Investing in smaller companies

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2. The arguments in favour of smaller companies

As with any investment approach, small cap investing has its proponents and its detractors. Its proponents argue the following points in its favour:

1. It's fun

   There's something appealing about investing in something other than FTSE 100 stocks. Much more satisfying to invest in an unknown company and watch it develop into Microsoft. But - and it's a big but - the fun soon goes out of it if you lose all your money.

2. Small caps are under-researched by the professionals

   Institutions concentrate their research on major companies with market caps of £500m or more. Why? Because their clients often deal in large volumes, which is only possible with large companies, and the funds themselves like to own stock that is easily re-sold. So small caps tend to be under-researched - which leaves an opportunity for the private investor.

3. Small caps are just too small for professional fund managers

   A professional fund manager responsible for hundred of millions of pounds cannot realistically divide his fund into hundreds and hundreds of small investments in small companies. He has to dole it out in big lumps. Again, this means that small caps are ignored by the majority of institutions.

4. Small caps are just too exciting for professional fund managers

   Obviously, this is only partly true, but the core theme - that fund managers are looking for an excuse not to buy an exciting small stock - has a grain of truth. Peter Lynch, an exceptional investor, describes his professional kith and kin as a bunch of run-of-the-mill, dull, comatose, sycophantic, timid camp followers and copycats, hemmed in by the rules.

5. Elephants don't gallop

   It is much easier for a small company to triple its turnover and earnings than it is for a large company, because the small company starts from a lower base. Since share price tends to follow earnings, it is easier for a small company's share price to double or triple than it is for a large company's. This is a massive generalisation, but the principle is sound.

1. What is a small cap? 2. The arguments in favour of smaller companies 3. The arguments against smaller companies 4. The aim of investing in smaller companies 5. No single method 6. Is it a good business? 7. Can you buy at a reasonable price? 8. Penny shares and other speculative stocks 9. A note about tax 10. Other tips 11. Conclusion

• Investor's Guide To Selecting Shares that Perform