SMALL is beautiful, with the smallest companies in the UK’s stock markets providing some of the most successful investments.

Many of these companies are what could be labelled micro caps, but what does that mean? Essentially, a micro-cap company is one whose market capitalisation is less than £150 million. To enable us to capture a significant proportion of the rapid early-stage growth of these companies, we will hold stocks until they are worth more than £250m before beginning a managed exit process. There are a huge number of companies that fit that definition on UK stock markets: more than 600 companies on the London Stock Exchange’s main market and over 800 on its junior Alternative Investment Market.

The micro-cap segment of the market offers investors an exciting opportunity to capitalise on the fast early growth phase of dynamic, entrepreneurial companies. These companies often take share from incumbents in markets experiencing disruptive change, or they can create greenfield opportunities for innovative products and services.

There is also substantial evidence that the micro-cap space can offer excellent investment returns. If you had invested £1 in 1955 in the smallest listed companies, as measured by the Numis 1000 Index, by 2019 that investment would be worth just over £15,000 compared with just under £1,000 if you had invested that £1 in the FTSE All-Share.

However, micro caps are sometimes overlooked because investors are cautious about the perceived risks of venturing into this part of the market. When investing, it is always the case that you try to pick the winners and avoid the losers, but this is all the more essential with micro-cap companies, where the variability in business prospects and outcomes can be large.

The average micro-cap company is at an early stage in its development but looking to grow rapidly. There is a degree of risk concerning the execution of ambitious growth plans and – as you would expect – not all of these small companies go on to enjoy success. While the micro-cap segment of the market has produced some very notable successes that have gone on to generate excellent shareholder returns and become much larger businesses, there have – of course – also been business failures.

As with any investment, the key is stock selection and constructing a diversified portfolio to try to mitigate the risks while taking advantage of the long-term opportunities. An advantage here is that micro caps are not as well covered by research analysts as the rest of the UK stock market – there are an average 21 analysts for every FTSE 100 company, compared to 0.5 for micro-cap companies – offering an edge to investors undertaking their own research into individual companies. The universe comprises innovative, fast-growing businesses and, despite the risks, a large number of the winners from transformative change are to be found here.

A distinguishing factor between those companies capable of exploiting the opportunity and those that are instead weakened by new market entrants is a pre-existing barrier to competition. For smaller companies, we would only consider investing in those that generate profits and have positive cash flow to underpin their market valuation. As a result of this investment rule, a large proportion of companies we hold pay a consistent dividend – often a sign of a well-managed company with a sensible strategy for generating returns for its investors.

More generally, we prioritise intangible barriers above all others, believing them to be more difficult than tangible assets for competitors to replicate. These barriers to competition – intellectual property, strong distribution networks and recurring revenues – afford companies the time to respond to technological advances and seize the opportunity for themselves, while also frequently providing them with captive customer bases into which they can market their new offerings.

Micro caps are an exciting part of the market, and well worth putting under the microscope.

Matt Tonge is a fund manager at Liontrust Asset Management.