A medium- to long-term approach to expected company growth, sales and productivity and overall capital efficiency underpin this fund manager's approach to small-cap investing.

According to UBS Asset Management portfolio managers Victor Gomes and Stephen Wood, the companies within its Australian Small Companies Fund are "strong franchises that don't need a lot of capital". The fund focuses on a portfolio of small company shares its analysts regard as undervalued, based on future cash flows.

Gomes and Wood emphasise the need for a healthy degree of scepticism when investing in small caps.

"There's no substitute to going out and meeting the businesses you’re interested in, speaking to customers, suppliers, competitors," Wood says.

"Don't take everything management tells you without questioning it – you need a sceptical view," Wood says.

Asked about how they decide to buy or sell specific companies, Gomes says this depends on the reasoning behind the initial investment.

"Every time we buy a stock, we have a note saying why we are there. And if we discover that management is saying something different, well, we don't mind the world giving a company a smack on the nose.

"But we don't like it if what we were told gets modified, or when we discover that what really drives a business isn't what we thought it was," Gomes says.

Investors must understand what they are buying and set a plan, "and if there's deviation from that, it's a selling indicator.

"And on the other side, we have an intrinsic value for each stock, and if it reaches that point it looms large on the sell radar. There's as much art and experience as science in this," he says.

Which stocks to avoid

Wood says investors should "be very wary of people making fast money out of the government – when they catch up with you, it's generally pretty savage".

Another asset manager with small-cap focused funds is SG Hiscock & Company, which invests in ASX-listed "franchise" companies with a sustainable competitive advantage, through its SGH ICE fund.

It prefers companies with "superior business models, with assets that are difficult to replicate" along with quality management with "sticky" customers and an economic moat to ward off competitors, says SG Hiscock portfolio manager, Callum Burns

Burns nominates A2 Milk (ASX:A2M) and TPG Telecom (ASX:TPM) as two of the fund's biggest successes historically, based on meeting its criteria and having attractive valuations at the time of its investment.

"We picked them through looking at their financial performance, and then through detailed discussions with management. And the reason we achieved the super returns is a number of those attributes won’t immediately obvious," Burns says.

He suggests the risks associated with small-cap investing can be managed through the quality of stock selection.

"If you can find a good company with positive attributes to its business model that give a competitive advantage, you can forecast earnings growth with certainty and value the company, then you can get a good return for investors.

"We think that's the best thing to focus on. If you can do that 45 times, you've got a very good fund,” he says.

According to UBS's Wood, small-cap investors can benefit by tapping into the expertise of professional managers.

"There are some good managers in our space, and a good manager over the last half-decade to a decade will have got you probably more than 10 per cent a year after fees. You compound that for a decade, and it's a fantastic return," he says.

Morningstar suggests investors seek stocks with sustainable competitive advantages – which it calls "economic moats". Why should small-cap investing be any different?

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Anthony Fensom is a contributor to Morningstar Australia

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