Investing in smaller companies

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6. Is it a good business?

If there is a single principle of investing in small caps it is to buy good quality growing businesses at reasonable prices.

The first part of this is identifying the good businesses. Among the factors you should consider are:

1. Management

   Try to get a handle on the quality of management, their experience in the industry, their track records, and whether they have previously been involved in any corporate failures. Find out whether they have significant shareholdings in the business, and whether there have been any directors' dealings which indicate management's confidence in their company.

2. What type of business is it?

   Is it a business with high profit margins or low ones, and how vulnerable are its margins to price-squeezing by competitors? Is the company's position protected by a strong competitive advantage (e.g. a leading brand, technical superiority, a critical mass of customers)? Ideally, you may want to consider a high-margin business that is growing and easily defended.

3. Sales and profits track record

   Is there an unblemished record of increasing sales and profits over the last 5 years, coupled with a consistent dividend payout, or is the picture more volatile than that?

4. Cash flow

   Some businesses throw off cash, others eat it up. Check whether your company has net cash on its balance sheet, and if it does, make sure that the figure is not overwhelmed by borrowings on the other side. Is it in a business that requires regular cash injections to pay for plant etc? Ideally, you may want to consider a company that creates rather than consumes cash.

5. Prospects

   Taking into account the company's size and current market position, as well as general structural and economic trends, is it a business that is going places? Has it got the potential to grow very fast if the cards go its way, and has management got the ability to manage hypergrowth?

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