3 Stable Small Cap Stocks

Many investors avoid adding smaller companies to their portfolio because these stocks can be risky - and expensive. We outline where opportunities still lie

Emma Wall 9 December, 2013 | 1:00PM

Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and here with me today is Equity Analyst Todd Wenning to talk about smaller companies.

Hello Todd.

Todd Wenning: Hi, Emma.

Wall: So, in 2012 and so far this year small and mid-cap stocks have had a terrific run. Looking forward into 2014 can we expect this to continue or is it the turn of the blue chip stocks?

Wenning: Well, I think small – as you said small caps have had a very strong run. But I think the key is to focus on the names that have economic moats and perhaps have had a little turbulence in the near term.

One company that I just mentioned in an article for Morningstar was Dialight (DIA). It came in – it had something of a profit warning. And one of the things that I like about the company was that it has strong competitive advantages in the lighting sector. So I think that type of company or the kind of companies that you want to look for when evaluating companies especially in this market that is growing up so strongly.

Wall: So basically it's about being more selective, rather than just going in for the FTSE 250 or FTSE 350 as a whole.

Wenning: Right. I think the broader market has had a very strong run and on average the names have become a little bit overvalued. But I think there are opportunities in small areas of the market where you can still make money.

Wall: So you mentioned that one of the qualities you look for is this 'economic moat'. For those people who aren’t familiar with the term it means a stock that has a competitive advantage over its peers.

Wenning: Right, not just a competitive advantage, but a durable competitive advantage. So these are names that have structural advantages over their competitors, where competitors have a hard time biting into the company’s profit margins over time. So look at company like Latchways (LTC) which has this fall protection systems. It's really hard for a person who is buying fall protection supplies for their, for the guys who are working on the windows, 10 stories and above to go cheap on fall protection system.

So companies that are able to do that have a good track record and strong brand should be able to defend against competitors.

Wall: Are there any particular sectors that will do better coming in 2014. Are we focusing on domestically focused stocks are we looking internationally?

Wenning: Well I think it really comes down to companies that have, like you said – like you talked about before an economic moat, but also very strong management. Companies that have especially in smaller companies where management matters a lot more than I'd say Coca-Cola, Warren Buffett once joked that a ham sandwich could run Coca-Cola because it's run so well already and has such strong brands that doesn’t really matter who's at the head.

But in a small company their capital allocation decisions can make a huge difference in what comes down the pipe for the company. So you really want to focus on companies with strong economic moats regardless of sector and companies with strong management teams.

Wall: So you've mentioned two already, is there perhaps a third for the readers.

Wenning: Well, there's really some interesting names in the small cap space. One of the things I really like about it is they really have a strong niche, whereas if you try and understand large, large companies you can get really bogged down in all different segments that they have. But in the small companies you have niches that you can really understand quite well.

One of the companies I really like is Stanley Gibbons (SGI), which does the stamp collecting and the stamp memorabilia and they basically have a very strong brand in the stamp collecting area.

So I would really like companies like that; they have slow growth, no one really gets interested in them, they are not really exciting companies, but they have very strong competitive advantages and over the long term that should bear out for shareholders.

Wall: Todd, thank you very much.

Wenning: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Dialight PLC310.00 GBX5.08
Stanley Gibbons Group (The) PLC2.10 GBX0.00

About Author

Emma Wall  is former Senior International Editor for Morningstar

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