Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Smaller quoted UK companies have soared of late, hitting a record high yesterday, as the FTSE small-cap index has risen by almost 70% over the past 12 months.

The FTSE index of smaller companies, excluding investment trusts, has performed even better than the FTSE 350, which includes the largest blue chips stocks in the FTSE 100. That too has risen well over the past year, but it does leave the benchmark FTSE 100 index still more than a tenth away from its 2018 peak, while the small caps have simply shone.

This outperformance by the small cap sector is not entirely new. Smaller quoted companies have long had the capacity to outperform their larger counterparts - because of to their size, small caps have the potential to grow more quickly.

That’s also why, for stock pickers, the small-cap end of the market has always been an exciting place to be. Admittedly, perhaps too exciting for some, as they are also inherently more volatile and therefore riskier.

Adaptability and versatility are the innate strengths of these companies though, and it is these same strengths that have been the name of the game since the pandemic threw our lives into disarray.

True to the saying “mighty oaks from little acorns grow”, small companies that are nimble and have innovative CEOs at the helm have been perfectly placed to make the most of the changes forced by the pandemic.

What is a small cap stock?

The definition of small cap varies and can shift over time, but generally the companies deemed to be small cap will be in the bottom 10% of the UK market in terms of their market capitalisation. But that does not mean they’re not household names, or profitable businesses. DFS, Halfords and Superdry are all FTSE Small cap constituents. Food wholesaler Booker, which was bought by Tesco, and tonic water-maker Fever-Tree, are two small caps that have also come good.

We have also, by extension, seen funds that focus on smaller companies tend to outperform their benchmark indices by a greater proportion than their large-cap peers.

As with individual companies, funds differ in what they class as small cap and how they manage constituents. That’s especially the case when they do what all small cap investors really want them to do - grow in size. For instance, while Edinburgh Worldwide Investment Trust holds on to investments as they increase in size - Tesla is currently its-largest holding - Henderson Smaller Companies Investment Trust will sell a holding within six months if it becomes so large that it enters the FTSE 100. BlackRock Smaller Companies Trust only invests in new holdings with a market cap beneath £2 billion and will sell any stock that enters the FTSE 100 within 30 days of entry. The smallest cap fund we have on the list of preferred funds is the Threadneedle UK Mid 250 Fund managed by James Thorne.

How to spot a winner

Not all small caps are household names, at least not yet - as no doubt every company chief executive has the ambition to make theirs one - so this means they tend to be followed by fewer analysts and are covered less in the media, with the result that fewer investors are aware of them.

However, this relative anonymity is also the sweet spot. Once a small cap company starts to deliver - and with a smaller company that means a potential double whammy of growth and re-rating - its upside potential can have serious legs for investors who got in early. It may be far greater than could ever be possible with a larger company.

Of course, not ever small cap is destined for greatness. And the wild - and often blue sky - ride of the dot.com boom and subsequent bust proved that to anyone who made the wrong investment choices back then.

The golden rules of successful investing should still be applied to small caps. Diversification is a must. You need a balanced portfolio with plenty of large cap ‘plodders’ to even out the extreme ups and downs that tend to come with small cap investing.

Spotting a winner can be a matter of trial and error, but if they are to really fly, look for a company that you could call a market leader, one that has a USP, is led by a strong management team and is, ideally, already cash generative and profitable.

And remember that while some of these companies will be innovative, exciting and fresh, they don’t have to be, to be a winner. Take Halfords, which was perfectly poised to take advantage of the cycling boom that took hold in the first lockdown. It has since seen its share price soar over the past year.

And while Halfords is one of the top performers among the small cap stocks over the past 12 months, it’s not the only example of double-digit share price growth in the small cap sphere. It is however, the sort of performance that blue chip companies - and investors - can only dream of.

Five year performance

(%) As at 30 April 2016-2017 2017-2018 2018-2019 2019-2020 2020-2021
FTSE Small Cap

20.5

5.9

-3.5 

-18.5

54.8

Past performance is not a reliable indicator of future returns

Source: Refinitiv, returns in US dollar terms as at 05.05.21

Important information

Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Overseas investments will be affected by movements in currency exchange rates.   Select 50 is not a personal recommendation to buy or sell a fund. The Edinburgh Worldwide Investment Trust invests in overseas markets and so the value of investments can be affected by changes in currency exchange rates. It also invests in emerging markets which can be more volatile than other more developed markets. These funds invest more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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