Small company, big potential

"The deregulation of credit markets in the mid 1980s led to enhanced economic growth," says Mr Williams. "But world growth has recently slowed significantly while many larger companies are struggling to find attractive areas for capital expenditure. Both of these factors make it harder to generate organic revenue growth and this is limiting profit, cash flow and dividend growth. But the key advantage of smaller companies is their extra growth potential, which is particularly important at times of weak economic trends."

He points out that prior to the credit boom the rate of UK economic growth was volatile but during this time of economic challenge smaller companies still outperformed "considerably."

Mr Williams expects that the majority of the micro-cap companies in the trust's portfolio will be quoted on the Alternative Investment Market (Aim), where most of the smallest quoted stocks are now listed.

"The FTSE Aim Index has fallen back by nearly 20 per cent since peaking in March 2014, but many Aim stocks have continued to deliver earnings growth over recent quarters," he says. "The net result is that there is a steep valuation gradient between largest and smallest stocks. But some micro-caps offer better growth and have less risky balance sheets, so are in a great position to grow their dividends more rapidly than the main market."

When selecting holdings for Miton UK MicroCap Growth, Mr Williams considers their medium to long-term dividend potential. He will focus on "immature income" - companies currently paying no or very modest income. "But over the next three to five years this fund will have more income growth," he explains.

Aim stocks remain under researched but this market is more balanced than the FTSE 350: energy only accounts for 10 per cent of the index weight, as opposed to 22 per cent in December 2012. The largest three sector weightings - industrial goods and services, health care and technology - account for less than 40 per cent of Aim.

Among these, small caps with value have tended to perform the best, while data from the US has shown that illiquid stocks tend to outperform too.

Examples of successful companies include Victoria (VCP), an established manufacturer of yarns and carpets with an estimated annual turnover of £160m. "In October 2012 a new chairman introduced a new strategy, and with a tighter financial focus the company has generated a substantial amount of cash," he says. "It announced a special dividend that amounted to a sum close to its entire market capitalisation in June 2014. Even after delivering an extraordinary rate of return over the last three years the business is only capitalised at £135m."

He adds that they are still identifying lots of stocks that still remain overlooked. "We anticipate these kinds of stocks should have plenty of scope to re-rate to higher share prices in time," he says.

Examples include International Greetings (IGR), a manufacturer of wrapping paper, cards and crackers, with an annual turnover of £220m.

"Earnings per share (EPS) is forecast to grow by a further 17 per cent in the year to March 2016," he says. "Following a couple of years of higher capital expenditure the company is now moving into a period of cash payback."

Miton UK MicroCap Trust is expected to focus on the industrial & manufacturing, technology, and consumer sectors, though it can invest across all sectors and its managers pick companies according to their individual attributes.

Mr Williams expects the trust will have low exposure to energy, mining and property, and will not invest much in biotech companies because they have low cash flow.

Stock selection

Mr Williams and his colleagues meet as many companies as they can - typically 60 to 70 a month.

"We avoid judging and selecting companies until we meet with them to ensure we make our investment decision based on a detailed understanding and the most up to date information," he explains. "Many companies won't attract our interest but there will be a few stand-out winners. One of the key considerations for us is whether they can generate more and more cash in the future, and whether they are going to deliver good turnover growth."

He is more interested in sustainable growth than high growth, as long as the company has really safe balance sheets. "We are especially tight on balance sheet stretch at present: we want companies that are either in net cash or with low debt," he says.

He adds that Miton UK MicroCap Growth Trust's portfolio holdings are selected for their regular cash flow rather than the potential for big upside on a one-off event.

Mr Williams and his team have five simple factual questions as part of their investment process, what he calls his "traffic light stock selection process," whereby they identify either green or red lights on the following:

■ Prospects for rising turnover;

■ Can corporate margins be sustained?

■ Is the management team good enough?

■ How much financial headroom is there in the balance sheet? And

■ Are there low expectations in the share price?

He says: "In our experience, companies with good and growing turnover, and sustained or improving margins, tend to enjoy rising share prices."