Ben Cobley visits the smallest companies on the FTSE Full List and discovers a batch of firms worth embracing – and many too dangerous to even approach.

A trip to the murky depths of the FTSE Fledgling list is not for the faint-hearted – in a bull or a bear market. Small, struggling, often restructuring, and very rarely profitable, the companies are the smallest players on the main market for very good reasons.

Most institutional players aren't allowed to invest in them (fund managers are rarely able to invest significant capital) and many private investors are reluctant, having bought-in during an optimistic phase in the management's plans – and at significantly higher prices than many now boast.

But shunning the truly tiny corporate sector in its entirety, as many analysts and investors do, robs you of the major attraction of smallcap investing in general, namely the opportunity of doubling, tripling or quadrupling your investment stake, whatever the prevailing economic weather.

Unknown training products supplier Feedback has doubled from a market capitalisation of £1.3 million since the onslaught of the second bear market raid in August 2000. Glass manufacturer Darby has risen from £3.2 million to £7.3 million over the same period, while air-conditioning systems group Energy Technique has surged from £2 million to £12 million. Housebuilder Ben Bailey has trumped all of these, surging from £3.6 million to £20 million. Over on the FTSE 100 during this time, meanwhile...

The smallest 25 companies on the LSE

The problem for all well-heeled and well- informed investors is that it's very often a trawl-too far to find these successful growth stocks amongst the hoards of troubled manufacturing companies, flailing technology ventures and general corporate detritus.

For instance, take a look at the bottom 25 companies by market value. Not one of these is valued at more than £2.6 million (the smallest is valued at less than the price of a two bedroom London flat). Finding a value stock worth even an outlandish punt is tricky. Most are loss-making, many have severely stretched balance sheets, and some look set to go bust unless something drastic occurs.

While probably not about to go bust, Network Technology, the technology and internet products group, has been flattering to deceive for years and is now valued at just £820,000. The latest interim results showed losses maintained at £650,000, with chairman Klaus Bollman claiming that 'the company continues on the road to recovery'. But there is little sign of this, and cash is very tight.

Plenty of other technology and internet ventures have plunged to similar levels, including former market favourites QXL Ricardo and Bede and IT solutions groups DCS.

Of all the companies this far down the food chain, IS Solutions looks one of the better placed to prosper in the long-term. But it is not finding the going easy, given the current lack of corporate spending on IT.

Corporate action is on the cards

One interesting feature of this bottom 25 is that half are – or were – 'old economy' ventures, dabbling in clothing/textiles and manufacturing.

Both of these areas are not in good shape, with cheap Asian competition and falling world demand combining with a severe skills shortage to hamper UK operators. And this is even before we get on to pension fund problems, rising insurance premiums and adverse currency translation.

All of these issues make management buy-outs, total sell-outs and sell-offs likely. But gauging the likely premium that will accrue to investors in the resultant pay-out is difficult.

Recent comments from George Govan, the chairman and chief executive of cutting tools maker Howle Holdings, should arouse investor interest. He was driven to declare that the 12 months to last September were 'a brutal year' for the company. With markets remaining poor and interest payments remaining stiff, a management buy-out looks very likely.

On the pensions front, Roxspur is sitting at a market value of only £1.2 million, having sold all of its electronics businesses. But the board admits that it could be rendered insolvent by pension claims being made.

Associated British Engineering (ABE) meanwhile, had a deficit valued at £1.8 million a year ago. The company itself is moderately loss-making, but last September had a decent-looking balance sheet including £1.5 million of cash and net assets of £3.2 million comparing favourably to a market value of only £560,000.

Those of a high-risk, speculative bent could dabble in ABE, as the company has been in talks about a possible management buy-out of its remaining operating subsidiary British Polar Engines. But less risk-friendly punters should stay well clear.

One that should definitely be avoided is FII, the footwear manufacturer. On the one hand, it reported turnover of £8 million for the six months to November, but losses of £2 million and a stretched balance sheet are very worrying.

A rather different scenario is being played out at Toye & Co, which, like many full list tiddlers, has decided to try its luck on Aim from May onwards, having made a small profit in the six months to June. This could presage a resurgence in its business, but it's too early to tell. Stay clear for now.

Unloved... and undervalued

Further up the Fledgling food chain much different scenarios are being played out. One dominant theme is that many companies find themselves with woeful valuations because they have issued profit warnings, and have been hammered as a result.

Traders with a sense of derring-do suggest that it is after the third profit warning that one should buy shares, when the firm is so bombed-out that no one else wants to know any more.

Nightclub operator Springwood fits that bill rather well, having delivered the necessary three warnings and seen its share price collapse from over £2 a couple of years ago to only 23p now. Though recent final results have added to a recovery from the depths of 11p, the shares still look undervalued at only 2.7 times this year's prospective earnings.

The problem for Springwood, as for many of its lowly-rated ilk, is debt. Balance sheet gearing was 117 per cent at the end of December, and the company has been struggling for cash, a situation made worse by an aborted fundraising last summer. But KBC Peel Hunt's Paul Hickman likes the story, pointing out that 'freeholds of £33 million and a newly- negotiated bank facility mean that Springwood stands a reasonable chance of being able to trade out of its current cash difficulty.'

Newcastle-based multi-services construction minnow Chieftain is an altogether different proposition. Its results over the past five years don't do much to inspire, showing pre-tax profits generally coming in at around the £700,000 mark. But as well as offering a decent yield of 6.7 per cent at the current 37.5p share price, the company's prospective p/e ratio is a measly 5.2, based on house broker Brewin Dolphin's forecast for £900,000 pre-tax this year. With no debt, the company looks a good portfolio stock – and looks like it is 'in play'.

Litho Supplies, on the other hand, looks a potential multi-bagger at current levels. It appear to be a quality, and historically highly profitable, company, trading well below its highs at the moment. A supplier of printing and graphic arts materials and equipment, it has been hit hard by the general media malaise over the past few years.

But even with a round of site closures and redundancies last year, Litho still managed to turn in a profit – a creditable performance given the market conditions. Excluding the exceptional costs associated with those changes, it actually made £1.8 million pre-tax, helping it to eliminate bank debt and face the future with a lot more confidence. In chairman Bernard Clark's words, the group 'can now face the future with a leaner organisation focused on the UK market that we know and understand well'.

One caveat is that profits have been falling for years, even before the current recession. But the group's market-leading position in digital printer distribution holds it in good stead.

With Rowan Dartington expecting profits to remain stable this year at £1.8 million, to produce around 5.5p of earnings per share, the current market valuation of just £7 million looks somewhat awkward beside tangible net assets of £12 million. Buy.

Tech minnows to gun for

Of all the different types of technology ventures, telecommunications equipment manufacturers have been harder hit than most. And with the markets for their goods showing little sign of improvement, they are generally well worth avoiding for the moment.

But a couple of profitable fledglings stand out. One, Intelek, serves the aerospace and satellite communications markets as well as conventional mobile phone and fixed line equipment manufacturers. So, none of its markets can be seen to be in particularly good shape.

Yet, almost immediately after a profit warning released in February, a string of long-awaited contracts were awarded, leading house broker Arbuthnot to upgrade its pre-tax forecast for 2003-4 to £1.8 million, to deliver 1.7p of earnings per share. With £1.4 million expected for the year just passed, and EPS of 1.6p, the shares therefore trade at a forward p/e of just over four. With net tangible assets of £6.8 million at the last reckoning in September, the shares are a clear Buy.

The other telecoms hopeful to look at is somewhat more speculative, but could offer stunning returns if it secures a replacement contract or two for a £11 million deal with BT that is being completed at the moment.

Telspec sells the major telecoms companies a selection of different types of product. Its 'pair-gain' equipment allows existing copper wires to carry the equivalent of 12 different phone lines, as opposed to the normal one. It is also a supplier of switching technology.

Investors have witnessed varying degrees of profitability in recent years but a new management team is in place attempting to consolidate. New finance director Martin Parmenter has succeeded in eliminating group debt, leaving net cash of £1.3 million at the end of September.

At £8.5 million, net assets are well above the market capitalisation (£6.1 million). The group is also profitable, turning a £1.9 million loss into a £1 million pre-tax profit last year. If it can secure contracts, it could become transformed.