Most leading brokers cannot spare the time and money to research smaller stocks. You are therefore more likely to find a bargain in this relatively under-exploited area of the stock market.” – Jim Slater

That builds on a core part of the strategy outlined by Jim Slater in his bestselling book The Zulu Principle, and the overall gist is that if you take the time to fully understand one individual subject (be it small-cap growth shares, or the history of the Zulu people), you’ll know more about it than most people on the planet.

There are those who believe that the large institutional investors, with their armies of analysts poring over every utterance from every company, simply can’t be beaten by the private investor. That’s wrong for a number of reasons, one being that a long-term perspective can easily beat the short-term horizons of the professionals, but it’s when we come to smaller-cap stocks that we really have an advantage over the big City firms.

Smaller companies ignored

Every bit of news from big FTSE 100 companies is instantly scrutinised and everyone and their dog immediately has an opinion. But smaller companies are frequently overlooked on this front. That’s for several reasons. Firstly, there are such a large number of them. If we add together all indices other than the FTSE 100 — the FTSE Small Cap index, AIM, and the rest — we’re looking at around 2,000 companies. Few have the resources or the desire to investigate all of those.

The mere size of smaller companies counts against them too. Fund managers with billions to invest are just not going to see companies valued in the tens of millions as worth their while, as they simply can’t buy big enough stakes to make much of a difference to their overall performance. The lack of interest is also clear from the number of brokers commenting on smaller stocks, and it’s often only the company’s own broker making recommendations (which are, of course, not much use due to the unavoidable conflict of interest).

Winners and losers

Looking through some of my old records, I see a company called Lo-Q, which was valued at just £12m back in 2009. Only the firm’s own broker and one other were offering recommendations, but I recall a few regulars on the Fool’s boards doing some in-depth investigation and liking what they saw. Today Lo-Q, renamed accesso, has a market cap of £279m. A 20-bagger.

Of course, there’s also a danger that under-researched shares can come crashing down. Another from my archives is Accident Exchange, which made money from renting vehicles to motor accident victims. It seemed like a good business, but a conflict with partners and resulting cash flow problems sent the public company into liquidation — from a market cap of £44m in 2008. So you do need to be able to stand a bit of risk.

You’ll most likely see more volatility in small cap shares too, with smaller buying and selling deals being enough to push the shares further up or down than we see with top FTSE 100 shares. But if you can keep your cool and not panic, and choose to put a portion of your investment cash into smaller companies — especially if you’re relatively young and have a couple of decades or more of investing ahead of you — you could rake in some nice profits.

A small cap idea

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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.