Little fish can be sweet

Small cap stocks tend to outperform while the good times roll, bulls are in charge and risk appetite is elevated. The chart below shows how the FTSE Small Cap index has left the FTSE 100 for dead during the course of the bull market which began in March 2009 and even the AIM All-Share has (just) managed to outpace the UK's megacap benchmark.

Mid - and small-caps have outperformed during this six-year market advance

Source: Thomson Reuters Datastream

This picture repeats itself over the last 12 months, with the mid-250 and Small Cap indices firmly in charge but it is of some concern to see that large caps have asserted themselves in 2015.

Mid- and small-caps have outperformed during this six-year market advance

Source: Thomson Reuters Datastream

Mid- and small-caps have outperformed during this six-year market advance

Source: Thomson Reuters Datastream

A shift from flightier small caps to more elephantine names often signals that a bull market is getting long in the tooth, as clients and advisers seek the relative safety of better financed, more diversified, larger companies so this is a trend that must be watched, by tracking the AIM and FTSE Small Cap benchmarks and the Russell 2000 relative to the Dow Jones Industrials and S&P 500 over on the other side of the Atlantic.

A preference for larger caps could be the result of clients' preference for income, while it could also reflect many funds' focus on the need to offer daily liquidity – small caps can be more difficult to trade, particularly when markets become more difficult. Equally, many brokerages are offering relatively little coverage of the UK market's minnows, as there is not enough secondary market volume or primary activity (flotations, rights issues, acquisitions and the like) to justify the cost involved. This creates an information gap, deters clients from getting involved and can lead to a vicious circle as less trade begets less interest and sliding share prices amid diminishing volume.

Yet for risk-tolerant, patient advisers and clients this could create an opportunity to buy ignored, unloved, misunderstood stocks cheaply. The hard part is how to identify such companies and this is where a good fund manager can truly add value. It may not be a coincidence that one new micro-cap investment trust has just begun operations and another begun to seek capital to invest, namely River and Mercantile UK Micro Cap and Mercantile and Gervais Williams' proposed Miton MicroCap Trust. The latter, which will focus on AIM-quoted firms with a market cap of less than £150 million, is due to publish its prospectus this month and is seeking to raise £100 million.

How to access small caps

Small caps' volatile performance means they are not suited to all clients' portfolios, given the risks involved, general lack of income and relatively lengthy time horizon which may be required for investments to bear fruit. The detective work involved in spotting small-cap winners, and dodging the inevitable duds, also means those clients who do want exposure may prefer to get it via a fund, be it actively or passively managed, rather than by selecting individual stocks.

• According to Morningstar there are over 40 actively managed OEICs which target UK small caps, although some reach as far as the FTSE 250 and very few specialise in just AIM-quoted companies. The table below lists the best five performers over the past five years, to provide a few examples.

Best performing UK small cap OEICs over the last five years

Source: Morningstar, for UK Small Cap Equity category. Clean funds only.

Where more than one class of fund features only the best performer is listed.

It may also be worth looking at funds which have a broader, more flexible mandate. JO Hambro UK Growth Fund is an example here. Run by Mark Costar, the multi-cap fund typically features between 50 and 60 stocks, of which between a third and a half lie outside the FTSE 100. Costar believes the small-cap arena is less competitive, as there is less broker coverage, and argues it is possible to find hidden gems down on the market's seabed, especially at a time when he believe the FTSE 250's outperformance means it is difficult to find value among the mid-caps right now.

The JO Hambro UK Growth Fund lies in the UK Flex-Cap equity category, according to Morningstar, and several of the performance leaders here over the past five years are no strangers to small-cap exposure.

Best performing UK flex-cap OEICs over the last five years

Source: Morningstar, for UK Flex Cap Equity category. Clean funds only.

Where more than one class of fund features only the best performer is listed.

• Investment trusts. Clients could also buy shares in a closed-ended fund. According to industry body the Association of Investment Companies, there are 16 dedicated UK Equity Small Cap specialists. Again, the table below lists the best five performers over the past five years, to provide a few examples.

Best performing UK small cap investment trusts over the last five years

Source: Morningstar, for UK Smaller Companies category.

• Exchange-Traded Funds. The pickings are thinner here,  perhaps owing to issues which reflect the asset class' underlying liquidity. Morningstar lists one small-cap ETF,  iShares MSCI UK Small Cap, and its trading history only stretches back three years.

* Share price. ** Includes performance fee

Take AIM

Small caps have the potential to be more dynamic than the cumbersome giants of the FTSE 100 and FTSE 250. Fledgling firms are frequently guided by entrepreneurial management and have the ability to grow sales rapidly from a small base. Furthermore, small-caps are often focussed on niche markets or are the beneficiaries of secular growth trends, which mean they are less reliant on the wider economy. This may be no bad thing, depending on the circumstances.

As these fledgling firms are by definition at the early-stage of their growth journeys, any number of catalysts can trigger dramatic share price upside. To highlight just a few, they include breakthroughs into profitability, contract wins which have a transformational effect on sales and earnings, or in the case of the biotechnology and resources sectors, commodity finds or the passing of regulatory approvals. Though buying a stock purely on bid hopes is a mug's game, traders might note that small-cap prey are frequently picked off by bigger corporate predators. This is a trend worth bearing in mind at a time when many cash-rich mid and large cap firms, with greater exposure to the moribund wider economy, need to turbo-charge their own sluggish growth rates.

Sceptics who prefer the potentially calmer waters presented by large caps will quickly run out a long list of reasons to avoid nascent firms. Small cap companies usually have greater exposure to a single product or service, can be overly reliant on the founder or chief executive and can be over exposed to one geographic region. This means they have a less diversified revenue base and can be vulnerable in the event of macroeconomic shocks, technological change or other unforeseen events.

AIM's name has also suffered because of some corporate governance issues, where the boardroom shenanigans at and subsequent delisting of Rangers Football Club and sudden disappearance of the senior managers of China-based Naibu provide lots of ammunition to the critics.

Despite such unwelcome headlines, supporters argue AIM is a much healthier market than in years gone by, even if its smaller. The number of stocks quoted on AIM peaked at 1,694 in 2007, with a market value of around £98 billion, just as the bull market topped out and the credit crisis struck. As of the end of March, AIM was home to 1,088 companies with a collective market cap of £72 billion.

Despite its diminished size, a pair of Government initiatives from 2013 have helped to tackle the bugbear of illiquidity. Chancellor of the Exchequer George Osborne granted ISA eligibility to AIM-quoted stocks, which were also exempted from stamp duty. In 2014, the average daily value of AIM shares traded was £169 million, the best figure since 2008, while the average number of bargains struck and average level of daily shares traded way came in only a touch below the record marks set in 2013.

Over 3,500 firms have joined AIM and raised £90 billion since 1995

Source: London Stock Exchange. *To the end of March

A grand total of 118 firms joined AIM in 2014 and just 106 left it (five via promotion to the Main Market) although so far in 2015 the 16 new entrants have been outnumbered by 31 departures. At least money managers are clearly being more selective about the floats they are prepared to buy and this greater focus might help the platform's long-term performance, especially if the sudden appearance of two dedicated micro-cap funds is a sign that valuations stand at interesting levels.

Russ Mould, AJ Bell Investment Director