How the experts pick small cap stocks

We talk to three fund management groups to learn the secrets of their success
Thursday 24 Nov 2016 Author: Daniel Coatsworth

We are big fans of smaller companies and that is reflected by the generous space given to this area of the market in our weekly digital magazine and across our website.

Many investors welcome the challenge of sifting through the large number of junior companies on the market. We certainly help with this journey by highlighting what we believe are the best opportunities, as well as companies we don’t think are capable of meeting the grade.

Not every investor has the time or inclination to do the heavy lifting research needed to sensibly invest in smaller companies. In which case, a better way might be to get exposure via the small cap fund route.

The detailed digging is handled on your behalf by investment experts and your risk is spread over a portfolio of stocks, in exchange for a small annual management fee.

Secrets of their success 

We’ve spoken to several small company investment professionals to get their unique view on the space.

This should be of interest to anyone considering the funds route, as well as DIY investors who want to emulate the successful strategies of fund managers or simply pinch some of their ideas.

This week we talk to Amati, Liontrust and Miton. Next week we will reveal how the experts at JPMorgan, Henderson and Unicorn pick their small cap stocks.

Victoria Stevens & Matt Tonge, co-managers of Liontrust UK Micro Cap (GB00BDFYHP14)

‘A fundamental principle of competitive markets is that profits regress to the mean,’ say the Liontrust pair.

‘We believe the secret to successful investing is to identify those few companies that have a durable “Economic Advantage” that allows them to defy this principle and sustain a higher than average level of profitability for longer than expected. This surprises the market and leads to strong share price appreciation.

‘This “Economic Advantage” investment process is the collection of distinctive characteristics of a company that competitors struggle to reproduce, even if those competitors have understood the benefits arising from those characteristics.

‘In our experience the hardest to replicate of these particular characteristics fall into three categories of intangible assets: intellectual property, strong distribution channels, and significant recurring business.

Liontrust UK Micro Cap’s biggest position is YouGov

‘Other less powerful but nonetheless important intangible strengths include: franchises and licences; extraction rights; good customer databases and relationships; effective procedures and formats; strong brands and company culture.’

Clear criteria

Liontrust believes that only distinctive and hard to replicate intangible assets can form the basis of a sustainable competitive advantage.

The asset manager says these assets deliver pricing power, protect margins, and thus drive sustained profitability. It says the market rewards excess profitability, particularly when it is higher than consensus expectations.

‘When implementing this into investment, we evaluate companies in the UK stock market for their possession of durable “Economic Advantages” by screening and scoring companies,’ explain the fund managers.

‘To pass our test, a company must demonstrate it has intellectual property, a distribution channel or repeat business. A higher score is given for these assets than other intangible assets. This initial screen gives us our universe of potential investments.’

The team expects slightly more from smaller companies. The pair remark: ‘We believe that “Economic Advantage” in smaller companies is created and maintained by talented individuals.

‘Research demonstrates that equity ownership motivates key employees, helps to secure a company’s competitive edge and leads to better corporate performance.

‘Equity ownership aligns the interests of employees with outside shareholders.

‘An “owner-manager” culture creates a more conservative attitude towards acquisitions and gearing. Every smaller company held in the portfolios has at least 3% of its equity held by main board directors. Companies are also assessed for employee ownership below the board. Changes in equity ownership are monitored,’ explain Stevens and Tonge.

What is the most exciting stock in your portfolio?

The largest position in the Liontrust UK Micro Cap Fund is market research group YouGov (YOU:AIM).

The company has built up a consumer panel of nearly 5m members globally from which it collects data on a broad range of subjects.

‘We find the company’s “Economic Advantage” primarily in a data-driven distribution network. YouGov’s brand tracking, customer profiling and market information expertise can quickly become ingrained within their own customers’ workflows, making the offering extremely sticky.

‘The company also has significant intellectual property within the vast bank of proprietary data collected from its panel over time, as well as the software used to manage this data.

‘In moving the company’s revenue streams increasingly towards data-driven products

and services (as opposed to one-off custom research projects), YouGov is not only strengthening its margins but also building its recurring and repeating revenue streams, improving visibility and quality of earnings,’ say the Liontrust fund managers.

Douglas Lawson, co-manager of TB Amati UK Smaller Companies (GB00B2NG4R39)

Amati is a well-known investor in smaller companies via both venture capital trusts and its small cap equity fund.

‘We are essentially growth investors, so we look for companies that have the potential to generate attractive levels of revenue and earnings expansion over the long-term,’ says fund manager Douglas Lawson.

Amati UK Smaller Companies is very excited about Keywords Studios

‘Normally, these companies are operating in nascent markets or are offering something novel in established markets. Sometimes these companies are the driving forces of structural changes in their industries.’

Desired characteristics

Lawson looks for companies that are operating in large markets with a distinctive offering that provides a competitor advantage, pricing power and barriers to entry.

‘At the same time, we are looking for a good profit to cash conversion ratio,’ he adds.

What is the most exciting stock in your portfolio

The one holding Lawson is most excited about is Keywords Studios (KWS:AIM), a provider of technical services to the video games industry.

He says the provision of these services to video games publishers is a fast growing market as the publishers continue to outsource non-core activities.

‘It is a very fragmented market, yet the publishers would rather deal with as few service providers as possible. Keywords has been solving this problem for publishers through the acquisitions of specialist service providers throughout the world, to take the group closer to being a global one-stop shop.’

Gervais Williams, fund manager for CF Miton UK Smaller Companies (GB00B8JWZP29) and Miton UK MicroCap Trust (MINI)

Gervais Williams is a well-known name in the small cap space and is also managing director of asset manager Miton Group (MGR:AIM).

‘I continue to look for companies with ongoing turnover growth and sustained margins because ideally we need to find companies where they will generate an attractive cash payback on their capex, etc. over time,’ says Williams, concerned about the risk of margin pressure.

Miton’s small cap funds recently took part in two IPOs – Autins and Van Elle.

‘Corporate margins have doubled during the boom years, and we fear we are now embarking on the other side of that time.’

Clear returns

Williams says he is looking for companies that invest for cash paybacks in three or less years.

‘Given productivity is flat lining at present, the more we can find companies that are generating productivity improvement the better their ability to take advantage of the lack of investment in others.

‘If there is more margin pressure going forward those with outstanding customer service have the best opportunity to sustain their margins.’

What has the fund manager been buying?

Recent purchases include some oversold stocks set for a recovery, claims Williams. ‘We have also supported some recent IPOs like Autins (AUTG:AIM) and Van Elle (VANL:AIM).

‘Generally, the worries about Brexit have left many of the stocks outside the mainstream out in the cold. So their valuations relative to mainstream stocks are looking unusually cheap.’

Williams continues to favour companies that can find ways
of growing independently of the underlying markets in which
they operate.

‘With world growth stagnating, we believe investors will need to widen their investment universe beyond the FTSE 350 to participate in stocks that will continue to generate attractive returns.’

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