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Are Small Companies Suitable For Long-Term Portfolios?

By Maynard Paton (TMFMayn)
November 22, 2001

Carburton Street, London -- Are small companies suitable for long-term portfolios? As with most questions associated with the stock market, there's never a clear answer. On the one hand, stock market tiddlers can be deemed "risky tinpots" at the mercy of large industry rivals. But on the other, they can be described as "potential ten-baggers" with plenty of scope for growth.

For and against

The general arguments for and against small companies are:

* Small companies have more room for growth. A company with 100m of revenues will find it easier to double its turnover than a company with 1b of revenues. "Elephants don't gallop", as Jim Slater once said;

* Small companies tend to be ignored by institutional investors, so the chances of finding a "bargain" are increased;

* Both the operational diversity and the accounts of small companies tend to be less complex than that of large companies;

* Small companies are likely to have less experienced management at the helm, with "growing pains" likely to surface at some point, and;

* Small companies can get squeezed by large rivals;

Body blow

In my opinion, the real danger for small company investors is the final point. More often than not, small companies come to grief when larger industry cousins start flexing their competitive muscles.

A classic example is Body Shop (LSE: BOS). Back in 1980s, the company was a stock market darling. Investors enthused over the growth prospects of the innovative toiletries retailer. However, what investors forgot to consider was the competition, and how Boots (LSE: BOOT) and the rest would promptly latch on to Body Shop's environmental bandwagon. This chart tells the story of Body Shop in the 1990s.

In more recent times, crisp manufacturer Snackhouse (LSE: SNK) and telecom firm Atlantic Telecom (LSE: ATN) have both been dealt fatal blows by the likes of Pepsico (NYSE: PEP) and BT Group (LSE: BT.A). If you've not got a competitive advantage, it can be tough for a tiddler.

Watch list

Here are the five smallest companies from the Qualiport's own watch list:

Company                   Share price     Market Value
                               (p)             (m)

Ultraframe                    205              199
Games Workshop                520              156
Ulster Television             283              148
Metal Bulletin                190              103
Latchways                     295               32

Importantly, all five have commanding positions in their respective fields. Ultraframe (LSE: UTF) dictates the UK's conservatory roofing market, Games Workshop (LSE: GAW) is without equal in the world of wargaming, Ulster Television (LSE: UTV) generates three times the revenues of its nearest commercial rival, Metal Bulletin (LSE: MTLB) publishes the definitive reports on commodity markets, while Latchways (LSE: LTC) is one of just two major players in the fall arrest safety sector.

While relatively small, all five companies are big industry players in their own right. And that's what really counts. Thus for long-term investors, the absolute size of a company is not that important. When considering long-term investments, the key is to identify companies with proven, sustainable competitive advantages, irrespective of corporate size. 

Simple bargains

Of the other arguments given, I'd say the simplicity that smaller companies tend to exhibit is a definite advantage. As companies grow, they have a nasty habit of embarking on acquisitions, diversifications, overseas expansions and the rest, all of which are activities that make the financial analysis a complex task. 

But of the remaining arguments, I'm less convinced.

For starters, to get an acceptable investment return, who needs growth? Take Imperial Tobacco (LSE: IMT). Making cigarettes is hardly a growth industry, but anybody buying Imperial shares during February 2000 could have doubled their money in eighteen months. While small, dynamic growth companies get all the headlines, "value" accompanying stable, pedestrian earnings growth can also generate decent portfolio returns.

Indeed, shares of Imperial and other so-called "old economy" firms were sold off heavily last year. So it seems companies of certain sectors, as well as certain sizes, can and do disappear from the radar screens of institutional investors.

And on the question of management, my gut feeling is that the good and the bad are equally distributed amongst the stock market. Allen Yurko and Lord Simpson, ex-bosses of Invensys (LSE: ISYS) and Marconi (LSE: MONI) respectively, are prime examples of FTSE 100 mismanagement.

Whether you look at small companies or large companies, the crucial points when considering a long-term investment remain the same:

* Do you understand the company?
* Does the company have a sustainable competitive advantage?
* Is the company's management competent?
* Is the company attractively valued?

Size, as they say, doesn't matter.

More: Qualiport discussion board 

The author owns shares in Games Workshop and Latchways