Three ways to invest in small companies

Most investors like to buy shares in big name companies. 

Bigger companies tend to be big because they’re successful and, because they’re successful, it makes sense that you’d want to own a chunk of them.

One of the problems with this is that large companies often struggle to grow. Take an oil giant like Shell or a big bank like HSBC. Both companies make lots of money but they’re so large it makes expanding tough. Elephants don’t gallop.

That may not be a problem for investors looking for dividend income. But as expansion is often tied to share price increases, some investors prefer to look for smaller companies that still have a lot of growth left in them.

Investing in these sorts of companies, the logic goes, means more opportunity for share price growth and thus a higher return on your investment.

What is a small company?

This may seem like a facetious point to make but it’s worth thinking about what makes a ‘small’ company ‘small’. 

There are lots of definitions floating around and so, if you are going to invest in investment trusts or ETFs, you’ll want to know what ‘small’ means to the firms managing those funds.

Most of them invest on the basis of market capitalisation. That is, the total value of a company’s outstanding shares determine whether or not it’s ‘small’.

For example, the iShares MSCI UK Small Cap ETF tracks an index of more than 200 small companies in the UK. Their inclusion in that index is determined by their market capitalisation.

But market cap is not always what defines a small company. The North Atlantic Smaller Companies Investment Trust (NASCIT), for example, invests heavily in unlisted companies, making market cap redundant. 

In fact, the trust has no clear definition of ‘small’, so it’s more up to you as an investor to see if you like what it’s buying.

Checking these things is an important step to take. Many people buy into small company funds thinking they're getting exposure to early stage startups. The odds are that won’t be the case, so make sure you’re getting what you think you’re paying for.

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Investing in small companies with investment trusts

One way to get exposure to small companies is to buy shares in an investment trust.

You have plenty of options here and the remit of the different trusts on offer is pretty broad.

We’ve already mentioned NASCIT, which can invest in firms based in countries bordering the North Atlantic Ocean and has holdings in LSE and AIM-listed companies, as well as unlisted businesses.

Others are a bit more specialised. JPMorgan’s Japan Small Cap Growth & Income Trust invests in small firms based in Japan. Jupiter has a similar offering, with its US Smaller Companies Trust focusing on American companies.

For something closer to home, there are plenty of trusts that focus solely on the UK. Montanaro’s UK Smaller Companies Investment Trust has holdings in firms listed on the LSE and AIM.

The key thing here is to make sure you’re happy with the trust’s remit and its strategy. This is not like putting money into an ETF and tracking an index. 

Trust managers take an active approach to investing and have guiding principles that will determine whether or not they buy shares in a company.

If you don’t like those principles or don’t agree with the fund manager’s strategy, you’re probably not going to want to buy the trust’s shares. 

All trusts have key investor information documents (KIIDs) listed on their websites, which you can also access via their relevant pages on the Freetrade app. Having a look through these will give you a good indication as to what a trust is buying, its remit and its strategy.

Investing in small companies with ETFs

An alternative to investing in trusts is to buy small company-focused ETFs.

Like their more ‘mainstream’ counterparts, these generally track a predefined index of small businesses. And as we’ve already seen, those indices are generally put together based on a firm’s market capitalisation.

But as with trusts, there are plenty of small company-focused ETFs out there and they also cover a broad range of companies.

As its name suggests, the iShares MSCI Japan Small Cap ETF tracks an index of Japanese firms with smaller market caps. iShares has two similar ETFs, one tracking US companies and another tracking UK companies.

Others have a broader remit. The iShares MSCI World Small Cap ETF covers small cap firms from around the world, although it is heavily skewed towards the US.

Even though there is no active investment strategy behind any of these ETFs, other than tracking their relevant indices, you may still want to have a look at what your money is actually going into. 

The main thing is that some of the companies in these indices aren’t really that small. For instance, the largest holding in the MSCI World Small Cap ETF is Caesars Entertainment, a huge gambling group with a market cap of close to $20bn. 

That may fit into what you see as a small business but it’s not the first firm which comes to mind when you think of firms matching the ‘small company’ description.

ETFs also have to issue KIIDs, so have a look through those before you buy anything and make sure you’re getting the sort of exposure you’re looking for.

Investing in small company stocks

Your final option for investing in small companies is to find individual shares to buy.

The biggest problem here is narrowing down your search. 

There are hundreds of small companies listed in the UK alone, so just saying you want to buy shares in a small company leaves you with a lot of options.

One thing you can do to narrow your search is look at specific sectors. 

For instance, there are a number of tech firms listed on the LSE’s AIM market which would probably fit most definitions of ‘small company’. That could include video game developer Team17, software maker Crimson Tide or defence tech group Cohort.

Another alternative is to look for firms with the sorts of fundamentals you like. 

Take Craneware, a company that provides software to US healthcare businesses. It has low levels of debt, an above average return on capital employed and decent annual revenue growth. 

If you like these sorts of stats then finding companies which meet them is one way to identify prospective investments.

And that speaks to a wider point about picking small companies to invest in. 

Knowing that you want to invest in a small company is the beginning of the investment process, not the end.

You still need to make sure a firm meets all the criteria that make it investment-worthy. You can’t just ignore those points because you’re so eager to buy shares in a particular type of business.

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Learn more:

How to invest in the stock market

Savings vs investing - which is better?

Detailed guide to investment risk

Investing in penny stocks

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