In the stockmarket, the top dogs are going nowhere – but the smaller mutts have plenty of growth in them yet, says Gervais Williams.
• Watch the full interview with Gervais here.
If you are looking for firms that can keep making good profits and paying rising dividends in an age of global secular stagnation, odds are you are looking in the wrong place. That, at least, is the firm view of Miton Asset Management’s Gervais Williams.
The super-low interest rates of the last seven years might have given us an asset-price boom, he says, but they haven’t given us sustainable growth. Instead, we have been “borrowing our growth from the future” and we are in “payback territory” – you can see this in the “poor economic numbers”. That means growth will be hard to find everywhere, something that “narrows the investment universe”.
We agree on that. But most managers, I say, make this lack of global growth their main reason to hold global blue-chip firms, on the basis that they are the only ones with the brand power to keep growing both sales and profit margins.
Williams isn’t so sure. These companies do have the “advantage of scale” and of low borrowing costs – both bonuses. But that doesn’t mean they can easily buck the economic trends. And when they find that they can’t, often their only way forward is to eat into each other’s margins. That’s when they all lose out – as in the supermarket sector in the UK. These big companies – thanks to quantitative easing (QE) and the “pack factor”, which pushes all fund managers to buy the same things at the same time – are also looking pretty expensive at the moment.
So if it’s protection from low growth they are after, investors would be much better off looking at small companies instead.
Surprisingly cheap stocks
Why? It is partly about value. Aim, the exchange on which smaller firms in the UK are listed, has been falling as sliding commodity prices have hit the more speculative companies on the market.
But the downdraft has caught lots of really good “regular turnover, regular profit” companies along the way. The result? The “differential in valuations between the top and bottom… is probably the most extreme I’ve known in my career for the last 30 years”.
It might be that this continues for a while yet as low growth leads to more QE, but right now we are moving into a “territory where it’s getting more dangerous to hold the status quo”. So people have to diversify – and with Aim stocks “ridiculously” cheap relative to the main market, they seem like a good place to start. Note that there have been “outflows out of this asset class pretty much for the last ten and 20 years… the actual net amount of interest in this area is as low as it was even in 2008 or 2009”.
But this isn’t just about relative pricing, says Williams. It is also about growth. Small companies “can grow even when the world’s not growing… it’s all about the ability to invest capital for productivity gain at a time when the world’s not getting much productivity”. That is “the true generation of real, long-term wealth”. You might not see much productivity improvement in the areas that have led markets in the last 25 years – think those dependent on asset prices and outsourcing – but look to the areas that have “been less fashionable, such as insurance and manufacturing, and you may well”.
Regular readers will know how interested we are in the “march of the makers” – the long-predicted resurgence in UK manufacturing – so I ask more about that. What is “undoubtedly true”, says Gervais, is that “the UK can manufacture well”. Look at our motor manufacturers and at the food-manufacturing businesses supplying our supermarkets: they are generating cash and defending margins – which ultimately grows dividends. Look at it like that and you can expect “the very smallest companies perhaps to grow their dividends at a faster rate than that in the main market”.
Something like this happened back in the 1960s and 1970s. Then we saw regular recessions and devaluations and also very unsettled periods in terms of interest rates. But small, quoted companies “outperformed again and again, for three entire decades”. That hasn’t been the case for the last 25 years, which is why many now think that the “small-cap effect” doesn’t really exist. But “we think that’s about to start again”.
Forget the trackers
That should really matter to investors. For the last 20 years, investing has been relatively straightforward – you’d have done pretty well just buying an index fund tracking the bigger stocks and being done with it. But with economic growth gone, successful investing needs more attention: if you want to “invest in individual, small, quoted companies that can put capital to productive use”, you can’t use an index. So what makes a company worthy of Williams’ new micro-cap fund?
We know that being very small is key. He wants to hold the kind of firms other people don’t get around to looking at, or which are too small for institutions – so firms with market capitalisations of under £150m, or even £100m. That means that to fill the fund he will have 120 or so investments in total, and have real conviction in all of them. That’s a tough call. But on the plus side, smaller firms tend to be very open to engagement – and if no one else is talking to them then Williams and his analysts can talk to them rather a lot.
We start with what Williams doesn’t like when he is looking at a company. “Anything that might be of an illegal nature.” I say we will take that as a given, despite the dodgy reputation of the small-cap world. What else? Firms with “stretched balance sheets”, tough targets and no emergency fund. Companies that aren’t growing sales. Firms under margin pressure. And businesses with overpriced shares. That seems reasonable. What’s the other side? Williams looks for firms that are growing their sales regardless of the economic environment; that have safe balance sheets (not too much debt); that can defend their profit margins; and with a niche of some kind.
This market will be “spiky”, says Williams, and small caps will suffer along with big stocks if the market crashes, so whatever you do you need to make sure that your investments have the resilience to cope – and potentially to take advantage of competitors who have overgeared (borrowed too much) into crisis.
The key here, for Williams at least, is to buy into the firms that have the balance-sheet strength and sales to keep growing their dividends – it is the growing awareness of rising yields (such has those he has produced in his Diverse Income Trust, which currently yields 3.8%) in the small-cap sector that he reckons will bring investors back to it. “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 that is so counterintuitive as to really shock many of the conventional assumptions.”
Two for the shopping basket
So what has he been buying recently? He likes International Greetings (Aim: IGR), one of the top three suppliers of wrapping paper globally. It may not sound exciting, but while it has a market capitalisation of only £50m, it has spent £10m on capital expenditure in the last three years. That has resulted in good productivity improvement, better service and defended profit margins.
The company is trading above City expectations and is now contemplating paying a dividend for the first time. It could pay as much as 12p a share, says Williams. It won’t – it’s more likely to start at 2p. But it might move to 4p. It might move to 6p. And it’s “a wonderful thing for an investor to be investing in a company that is productively improving and generating cash, and paying decent yields”.
I couldn’t agree more. Any others like that? Williams suggests K3 Business Technology (Aim: KBT), a supplier of integrated business systems and the UK leader for some Microsoft systems. Demand for its products is so strong that it has to “run to keep up”.
Yet the company trades on a price/earnings ratio of only 12 times, dropping to eight times next year. This, says Williams, is a “lovely investment”.
Who is Gervais Williams?
Gervais Williams, 55, has been managing director at fund management group Miton since 2011. More than £1bn is invested in his funds, which include the Miton UK Smaller Companies fund, and the Diverse Income Trust (LSE: DIVI), which he co-manages with Martin Turner. The trust – which is biased towards smaller and mid-cap stocks over the long run – has outperformed the UK equity income sector substantially over the past three years, rising 90% compared to a 67% gain for the sector as a whole. It currently trades on a premium to net asset value of around 1.8%.
Williams graduated from the University of Liverpool in 1980 with an honours degree in engineering. He has been an equity fund manager since 1985, working with Throgmorton Investment Management and Thornton Investment Management, before joining Gartmore Group in 1993, where he spent 17 years, heading up their UK small companies fund.
He has published two books on investing: Slow Finance: Why Investment Miles Matter (2011) and The Future is Small: Why Aim will be the World’s Best Market Beyond the Credit Boom (2014), in which he outlines his view that large companies will struggle following the credit crisis, leaving the best opportunities to be found in small stocks.