UK small firms flying despite the downturn

New research says investors could lose out if they ignore companies close to home.

Online fashion market leader ASOS wasn't heard of 10 years ago

Investors shouldn't ignore the potential of British businesses, according to new research.

Brian Dennehy of FundExpert reckons the UK small-business sector "represents a rich vein of UK potential in this time of economic gloom".

His evidence? "The UK smaller companies sector was the most profitable IMA (Investment Managers Association) sector, bar none in 2012," he points out. The sector climbed 22.6 per cent over the year.

"And in the last six months small caps have outperformed their large-cap peers with the FTSE Small Cap index climbing 17.65 per cent compared to the 11.14 per cent increase recorded by the FTSE 100."

Mr Dennehy believes that there's more upside to come – with the right stocks.

"While the easy money was made in 2012, the key to investment returns in 2013 will be finding the exciting British businesses that are growing profits despite the economic backdrop, and identifying the funds that invest in them," he said.

Adrian Lowcock of Hargreaves Lansdown said the recent outperformance comes as no surprise.

"The continuation of smaller companies to deliver is not too surprising as they do tend to perform well when stock markets are rising, confidence grows and investors are willing to take on more risk," he explained.

Mike Prentis of BlackRock Smaller Companies Trust, said recent economic good news, such as the UK avoiding a triple-dip recession, strengthens the argument for small firms.

"In the past, UK smaller companies have tended to do well coming out of recession and going into periods of growth," he said.

Successful smaller companies can offer investors massive potential especially if they are able to grow and take on established market leaders.

"We have seen the likes of Rightmove and ASOS dominate their markets when only 10 years ago they were not even heard of," Mr Lowcock pointed out.

FundExpert examined the holdings of the top-performing UK smaller companies funds to discover which stocks were the most popular. They came up with three. First is buy-to-let lender Paragon which is showing positive signs after a few years in the doldrums as a result of the slump in the property market since 2008.

"After a difficult recession the last two years have seen a steady recovery in the share price and conditions are looking bright," said Mr Dennehy.

Next is Xaar, which supplies industrial inkjet printheads.

"It's just published its strongest results statement in years and ahead is potential entry into the semi conductor market," he said.

Finally, Mr Dennehy picks translation business RWS.

"It has strong intellectual property through its skilled employees and benefits from the global growth in research and development."

Rather than investing in the individual stocks, you can access them through a fund, such as Franklin Smaller Companies, Mr Dennehy said.

However, over the last six months the sector's top performer was Fidelity's UK Smaller Companies fund which rose 27.3 per cent. That was followed by funds from Ignis, up 20.57 per cent, and R&M, up 19.31 per cent. Franklin's fund climbed 17.33 per cent.

Meanwhile Mr Lowcock favours Old Mutual UK Smaller Companies .

"At a sector level, it is overweight in electronics, technology and media, as well as UK housebuilders which fund manager Daniel Nickols believes will benefit from government support and improving profitability," he said.