Finding the right formula

Posted by Guest in Portfolio management category on 12 Sep 17

Smaller Companies 

People often ask me about my outlook for UK smaller companies, assuming I possess some sort of crystal ball that gives me an insight into how the UK economy will perform over the next year or so. While sometimes I wish that were the case, I have no more knowledge of how Brexit negotiations will pan out, or what the level of sterling is going to be once we leave the EU, than any other informed investor.

Where I genuinely believe the team and I have an edge is in our ability to pick individual stocks. Each holding in the portfolio is continuously examined on a case-by-case basis, battling for its rightful place. Whether it stays or whether it goes depends on one key question, ‘where does the performance return come from?’ Central to that query is the premise that, because smaller companies are often under-researched by analysts, it is possible to find errors in profit forecasts, resulting in instances where prices of stocks can be meaningfully re-rated.

Looking for those three key attributes

When picking stocks, we essentially look for three main attributes in a company. The first is the ability to deliver above-average profits growth, irrespective of whether the overall economy is doing well or not. This could be because the company produces a virtually unique product or service, to the extent that there is little in the way of competition.

The second attribute comes back to the relative paucity of research coverage in our asset class. The team and I spend a good deal of our time looking at the structure of analysts’ forecasts, trying to understand the assumptions behind the key modelling sensitivities and uncovering instances where those assumptions are, in our view, just plain wrong. The ability to surprise stock market followers is what typically results in an uplift in share price performance.

The third and final attribute is finding businesses which, we think, could be substantially re-rated by the stock market. This may be because there is some influential event, such as a new management team, or change of strategic direction, which could boost profits, but which analysts have not yet fully factored into their profits forecasts. Let’s look at some examples of companies displaying the first and second attributes.

A company with above average profits growth: Fever-Tree

A classic example of a company with above average profits growth could be Fever-Tree – the AIM listed producer of premium mixer drinks, ranging from flavoured tonic waters, to ginger beer and Sicilian lemonade. Very strong sales growth in UK, together with a growing presence in both the US and Europe means we believe there is scope for on-going profits growth, in excess of what is currently built into analysts’ forecasts.

An example of an under-researched company: Blue Prism

On the face of it, this is a very expensive stock. But I do think Blue Prism, another AIM listed company, is one of those rare examples of a truly disruptive UK technology business and is a genuine global leader in its particular field. It’s a software business that operates in the so-called area of robotic process automation. This is the automation of basic administrative tasks – things that, if you can do tasks at speed in an error-free way, the whole process of production can become hugely efficient.

What price are we paying for UK smaller companies?

As with all stocks we buy, it is important to weigh up the value we attach to them compared with the amount we are willing to pay for them. Overall, our benchmark index, the Numis Smaller Companies index (ex-investment trusts) trades on a 12-month forward price/earnings multiple of around 13.5 times. That compares to a price tag of 14.4 times for the FTSE All-Share index1. We do not believe that discount is justified, especially in light of the fact that smaller companies typically produce faster growth than their larger company counterparts.

A final word…

So, apart from looking for those three, key attributes in a stock; one final word from the team and me. Don’t become too emotionally attached to businesses. We are buying shares; buying something that’s inanimate, in a way. Falling in love with companies is not necessarily a positive thing to do. To have that sense of detachment and objectivity is very important.

Happy investing.

1Source: Peel Hunt as at August 2017.

Please remember that past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back any of the amount originally invested. Exchange rate changes may cause the value of overseas investments to rise or fall.

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