Should you invest in small businesses?

Important information
Your capital is at risk. All investments carry a degree of risk and it is important you understand the nature of these. The value of your investments can go down as well as up and you may get back less than you put in.
Could you be missing out on big returns by ignoring small firms when it comes to investing? We take a look at the different ways you can invest in a small business, as well as the opportunities and risks of doing so.
UK retail investors showed a strong home bias on the final approach to the tax year-end deadline on April 5, having stuffed their stocks and shares Isas with UK companies.
Investment platform Hargreaves Lansdown reported the top share purchases by its customers for the 2023/24 tax year were Legal & General Group, Lloyds Banking Group, BAE Systems, Aviva, Vodafone, Phoenix Group, Glencore and British American Tobacco. These are all members of the FTSE 100 index of the largest companies listed on the London Stock Exchange.
Meanwhile, US companies Nvidia and Tesla also made the “most bought” list. But, again, these are large companies, which raises the question: “Are investors missing out on growth opportunities?”
In this article we cover:
Read more: Is now a good time to invest in US shares?
Why people buy shares in big firms
Investors hold large companies for many reasons, including their income-paying abilities, defensive properties, large cash balances, global franchises, pricing power, or because they are brands with in-built inflation-proofing. And the FTSE 100 hit new record highs this week, with many analysts expecting the value that the London market offers to be increasingly recognised.
However, investors always need to have an eye on diversifying their holdings to spread their risk. Energy and financial stocks dominate the market capitalisation of the FTSE 100, which could mean you’re over concentrated in a particular sector.
Read more: Is now a good time to buy UK shares?
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Can small firms mean beautiful returns?
“Elephants don’t gallop”, is one of my favourite stock market sayings. Jim Slater, a well-known small company investor, borrowing it from Rudyard Kipling, was referring to the fact it’s much easier for a small company to double its size – and your investment – than it is for a large one.
Since 1955, the Numis Smaller Companies Index excluding investment companies (NSCI), which represents the bottom 10% of the UK market, has beaten the FTSE All-Share on average by more than 3% a year on a total return basis.
So if you don’t yet have exposure to smaller companies, it’s time to consider this.
There may be additional risks involved when you invest in smaller companies, depending on whether you go for start-ups or smaller companies listed on the stock exchange.
Read more: Why some people are investing in Jellycats?
Becoming an angel investor
Perhaps you have an urge to be like a dragon in BBC programme Dragons’ Den. In which case, one route is being an angel investor.
But “angels” usually have a track record of appraising businesses. Many are also serial investors or entrepreneurs, so they understand and are willing to take risks in order to earn a higher return.
To find out more about opportunities and how to get started you could contact the UK Business Angels Association, which holds events and runs educational courses. Alternatively, the UK Angel Investment Network offers investment opportunities starting from £1,000.
But there’s usually a financial barrier in the way too. The Financial Services and Markets Act 2000 states that angel investors must self-certify as a sophisticated investor or high net worth individual.
At the end of January, the financial regulator’s rules raised the bar for classifying a high net worth individual. Under the new thresholds, an individual would have needed income of at least £170,000 in the last financial year, or net assets of at least £430,000 throughout the last financial year. Since then, the thresholds have been put back to the previous level of £100,000 income and £250,000 in assets.
The wisdom of crowdfunding
Crowdfunding may be a more realistic route for wannabe dragons with more modest means. This is where smaller businesses raise funds from multiple individuals. There are several crowdfunding platforms facilitating crowdfunding for start-ups, but if you want a UK-based website, try Crowdcube.com which allows you to back European businesses from as little as £10.
If you qualify to be an angel investor or have the risk appetite for crowdfunding, make sure that you’re not taking unnecessary risks. Even the most brilliant business ideas can fall flat, sometimes because the market is not ready for them.
Read more: Best apps for everyday investors
How likely is it that firms will succeed?
There’s an old saying in start-ups: “Being early is the same as being wrong.”
You may remember SixDegrees.com, the original social network that only lasted from 1997 to 2000. Or Pets.com that sold pet supplies to retail customers from 1998 until it was shut down in November 2000.
A large proportion of start-ups fail to deliver for their investors. Research by accountancy firm Archimedia Accounts found that more than 5% fail in the first year and only a third make it to five years. Just over two thirds of companies formed in 2016/17 survived five years, while 30% of companies that started in 2020/21 (at the height of the Covid pandemic) failed to last two years.
So you may want to explore some ways to invest in smaller companies that leave you less exposed to the risks of business failure. One is investing in publicly listed companies that have to adhere to regulations and reporting standards, publishing accounts that can be scrutinised by institutional investors and analysts.
The FTSE Small Cap Index includes the smallest companies on the London Stock Exchange main market, such as Foxtons estate agents, Topps Tiles and Smiths News. Alternatively, the Alternative Investment Market is a specialised section of the London Stock Exchange catering to smaller, more risky companies. Some companies listed on AIM are also well-known established brands, such as low-cost airline Jet2, drink mixer producer Fever-Tree Drinks, and online fashion retailer Boohoo Group.
Getting first bite at a small firm
You could also look to invest when a company first lists on the stock market, called an Initial Public Offering (IPO).
The five companies that joined the UK stock market in 2024 – MicroSalt, European Green Transition, Helix Exploration, Fuel Ventures VCT and Air Astana – have generated more than six times the return achieved by the FTSE All-Share index since the start of January, according to analysis by investment platform AJ Bell. Their average return to April 15 was 16.4% compared with 2.5% from the benchmark UK index.
AJ Bell says six companies may choose to float (list on the stock market) this year. These are London Tunnels, Waterstones, Boots, Starling Bank, Unilever’s ice cream division and Froneri.
So there’s the unusual prospect of seeing two ice cream businesses join the stock market. Unilever has already announced plans to separate its ice cream arm, whose portfolio includes Cornetto and Magnum. Meanwhile, Froneri is a 50:50 joint venture between Nestlé and private equity firm PAI.
Read more: What is an IPO and how can I invest in one?
Letting a professional pick small caps for you
If you don’t have the time to research FTSE Small Cap, AIM companies or IPOs, you could access smaller companies via a fund or an investment trust that is managed by a professional fund manager who specialises in investing in this sector.
At the moment most smaller companies investment trusts are trading at discounts to the underlying value of their assets, which means you could be picking up a bargain if you hold them for the long term. This way you will be holding a diversified spread of smaller companies too, reducing the risk of one failing.
One to consider is JP Morgan UK Small Cap Growth & Income which is trading at a discount of 10% but has an excellent performance track record. You can research this and other investment trust options at the Association of Investment Companies’ website: www.theaic.co.uk
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