Merryn Somerset Webb interviews small-cap stock expert Gervais Williams about how penny shares outperform blue chips ‘again and again’.
• If you missed any of Merryn’s past interviews, you can see them all here.
Transcript
Merryn: I’m here today with Gervais Williams from Miton Asset Management, who’s also the manager of a variety of small-cap and micro-cap funds, some of which we have looked at in the magazine before. We’ll talk about those in a minute, but first, Gervais, I just want to ask you about the market as a whole, you have fairly firm views on where the wider market is going over the next few years.
Gervais: Yes, the market has been very good. We’ve seen, actually, bond yields come right the way down and that’s really driven interest in all asset classes, not just equity markets but also property and corporate bonds. They’ve all moved up together and I think that’s unnerving some investors. They’re getting a bit worried that they’re all moving up together because we all know that if bond yields peak out, they might peak out –
Merryn: OK. So the markets all moving together, equity markets, bond markets, etc., this is purely a function of low interest rates?
Gervais: Yes, and particularly low bond yields, which has really driven this. I think what’s been interesting is alongside of that, we’ve actually seen pretty poor economic news. World growth has stalled. We’ve seen even US growth come back quite considerably but, I think that’s my view, that we’ve been borrowing growth from the future for the last 25 years. I think we’re in payback territory. I think we’re in something of a growth hangover.
Merryn: OK. And how does that affect equities?
Gervais: Well, the problem is, of course, it means that growth is more difficult to find. I think a whole generation of fund managers have got used to finding growth relatively easily; big companies, small companies, UK companies, international companies. And I think what we’re seeing is that investment universe narrowing because there are fewer companies which are able to grow.
It will be tougher for small companies but it will be really tough for some big companies because many of those are, by their nature, large. And if the world’s not growing it’s more difficult for them to grow.
Merryn: But the managers of funds that buy these really big companies will always tell you that a company with a global presence and a big brand, and pricing power, can grow whatever the environment it’s in. So buying these big companies is a very long-term defensive way to invest.
Gervais: Yes, certainly. They have the advantage of scale. They have the advantage of brand. They have the advantage of low costs in terms of borrowing and those kinds of features. But actually, when the world’s growing there are fewer of them which can actually buck that economic trend. And if they start moving up against each other, such as you’ve seen perhaps in the supermarket sector, they start knocking each other’s margins and both of them lose out from that kind of thing.
So there will be some winners, undoubtedly, in the big cap area but there will be fewer and there will be more risks associated with some of the bigger companies.
“We’ve been borrowing growth from the future for the last 25 years. I think we’re in payback territory”
Merryn: OK. So, as we’re not going to hold these very big companies, we’re going to hold what instead? Mid-caps, small caps, very small caps, you’re involved in all of these, right?
Gervais: Absolutely. I think the area which looks most attractive at the moment is many of the smallest companies. The AIM market has been falling in the last year. A lot of the more speculative companies have come under pressure because of the commodity prices and some of the less speculative companies, some of the more regular turnover, regular profit companies, are also being dragged down in that downdraft.
And so the valuation to the very smallest has dropped. They’re growing very nicely, not all of them but some of them. And so they’re on very low valuations and the bigger companies have been moving up with the quantitative easing and all of that pack factor. And that’s really driving a differential in valuations between the top and bottom, which is probably the most extreme I’ve known in my career for the last 30 years.
Merryn: Let’s go back to the QE briefly. If, as we said earlier, we do have this continuation of very, very low growth, or possibly no growth, and then we get another round of QE, which is really quite likely, both from the UK and from the US, then surely we should probably stick with very big companies?
Gervais: That’s right. The current trend will continue until it comes to an end. We don’t quite know when it comes to an end but the nearer you get to this peak, the more you have to start thinking about what you’re going to do next. And it’s quite interesting to see investors beginning to get anxious about that. We may even get QE in China. Who’s to say? It may go that final distance but it’s all leading us into a territory where it’s getting more dangerous to hold the status quo. And so people are looking to diversify their assets and that’s really what’s beginning to happen in markets.
Merryn: OK. So then at the lower end, in the small cap end, you see both diversification but also, in particular, value?
“I see ridiculously cheap valuations relative to the main market … small companies can grow even when the world’s not growing”
Gervais: Yes. Most particularly I see ridiculously cheap valuations relative to the main market and actually, I see the opportunity for some companies, not all, to buck the economic trend. Some small companies can grow even when the world’s not growing. It’s the ability to invest capital for productive improvement; productivity gain at a time when the world’s not getting much productivity, which is the true generation of real, long-term wealth.
Merryn: OK. And are there particular sectors or areas that will see this growth?
Gervais: I think most of the areas will have an area of productivity improvement but perhaps some of those areas which did so well in the last 25 years, many of those depending on asset prices, many of those which are dependent on outsourcing, they may find it more difficult. I think some of the areas which have been less fashionable, insurance may be an area which is doing pretty well. It may be that manufacturing could do pretty well. Some of these areas which are not as well covered by the main markets, we think may be some of the best areas of productivity improvement.
Merryn: OK. Let’s go back to manufacturing. There’s been a lot of talk about the ‘march of the makers’ in the UK reshoring, etc., but their most recent GDP numbers showed that’s not really happening, which is disappointing.
Gervais: Yes. Our currencies are moving around and the data will move around as well. But what is undoubtedly true is the UK can manufacture well. Look at some of the motor manufacturers. They may not be owned by the UK but many of those suppliers are UK companies. Look at some of the food manufacturing areas. Again, they’re not necessarily always owned by the UK but there are lots of good food manufacturing businesses there which are supplying many of our supermarkets. And I think many of those are getting commercial returns generating cash, defending margins and that’s generating cash, which ultimately grows dividends. And that’s ultimately what we expect, the very smallest companies to perhaps grow their dividends at a faster rate than that in the main market.
Merryn: But let’s talk about what constitutes a Microcap and a small cap. Where’s your line?
Gervais: Yes. It’s a very good question because there’s a real ambiguity about where small caps start and stop. A lot of people regard £2bn companies, £5bn companies in certain cases, as small caps. I think the key issue is that those areas are well held by institutions.
What we’re talking about is getting away from the consensual holdings, so that many of those companies which are often too small for institutions. Certainly, below £150m cap and possibly below £100m market cap, I would argue are the areas which are really interesting because nearly all institutions, nearly all small cap funds, already don’t hold them. And it’s that differential, the fact that we haven’t got many investors in there and if these things start to perform, then we get new capital put into them, we’re getting into a virtuous cycle where more capital is coming in to an area which is outperforming, which is relatively liquid and can drive that performance.
Merryn: What about the argument that the best of these smaller companies, the best of, say, Microcaps in the UK, are unlisted, so the best way to really find this growth is to find them before they list?
“Small quoted companies outperformed again and again, for three entire decades. We think that’s about to start again”
Gervais: I think, certainly, there are great returns to be had from venture capital. It’s an area which hasn’t had a lot of capital invested for many years. I think what’s been interesting is recently we’ve seen a lot more company start-ups and that kind of thing. But the real advantage of being quoted is the ability to raise capital, especially at a time when the world is difficult, perhaps when markets are uneasy and you can actually get the use of that capital when big – when small businesses, private businesses are starved for capital.
And what we saw in the 70s and 60s, very difficult times in the UK. A period with regular recessions, devaluations were regular and we had some unsettled periods with interest rates going up very substantially, small companies outperformed. Small quoted companies outperformed again and again, for three entire decades. We think that’s about to start again.
Merryn: And there has been some academic research that suggested this small cap effect, which is what you’re talking about, doesn’t really exist.
Gervais: It certainly hasn’t existed for the last 25 years. If you look at the small companies that enter the market, relative to the main market, it’s produced no return, no premium return for the last 25 years and nearly everyone thinks it’s gone. But I would argue that’s the exception. The exception has to be in the wide availability of world growth in the last 25 years, which means that most investors didn’t need to get involved in small companies. After all, they’re small, they’re fiddly. Each individual company makes very little difference to the overall performance of the funds and so most institutional investors have got quite used to investing in the top 350 companies and making very good returns. Indeed, you could have just bought an index fund for the last 25 years and done very well with it.
I think what’s actually happening is that that trend’s beginning to come to an end and as those small companies start to move up, indexation is not possible at the bottom end. And it’s that ability to invest in individual, small, quoted companies which can put capital to productive use, which is really the excitement.
Merryn: How many companies will end up being in the Microcap Fund?
Gervais: The Microcap Fund will have around 120 holdings to start with.
Merryn: That’s an awful lot of small companies for you to keep in your head at one time, pay attention to. I know you’ve got a great team, etc., but nonetheless, that’s a lot of –
Gervais: Yes. Of course, we are investing over time. We’re not just having to worry about what Mrs Merkel’s saying tomorrow and changing our mood every five minutes, so we don’t have to worry about that. But most particularly, many of the smallest quoted companies are very small. If you’re investing in a £25m company, you may only get £0.5m in, maybe £1m invested. But if it makes two or three times your money over a three year period, that’s absolutely fine for our clients. So, actually, to invest in many of the very smallest companies, we need to be prepared to invest small amounts of money in each individual holding.
Merryn: Given that these aren’t companies that will be very well covered by analysts you have to do all the original research yourself presumably?
Gervais: Yes. I mean, of course, that’s not so bad. It means that we have real conviction in what we do and ultimately, it can mean that prices are more mispriced. It’s not easy to outperform but it’s easier to outperform at the bottom end. Again, that will add more value for our clients.
Merryn: And does it make you quite active investors in that are you able to have some influence over how these companies are run? Say you have a £25m company and you’ve put in £1.5m, £2m, do you then have a governance role?
“Defending profit margins is going to be a really difficult issue… we need to expect profit margins to come under pressure with austerity”
Gervais: We certainly have a governance role. We certainly take the engagement with corporates very seriously but we don’t run the companies. The management team know the company so much better than we can and we’re only one shareholder after all, in a representation of other shareholders, so that management need to hear other shareholders’ views, come to their view and make their own decisions. If we don’t like what they’re doing, we can always sell the stock. We don’t tend to be that activist because getting everyone else arranged and agreed to a certain course of action is very time-consuming and actually, distracts away from meeting so many of the other companies where we could be allocating capital and getting productivity improvements.
Merryn: One of my readers asked me to ask you if you have any red flags that would make it impossible for you to invest in a small company? We can ask about what attracts you to small companies in a minute, but are there things that you would consider to be huge danger signals that would make a microcap not worthy of making it onto a shortlist of yours?
Gervais: I think the area which is easy to avoid is anything which might be of an illegal nature. No, most companies are –
Merryn: I was going to take that as a given.
Gervais: You say that, but there are certain gaming companies, for example, which operate in international markets which are not entirely legal. Maybe they’re not illegal but they’re not entirely legal, so for us that’s just a bit of a red flag.
Anything which puts a company where it’s wholly dependent on hitting forecasts and expectations within six or 12 months, where the balance sheet is so stretched that if they don’t hit those targets you’re going to have to an emergency fund-raising again, is another red flag for us. Because, as you can imagine, if they don’t hit those targets you’re suddenly being caught out with an emergency fund-raising, often at very delusionary levels. So those are the two big ones.
And we tend to avoid companies, largely, which aren’t growing their sales, companies which are under margin pressure and companies, ultimately, which are very expensive. High valuations are also a reason why we might not invest in a company.
Merryn: OK. So the attractive points of view, basically the opposite of those, growing sales, low valuations?
Gervais: Absolutely. We need, really, to generate more cash for our clients in time, companies which can grow their sales even when the market’s not growing. We need companies which can sustain margin. Defending margin, I think, is going to be a really difficult issue. Margins have doubled really, corporate profit margins, since 1985. That’s not to say they’re going to halve again but I think we’re near highs in the US and the UK, and we need to expect profit margins to come under pressure with austerity in time.
And we need to find companies which can defend their margin through service, through investing for productive improvement, through having a niche operation which is better than most others. And we need companies, ultimately, with safe balance sheets. The markets will be spikey. I can’t say when or why but they will and we always know, when things get spikey you want companies with strong balance sheets which can actually weather the storm and ultimately take advantage of the weakness of their competitors who may over-geared at that time.
Merryn: And as these companies grow, and let’s, again, stick with the Microcap Fund. As they grow, if you have a limit of £150m, how far can a company grow beyond that limit before it’s sold or is this just simply a limit where you buy under and it doesn’t matter how much they grow from there? They can turn into a mid-cap and stay in the fund.
Gervais: What we’ve suggested is that, actually, we can invest in, principally, companies below £150m but it’s not a hard limit. For example, if we had a company perhaps, which have moved from £100m to £160m, it was doing really well. It was doing a secondary fund raising for a very exciting acquisition or a new factory or whatever, and the opportunity for an upgrade was substantial, we were being offered share at a discount, it would be crazy for our clients to turn down the opportunity to increase our holding at a discount for a business which is worth more after the deal.
“The best returns are often from the very smallest quoted companies; the £50m companies, the £25m companies”
So we can absolutely continue to invest in companies above £150m for that reason but ultimately, the best returns are often the very smallest quoted companies, the £50m companies, the £25m companies. So we’re generally looking to take profits in companies as they move to £150m and £200m, and sometimes £300m. Perhaps it went on straight away, and reinvest at the bottom end of the market for that productive improvement because they’re often the cheapest companies. They’re the companies which find it easier to double. It’s not easy to double but easier to double.
Merryn: We talked earlier about how small caps is rather an unpopular asset class at the moment. You were saying there have been significant outflow recently.
Gervais: Yes. What’s been amazing is, really, there’s been outflows out of this asset class pretty much for the last ten and 20 years. So during the time when most OEICs have been attracting inflows, small companies have been, not just seeing less inflows, they’ve been seeing outflows. It got to the bottom about 2008, a slight pickup in 2009 – it didn’t really last. A bigger pickup in 2012 into 13 but now we’ve seen it peak out and great sales. So the actual net amount of interest in this area is as low as it was even in 2008 or 2009.
So this is an extraordinary position where we see the best performing asset class is pretty much the single asset class where most institutions are most underrepresented.
Merryn: Interesting one. Obviously we’ll take your word for it that this is the best asset class to be in at the moment. What’s going to bring other people back in? What’s going to reverse this outflow?
Gervais: I think what’s already started to happen is, we’ve seen many of the largest companies are struggling to grow their dividends at the rate they have in the past. Smaller companies tend to have better balance sheets, so they’ve got more ability to pay dividends on lower valuations. Even if you pay a cover dividend you often find the yield is better because the valuation is lower, so you find that the dividend yields are probably more attractive than many people think. And most particularly, if you’ve got a business which is growing and generating more cash, then you can grow your dividends.
And so, what we’ve seen over the last 12 months is that small companies are growing their dividends faster than big companies. This is what actually happened in the 70s and the 60s, and we think that that’s the difference. It’s not well recognised at this stage but it’s going to be the key driver of asset allocation into the sector. It’s going to be something which is so counterintuitive as to really shock many of the conventional assumptions.
Merryn: It’s a very counterintuitive idea, that people will start investing in the very small companies’ field.
Gervais: Yes, it’s very interesting. If you look at the Multicap income fund, the Diverse Income Trust we set up, actually we’ve seen fantastic dividend growth from that in the last 12 months.
Merryn: And what’s the yield on that at the moment?
Gervais: The actual fund is yielding about 3.8%, 3.9% in terms of the portfolio. The investment trust, there is some charges against that, so the yield is nearer 3% to be honest. But actually, the underlying income from the portfolio is already nicely over 3.5%, which is perfect. And particularly, more importantly, it’s growing at a great rate.
Merryn: One thing you can’t do with a Microcap Fund presumably, is control the discount as well as you can on your other trust?
Gervais: Yes. Both trusts have an unusual structure where all investors are allowed to redeem their entire holding every year. It’s at the director’s discretion but they’ve said, they’re minded to approve all requests. We had exactly the same structure in Gartmore Growth and the discount, even in 2007, 2008, tended to remain remarkable tight. It wasn’t zero but it was much, much less than most other funds because it clears the overhanging cellars every year, which means the only investors in it are people who want to be in it.
And if new investors are looking at buying it, they don’t have to worry too much about the discount opening up because they know the overhanging cellars have already been cleared. So it means there’s more turnover in the stock and it does mean that ultimately, the fund itself is better supported and for that reason the discount doesn’t tend to open up.
Merryn: Yes. Given it’s worked so well for you, this discount control mechanism, why do you think the rest of the sector doesn’t use it?
“In the last 12 months small companies have grown their dividends faster than big companies. It’s going to be the key driver of asset allocation into the sector. It’s going to be so counterintuitive as to really shock many of the conventional assumptions”
Gervais: I think there are real issues for subprime managers because if 70%, 80% of the fund decided to redeem, the fund does come to an end. There’s no vote or anything else. Basically it means that every year the entire-
Merryn: But that is effectively a vote, isn’t it?
Gervais: It is a vote. It’s a very easy vote. You just tick the box and send your form in. And so we have to work really hard to make sure that our existing clients are happy with the fund perhaps a little harder than many of the other funds.
Merryn: So beyond creating good performance, is that a role with quite a lot of contact with your own shareholders?
Gervais: Certainly. We’re very keen to go and see our shareholders. We also spend a lot of time on the Annual Reports actually, to make them really accessible, to make it really clear what we’re trying to do, to really help and make sure it’s obvious for our shareholders what we’re trying to do and hopefully attracting new investors in as well.
Merryn: Interesting. What I can’t let you go without are a couple of your favourite stocks at the moment?
Gervais: We’re buying quite a lot of stocks. I’m not going to talk about anything I’m buying right now.
Merryn: OK, nothing you bought now. What’s the last thing you bought that you’ve completed buying?
Gervais: One which we saw just a couple of days ago is International Greetings. It’s a business which is in wrapping paper around the world, one of the top three suppliers. Not necessarily an exciting company but a business, which is now about £50m market cap, which has invested £10m CapEx in the last three years in productive improvement; productive improvement in Holland, productive improvement in the UK. That’s defended margins. That’s meant they’ve got more growth potential and improved service levels. And that meant that a couple of weeks ago, they actually said that they were trading above expectations.
The debt had fallen faster than they expected and having never paid a dividend, they’re now contemplating a dividend. It’s on a P/E of eight. It could pay yield of 12p. It’s not going to pay a yield of 12p but it might start at a yield of 2p. It might move to 4p. It might move to 6p, I don’t know. But that’s a wonderful thing for an investor to be investing in a company which is productively improving and generating cash, and paying decent yields.
Merryn: Another reader asked me to ask you that even with these wonderful stories, and you tell a story like that and it sounds fabulous, but if there’s a proper market crash smaller stocks like this are still going to fall more than the larger cap stocks, aren’t they?
Gervais: They tend to be more liquid. So they tend to be – the big companies perform more aggressively to start with and these tend to catch up with a delay. What’s been interesting, if you look back in the 1970s and 1960s, particularly in the 1974 crash, many of the very smallest companies actually didn’t fall so much. They outperformed ahead of the period because they were growing their dividends. They tended to have slightly safe balance sheets. Some of them do go bust. Lots of them do go bust but in fact, the pricing, the pullback on the very smallest companies actually was less than the main market. I don’t know why.
I wasn’t around in 74 but it was interesting that it’s not always the case. I can’t say it’s going to be, necessarily, the case but the nice thing is, we’re coming off a much lower valuation. Valuations are not quite half, just a little bit above half the main market. They might halve with the market if the market halves but they’ll be on P/Es of four and five and –
Merryn: And that will be an amazing time to buy them.
Gervais: We’ll have to get over the disappointment.
Merryn: That’s great. What was the stock you bought before International Greetings? Let’s have one more. Everyone loves a stock tip.
Gervais: OK, yes. I think software can be an area where you can get productive improvements as well. So if you take K3 Business Systems, this is a business which is involved in two areas. It is manufacturing software for retailers using a new AX, Microsoft AX, software platform.
And they are so strong, the demand is so strong for the retail logistics platform, they can’t keep up with demand. They actually have to run just to keep up with customer demands. Microsoft have approached them and asked them if they can sell their system themselves, using their own sales force in the US. What a wonderful thing. Again, a PE probably 12 times dropping to 8 times next year. A lovely investment, again.
Merryn: Thank you. Another lovely story. Thank you very much.
Gervais: Thank you very much for the opportunity.