Investing in smaller companies with big ideas

Putting your money into young, ambitious businesses, early in their development can be hugely lucrative over the longer-term.

The most successful will repay your faith with generous dividends and handsome share price increases on their journey to becoming household names. And a quick look at the biggest companies on the planet illustrates this point: Google, Amazon, Microsoft and even Tesco all started out as relatively modest firms with big ideas.

Bill Gates founded Microsoft in the mid-1970s and floated it on the stock market in March 1986. At that point, its shares were priced at $21 each and the market capitalisation was around $700m^.

Today, the shares are trading at $281, and the company is worth more than $2 trillion^^. Investors that backed the company 35 years ago will now be sitting on a fantastic profit.

Benefits of smaller companies

Every investor dreams of making a fortune by accurately predicting the next Microsoft. And there’s no denying that such ventures are exciting to invest in. Many of them are coming up with innovative approaches that can potentially change how we live.

Their size enables them to be nimbler and more responsive to trends than their larger market capitalisation rivals. This can give them a distinct business advantage.

In addition, smaller companies are often under-researched by analysts. This means the stock market can easily overlook important factors and draw the wrong conclusions. As a result, canny investors that have done their research can swoop in and buy undervalued shares and make a profit when the market catches up to their potential.

Dividends

Generally, smaller companies can be less likely to pay dividends to investors as they are often in a growth phase and looking to reinvest in the business.

However, some smaller companies do pay dividends and those from firms listed on AIM have recently rebounded strongly, according to a recent report from The Link Group. Its analysis revealed underlying pay-outs soared 56% to £265m during the second quarter of 2021 as Covid-19 restrictions eased^^^.

Potential problems

Of course, investing in smaller companies is not risk-free. By their very nature, many of these companies are at an early stage in their development and could be unpredictable. This means their products and services may be unproven or they are at risk of increased competition from better-equipped and more established rivals.

For every success story, there are plenty of disasters. While some firms will enjoy rapid growth, many more will remain small forever or fail completely. In addition, investments in small companies can be very volatile, with the share price swinging quite dramatically. This can result in significant share price falls. So, it’s not an area for the faint-hearted.

How to invest in smaller companies

You can buy the shares of individual smaller companies. This is an option if you have a strong feeling about a particular name – and are happy with the risk being taken. If the stock subsequently soars in value, your decision will be vindicated. However, if the share price takes a while to rise, or even falls, then you could be out of pocket. If you have invested in a single stock that goes bust, you could lose all your money.

Of course, an alternative to buying into individual businesses is opting for an investment fund run by a manager who specialises in smaller companies. A fund will invest in many different smaller companies, which will give you diversification and reduce the risk – and impact - of individual failures.

There are plenty to choose from in the IA UK Smaller Companies sector, so you’ll need to take some time to look at their objectives and their longer-term aims. Alternatively, you could look at the smaller companies funds our research team has identified for the Chelsea Selection.

Here are a few funds that might be worth considering and some of the stocks in which they invest.

Liontrust UK Micro Cap

Managed by Anthony Cross, Julian Fosh, Victoria Stevens, Matt Tonge and Alex Wedge, this fund aims to identify companies with a durable competitive advantage. The hope is, this will allow them to defy industry competition and sustain a higher-than-average level of profitability for longer than expected. 

The largest holding is currently Churchill China, a manufacturer of professional tableware, which has a 2.6% share of assets under management, according to the most recent fund fact sheet^^^^. Technology is the most significant sector weighting with 28.7%^^^^.

The fund’s latest commentary also highlighted Yourgene Health, an international molecular diagnostics group, whose revenue was up 80% in the three months to the end of June 2021. It was led by Covid-related services and product sales. “The company accelerated investment in its product capability and strengthened its position in North America during its previous financial year,” the team added.

Unicorn UK Smaller Companies

The aim of the fund is to achieve long-term capital growth by investing primarily in UK companies within the Numis Smaller Companies plus AIM index. This covers the bottom tenth of the main UK equity market – by value – as well as AIM stocks that meet the same size limit.

The approach of the portfolio, which is run by Simon Moon, with Alex Game as assistant fund manager, is to identify individual companies that look attractive. In the latest fund fact sheet, the managers highlight the success of Microlise, which has enjoyed a positive share price performance since its IPO on AIM in July 2021^^^^.

“Microlise, which is a software business, also announced during the month a contract with JCB, a manufacturer of construction equipment, to provide transport management software,” it stated.
At present, engineering has the largest sector weighting in the fund of 18.8%, followed by the 13.3% in financial services^^^^.

TB Amati UK Smaller Companies

This unconstrained fund, which is run by a team of small cap specialists, looks for structural UK growth businesses that can grow faster than the economy.

As far as sectors are concerned, financials and health care are the two most significant, with each having a 16.9% share of assets. The largest stock weighting in the fund of 3.1% is in OSB Group, a specialist lender focused on underserved sub-sectors of the mortgage market. The next biggest is Renalytix, an artificial intelligence-enabled in vitro diagnostics company, and eyewear supplier Inspecs, both of which have a 2.4% share of assets under management.

According to a recent fund update, a new position was taken in Ergomed, a global contract research organisation that provides services to oncology and rare disease drug programmes. “The company is growing strongly, both organically and through acquisition, with the US being a target market due to the high levels of trial activity and drug launches,” it stated. Other positive recent contributors to the fund’s performance have been Accesso, the online ticketing and virtual queuing specialist, whose revenues are ahead of expectations.

^Source: Microsoft investor relations FAQ. Microsoft’s IPO offer price, 13 March 1986
^^Source: Google Finance, 5 October 2021
^^^Source: Link Group AIM Dividend Monitor, Issue 4 September 2021
^^^^Source: fund provider, 31 August 2021

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice. Mention of specific securities is for illustration only and not a recommendation to buy or sell those securities.