs trade at a discount to the value of their assets, the managers will usually agree to buy out investors who want to sell their shares, at a discount of 10 per cent to the trusts' net asset value per share. The best VCTs have delivered annual returns of more than 17 per cent a year, while the worst have lost more than 10 per cent a year. However, there are only a small handful which would have left investors sitting on a capital loss, once the tax relief has been taken into account.
Yearsley says that investors should not have any more than 5 to 10 per cent of their equity portfolio in smaller companies, and warns that investors should be wary that smaller companies, as a whole, tend to perform worse when the broader medium-term economic outlook is perceived to be poor, as it is at the moment.
Nichols agrees: "It makes sense to talk about small companies as a separate asset class. At certain periods of the economic cycle, you would expect it to perform in a certain way. For example, when people have appetite for risk, you would expect it to outperform."
He concedes that due to the slightly bleaker economic outlook at the moment, he has been repositioning his fund accordingly. "We've been trying to position our portfolio on what we consider to be more defensive stocks and sectors," he says. "For example, we're quite keen on the support services and healthcare sectors, which can deliver good growth regardless of the economic environment. Equally, we're avoiding areas which are exposed to the consumer, and which are sensitive to interest rates, such as housebuilders."
Unless you're an experienced investor, it's worth getting some advice before you invest in a higher-risk area such as the smaller companies sector.
To find an independent financial adviser in your area, visit www.unbiased.co.uk.
Solid bets for the future
If you're looking to invest directly into smaller companies, Dan Nichols, the manager of the Old Mutual Smaller Companies fund says it is worth considering more defensive businesses, which are likely to continue generating solid earnings growth, even if the economy suffers the severe slowdown that some are predicting.
His favourites include Babcock International Group, which provides support services to the Ministry of Defence, servicing British submarines and other military equipment. With ongoing military programmes in Iraq and Afghanistan, Nichols says Babcock's revenues look to be relatively secure over the coming years.
He also picks out Southern Cross, a care home provider. With a growing number of people in need of long-term care every year, companies such as Southern Cross also have a relatively secure income stream which should be resilient in tougher economic conditions.
If you're looking for a professional to pick the smaller companies for you, Ben Yearsley of Hargreaves Lansdown recommends Dan Nichols' Old Mutual fund, as well as Artemis' Smaller Companies fund, managed by John Dodd, and Standard Life's Smaller Companies fund, run by Harry Nimmo.
For those in search of VCTs, Yearsley recommends the new Matrix Income & Growth fund, which invests in unquoted companies. For those looking for an AIM VCT, he recommends the Noble AIM VCT, managed by Paul Jourdon.
For more information on VCTs available this year, visit www.h-l.co.uk/vct or www.taxefficientreview.com. For performance information in unit or investment trusts, visit www.trustnet.com.