Six golden rules for investing in small-cap stocks

Ken Wotton talks to FE Trustnet about his process when finding fast-growing, innovative and disruptive companies in the small-cap space.

With many smaller companies trading at sizeable valuation discounts to larger counterparts, smaller caps may offer a fertile ground for investors. As this area of the market attracts less attention from professional research organisations and brokers, many investors are unaware the UK is home to a vast number of high-quality smaller companies. This presents an opportunity for dedicated investors to back some of these fast-growing innovative and disruptive companies.

However, selecting such winners requires patience, as well as a commitment to invest in the resources necessary to research such a diverse group of businesses. At Gresham House, every stock considered for investment is thoroughly interrogated utilising proprietary research. A ‘conviction score’ is awarded to each potential stock based on six key fundamental components.

1. Management and shareholder structure

We place a significant focus on entrepreneurial and high-quality management teams as a key driver of business growth and shareholder value creation. We also analyse shareholder structure, management ownership and incentives, and alignment of interest with our objectives as investors.

2. Long-term corporate strategy

We assess the company’s strategic positioning and how management is looking to enhance strategic value. We measure the clarity, simplicity and deliverability of the business strategy and how it links to long-term value creation.

3. Realistic market opportunity

We seek to understand the size of the company’s realistic addressable market and the trends and sector dynamics likely to affect this over the life of our investment. We also look for a company’s management to be able to clearly define its opportunity, including ways to expand its addressable market through international expansion, new product development and/or acquisition.

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Please note, the views expressed in this article are Ken’s own and should not be taken as investment advice.