Keep looking out for all things great and small cap

In today's world of ever-increasing concentration, a revival of either Eighties fashions or premium valuations looks remote

The FTSE SmallCap index has enjoyed a spirited revival since the dark days of December 1998, which marked its nadir after a long period of relative decline, neglect and marginalisation. The next year was a vintage year as investors and corporate predators alike bought up assets, often at knock-down valuations. The mood music changed in October 1999, with a fresh impetus gaining sway. From that date until very recently the key driver of small cap outperformance has been primarily the abundance of technology companies within the ranks.

The FTSE SmallCap index has enjoyed a spirited revival since the dark days of December 1998, which marked its nadir after a long period of relative decline, neglect and marginalisation. The next year was a vintage year as investors and corporate predators alike bought up assets, often at knock-down valuations. The mood music changed in October 1999, with a fresh impetus gaining sway. From that date until very recently the key driver of small cap outperformance has been primarily the abundance of technology companies within the ranks.

But with the narrowing of the valuation discount and crumbling of enthusiasm for technology shares, what will sustain investor interest in smaller companies? Will the market resume its exclusive concentration on blue chips, which it abandoned two years ago?

The last period of sustained small cap outperformance, which occurred in the heady 1980s, was driven by the widespread belief in the inherent superiority of smaller companies in the newly promoted enterprise culture. Small was indeed beautiful, faster earnings growth was rewarded by premium ratings and no portfolio was complete without a full quota. But in today's world of ever-increasing concentration, a revival of either Eighties fashions or premium valuations looks remote.

Successful investment in smaller companies is more than an index story. There are some 2,000 quoted shares in the UK outside the FTSE 350 Index, accounting for around 5 per cent of the total value of the stock market - equivalent to little more than half the size of Vodafone. But as fast as the pool is replenished by new issues (usually in fast-growing sectors) it is being drained by the action of other companies reverting to private status or being taken over. Only a minority are worth investing in; many are dull with little scope to produce positive returns. In the absence of a general small cap revival, generating worthwhile returns from this diverse universe depends on thorough research and effective stock selection. This requires specialist skills, a flow of investment information and, above all, access to company managements. The rewards can be spectacular; shares in 17 companies rose by more than 1000 per cent in 1999.

It is all too easy to dwell on the disadvantages of investing in smaller companies. Lack of liquidity, the risks arising from being a minority shareholder, relatively high dealing costs and the sheer effort entailed in making decisions from such a large number of potential candidates. But these are the very features which provide such a fertile ground for the determined stock-picker. The inefficiency of these markets provides tremendous scope for discovering exciting but under-researched gems whose valuations take little account of their growth potential. Both in the UK and Continental Europe smaller companies are at the cutting edge of innovative technologies and processes, often occupying niche areas of international importance.

Finding tomorrow's FTSE 100 Index winners when still in the early stage of their life cycle is the dream of every analyst! Businesses like Capita, Logica and Sage have completed this journey, hugely enriching those who discovered them when they were relatively unknown and who have held on for the ride.

There is potential to repeat this process, especially with the continuing explosive growth of new technologies. Successful stock-picking will produce rich rewards, even against the uncertain background for smaller companies in general.

Private investors face a number of hurdles in realising the full potential from smaller companies. They are generally denied access to new issues, which are usually placed with institutional fund managers. Many of these have generated stunning returns this year in early dealings. While broker research is more readily available and media coverage is improving, meeting company managements is not usually possible. This inevitably increases the level of risk, especially if an individual buys only a limited number of shares, without fully understanding their fundamentals.

The losses resulting from acquiring dot.com shares earlier this year illustrates this point all too graphically. An alternative route is to buy a well-managed specialist collective fund. These harness small cap potential, limit risk by investing in a broad spread of companies and relieve individuals from the effort required to find the winners.

* The writer is head of global analysis at M&G. Derek Pain is away