How to find the star tech shares of tomorrow

One key area where smaller companies have produced outstanding returns is the technology sector. Nevertheless, past tech bubbles serve to remind us that hype and inflated expectations in the sector can easily blow realism out of the water, especially where tech start-ups are concerned.

We ask fund and trust managers how they view and assess small tech firms when they are looking for investment ideas, and how they avoid the damp squibs and one-hit wonders.

Smaller tech companies are not all equally small, of course. The FTSE Small Cap index includes companies worth £150 million, while firms with a market capitalisation of less than £150 million fall into the micro-cap category and are, of course, found in AIM.

When investing in smaller tech companies, Matt Tonge, co-manager of the Liontrust UK Micro Cap fund, seeks to invest in companies with a capitalisation of less than £150 million. He then looks to exit an investment if a firm's market cap exceeds £250 million. In contrast, private equity firm Calculus Capital, which offers both enterprise investment schemes (EISs) and venture capital trusts (VCTs), favours tech companies with a value of just £2-£5 million, which allows it to access a wide range of small and start-up tech firms.

Tech companies can also be at wildly different stages in their development. Some companies are nascent in terms of innovation, and are mainly focused on developing and investing in their products, so they may have no revenues or profits to speak of yet.

Richard Bullas, co-manager of the Franklin UK Smaller Companies fund, avoids such early-stage companies, "even though that is when technology companies are at their most exciting stage". Instead, he focuses on companies that are profitable and have strong cash flows.

Bear in mind, however, that it can be hard to determine what counts as a tech firm. Some holdings in the broader-focused Liontrust UK Micro Cap fund, for instance - such as DotDigital, an email marketing provider - are classified as tech companies.

Others are technology-based but are classified as something else: AB Dynamics (automotive testing), Sprue Aegis (smoke alarms) and Vianet (vending machine telemetry) sit in the industrials sector, while YouGov (market research) sits in consumer services.

Key questions

Julian Chillingworth, chief investment officer at Rathbones, points out that changes brought about by new technologies are generally good for economic productivity and prosperity. However, the dotcom boom and bust that peaked in 2000 shows that investing in technology companies carries great risk - although the risk of an opportunity lost as a result of not investing in technology can also be huge.

He says: "Investors may be right when they identify the potential of a particular technology. But are they able to identify how it will be adopted and which companies will profit? Technological shifts may stall for decades before reaching a tipping point."

He adds: "Is it better to invest directly in smaller technology companies by trying to spot, let's say, the next Apple or Facebook, or in technology funds managed by specialists and offering diversification against the inevitable business failures that occur in such a high-risk area?"

It's important to accept the failure of some technology companies as part of the game, argues Kealan Doyle, chief executive at Symvan Capital, a 'California-style' tech EIS fund manager. "While 90% of smaller tech companies may not succeed, one that does will make a bigger profit then any hedge fund."

He spends a lot of time analysing companies' business models and also how well smaller tech company teams function. "Can they work with other people and each other, or are they egomaniacs?" His EIS invests in companies such as B. Heard, a platform that combines price comparisons with a Trip Advisor-style forum.

Darius McDermott at Chelsea Financial Services says: "If you are looking at stocks, always look for companies that have real revenues and products. Avoid blue-sky tech that is burning cash. It doesn't matter how good an idea or product is, if a company is burning cash, it is going to have to come back to the market and ask for more cash by issuing shares at a discount, and the shares will have to go down.

"Even if a firm looks expensive, if it has real profits and can fund its own growth, it can still do very well. Look how well ASOS has done."

In part that's because fledgling technology firms are frequently guided by entrepreneurial management and are able to grow sales rapidly from a small base.

Sceptics say small-cap tech firms usually have greater exposure to a single product or service, they can be overly reliant on the founder or chief executive and they can be over-exposed to one geographic region.

Here the biggest danger is that a tech company has come up with a solution for a problem that does not exist. The next biggest danger is that an idea is a good one, but it takes longer than expected for customers to realise this.

McDermott says tech is an area where he would always advocate investing through a fund rather than individual stocks in order to spread risk. "There are plenty of pitfalls, and often companies with exciting new tech are making up for a lack of profits with a good story."

Trust in stockpicker prowess

Tech is an area where a strong stockpicking team can bring big benefits for investors, in terms of both controlling risks and spotting potential for returns.

For example, to avoid one-hit wonders, the Liontrust team only invests in profitable microcap companies headquartered in the UK, and therefore subject to UK laws, regulations and standards of corporate governance. In addition it looks for companies "where a minimum of 3% of stock is held by directors, which ensures the interests of shareholders and company management are aligned".

Finally, Liontrust seeks out companies that benefit from a barrier to competition 'in the form of intangible assets such as intellectual property'. Tech firms with the most innovative intellectual property are arguably most likely to succeed in the market.

Plenty of options

It's possible to invest in smaller tech companies through collective investments: funds and trusts, trackers, ETFs, VCTs and EIS. McDermott says funds good at investing in smaller tech companies often have a VCT background, so they are used to fishing in this pool.

He cites as examples Woodstreet Micro Cap (Baronsmead VCT), Marlborough UK Micro Cap (Hargreave Hale Aim VCT), TB Amati UK Smaller Companies and MI Downing UK Micro Cap. He adds that Baillie Gifford Global Discovery is a great global option too. Such funds tend to invest heavily in North American equities.

The closed-ended structure of trusts makes them good choices for those investing in smaller companies, where shares may be illiquid because they are not well-known and their availability is limited. Trusts can choose to invest in relatively illiquid firms for the long term without having to sell assets to fund redemptions in the short term. The River and Mercantile UK Micro Captrust, with 31% in the technology sector, is one of the sector's strongest performers, having gained 32% over the year to 1 April.

ETFs provide an alternative route for those looking for a cheap passive route into in smaller technology companies. There are broad-based small-cap ETFs, but also more focused funds.

Howie Li at ETF Securities says: "A lot of people can't relate to the S&P 500, but they can relate to robotics and cybersecurity." That is why his firm aims to capture bigger themes or 'mega-trends' it believes will provide double-digit growth over the next five to 10 years. The ROBO Global Robotics and Automation GO UcitsETF has about 40% of its holdings in smaller companies around the world.

Small company investment ideas

Darius McDermott says: "Look for businesses that are easy to scale and don't require huge capital investment but are well-protected from competitors. Be aware that exciting tech companies tend to be expensive and are typically vulnerable in a market sell-off."

Examples he likes include payment processing companies such as Universe Group and Paypoint. Judith MacKenzie at Downing UK Micro Cap owns Universe, which has performed very well for her.

Ben Yearsley, investment director at Shore Financial Planning, tips a tracker option, Close FTSE techMARK, which invests in UK technology. He also picks out Herald Investment Trust, which has a small-cap tech bias.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.