Are things as bad as they look economically? And what small-cap stocks will do well? John Stepek talks to our Roundtable panel of experts to find out.
John Stepek:The focus is small caps today, but let's start with an overview. Practically all the central banks are printing money now. Is the worst of the financial crisis over?
David Taylor: It's too soon to say, but the outlook certainly isn't as bad as current share prices imply.
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Paul Marriage: I don't do macro, but safe haven' assets look exorbitant compared to British small caps.
Giles Hargreave: I certainly wouldn't want to have too much money in the bond market. And if you are not going to be in the bond market and you can't be in the bank, you might as well be in equities. If you are going to be in equities, why wouldn't you be in small caps? Even though the index as a whole has underperformed, the good small-cap funds have outperformed massively. So think what might happen if you get a general outperformance by small caps and you are also in the right fund.
Tom Bulford: Yes, people are very risk averse at the moment, so small caps are right out of favour which is probably the right time to be looking at them.
Giles: A lot of money has been going into equity income funds.
Paul: Also, if you look at the FTSE 250, on a total return basis [ie, including reinvested dividends], it's 20% above its 2008 peak. People who want high growth, without the illiquidity of small caps, have just bought mid caps. But now mid caps look vulnerable the index is stuffed with small-cap stocks that have been massively overbought. They are good companies, but they're on 20 or 30 times earnings they're fully valued.
David: The problem is that if you were in the average small-cap fund in 2007 and 2008 when things went horribly pear-shaped, you lost a lot of money. So people are avoiding less because of valuation than due to lack of confidence.
Stuart Widdowson: But could we see something like 2007/2008 again? I think not. Small caps are much less geared than they were. To get the same sort of earnings per share (EPS) fall that some suffered, you'd have to see much bigger top-line falls than in 2007/2008, which seems unlikely. Also, are people who sold good companies back then at a third of the share price they're at today really going to do it again in a hurry?
Giles: It's not just 2007 and 2008 though. In 2002/2003 you pretty well halved your money. What people need to understand is that there will be ups and downs that's inevitable. Yet over the long term, if you are in the right funds, you will make many times your original money.
Paul: There's that great statistic: if you'd invested £1,000 in 1955 in the All Share it would be worth £620,000 now. If you invested it in the bottom 10% of the market by value, it is more like £3.2m.
John: Any specific sectors you think are particularly interesting?
Paul: We have two simple rules. No loss makers and no oil and gas or mining.
Giles: I don't care about sectors if I can make money, I'll make money. With oil exploration at the moment, the margins are huge if you can find a country with the right fiscal regime. You wouldn't want to go anywhere near Russia. You will lose 70% or 75% to the government and at least 20% on exploration costs. That doesn't leave much. But Africa is slightly different and funnily enough, Colombia is very good.
John: How do you pick the right ones?
Giles: The best thing to do is to wait until a firm is in production and is exploring further in the same area: so it's more like infill, rather than exploration. Nowadays they're a lot better at it 3D seismic and other technology has improved returns considerably. One oil and gas stock I like is Colombia-based Amerisur (LSE: AMER). It's already producing a couple of thousand barrels a day. We will get the results of its next well quite soon. These are basically infill wells, not exploration wells, and it's got permits to drill a further 55 in the same area.
It's projecting 5,000 barrels per day (bpd) production by the end of the year it's already in for 2,500. The following year, I can't see it being less than 10,000 bpd, at a $20 a barrel cost. The royalty is 6% to 20%, depending on how much it is producing. At 5,000 bpd you're looking at $150m annual cash flow; at 10,000, it's $250m. And by the time you've drilled your 55 wells in three or four years' time, who knows how much it could be? The stock has come down a bit because the last well wasn't as good as the previous one: it's only producing 500 bpd, while the previous one was producing 1,500-2,000. So there are risks, but overall it's exciting.
Tom: In terms of interesting sectors, there is a bull market in biotechnology in the US, where the Nasdaq biotechnology index is up about 40% over the last year, yet nobody here seems to have noticed.
While we're on the natural resources theme, if you are looking at a minerals project, you want a large resource in a place not run by crooks, and you want a type of commodity that can't easily be found and dug up elsewhere. Sirius Minerals (LSE: SXX) fits the bill: it has a large potash project in Yorkshire. It'll cost plenty to get it out of the ground, but you would think that if it can't raise finance for this, then other natural resource companies in dodgy countries around the world certainly won't be able to raise the funds they need. So it's high risk, but potentially high reward.
John: Dave, have you got a tip for us?
David: We own a very small software company called Sanderson (LSE: SND). It's got two divisions. One does retail software, the other manufacturing. The retail side is about helping smaller and mid-sized retailers with their online offering and co-ordinating it with their in-store offers. It has a £17m-odd market cap and cash on the balance sheet. The yield is around 2% and trading is going well. The chairman owns 29.9% of the company and on 1 January, when he wakes up, 60% of his business will be recurring revenue.
Stuart: I've got a software company too: Allocate Software (LSE: ALL). It provides workplace efficiency solutions to the healthcare and defence sectors and does electronic rostering systems for hospitals. Staffing is the NHS's biggest cost it's incredibly inefficiently managed. When properly implemented, this software effectively cuts the temporary labour cost to zero. So you get a rapid payback.
It's the clear leader in a growing market, but a third of NHS trusts in Britain still don't have it, and internationally it's virtually unused outside of America. The company has spent a long time and a lot of money over the last three years recoding its software to go multilingual, so that should allow decent future growth. It has also assembled several products to cross sell to its customer base.
It has done a number of deals recently and there are opportunities to cut costs and improve operating margins. Finally, its earnings quality is improving. The business model it uses means it effectively resells its licences every five years, so as its customer list grows so does its earnings visibility because its customers come back every five years.
John: Any concerns about austerity cuts?
Stuart: NHS trusts have a specific ring-fenced budget for productivity-enhancing initiatives'. So that's where this spending comes from. If you put this into a hospital it pays for itself within four months why wouldn't they do it?
John: What about you, Paul?
Paul: I like Good Energy (LSE: GOOD). It's a fully integrated utilities company. If you like your electrons green', it's Britain's go-to provider. It owns energy-generating assets such as wind farms, and sells energy to tens of thousands of customers. Also, if you put solar panels on your roof, you need someone to deal with the administration involved in getting hooked up to the grid Good Energy is the top provider of that service.
It has a low valuation, a modest market cap and good management an entrepreneurial chief executive teamed with an ex-public company chief financial officer a good combination. It's at early stages and I think it's doing all the right things.
John: Going back to the economy in general I get the impression most of you think things are better than they look?
David: Well, we are in a recession. But if you go back to 1992, when Norman Lamont said that the economy was recovering, everyone laughed at him but he was dead right. You can never tell we worry so much about Europe and everything else, but for the last three or four years the British corporate and consumer sector has been repairing its balance sheets.
Employment is rising and real [inflation-adjusted] incomes will start rising next year. The government has issues in terms of debt, but gradually things are getting better. There are still a lot of people working and earning, and still a lot of cash that has to be invested.
Stuart: Mathematically too, in Britain, if the public sector is shrinking and the private sector is flat, GDP is going to fall. But arguably the state is too big anyway.
Giles: Can I also just point out I'm quite old but I am used to 5% or 6% interest rates and inflation between 5% and 7%. Now, we have 2.5% inflation and zero interest rates how lucky are we? It's not going to last forever, but it's not a bad scenario and it's certainly not the doom and gloom that people talk about.
Paul: I spend quite a lot of the time on the road. Yes, you see closed shops and derelict industrial sites. But for every one of those you see a company on an industrial estate making world-leading products and creating a lot of wealth. We always hear about how fantastic the German economy and the Mittelstand [Germany's small business sector] is but you can't buy the Mittelstand, it's all private.
In Britain, we have a much larger proportion of public companies, a much longer heritage and generally higher reporting standards, so it's quite a mature market. It's easy to sit and get grumpy if you watch the news, but if you go out and try to find and invest in these companies, there is a lot to be excited about.
John: Let's get the rest of your tips can we have another two each?
Our Roundtable tips
Giles: This one is a bit speculative it's a play on the rising iodine price. Iodine is an interesting commodity. Demand is growing quite rapidly (it's used for everything from healthcare to paint), but production isn't. The Chileans and the Japanese produce it, but they can't produce much more.
However, Iofina (LSE: IOF), this funny little American company, has discovered some technology that enables it to extract iodine from used oil wells. The oil companies finish extracting the oil, then do a deal to allow Iofina to extract the iodine. It seems to be able to do it rather more cheaply than the Japanese and the Chileans can.
Its first well was completed last month and is now producing, so it's proved the process works. The second well is going to be much larger, producing in the region of $4m-worth of iodine with a 50% profit margin. Iofina has done deals with several oil firms, so future capacity is substantial. Investec forecasts that it will be making £10m by 2014 and if you listen to the chief executive, that's a long way short of what is possible.
David: My second tip is a small company called Acal (LSE: ACL), which distributes specialist electronic components across Europe. To put things in context, there are two giants in the component distribution industry, Arrow and Avnet. Then there's two mid-range, £600m-£800m companies called Electrocomponents and Premier Farnell. Finally, you've got Acal, which does the specialist business that the larger guys don't do.
If you're in the US and you've got a low volume specialist product that you want to get into the market, Acal is becoming the European distributor of choice. It has cash on the balance sheet, a £50m market cap, growing turnover and growing profits. There's a new management team who I rate.
It's a slow burner, but when investors come back to small caps, it'll be at a time when confidence is rising. And when confidence is rising and economies are going up, component distributors will almost by definition be trading quite well. So I don't know when it's going to happen, but on a single-figure multiple, a 5% yield, and with cash on the balance sheet, just tuck it away.
Stuart: US property has had a tough time over the last four or five years. However, the market seems to be clearing in most states. This is why you should buy Lupus Capital (LSE: LUP). It's a leading manufacturer of window hardware and seals and has a lot of exposure to the American new-build residential market. Build rates are starting to pick up from the bottom, but are still well below the long-term average.So if you believe the US residential build market is on the mend, you should buy Lupus.
The business has sold its non-core units, so its balance sheet is very strong. The team has a proven record of adding value through mergers and acquisitions, and there are opportunities to consolidate the market in America. It's had a good run of late but I think it has the potential to go further.
Paul: There are a lot of businesses out there making good money now, which I would describe as nettle graspers'. They used the 2008/2009 slump a good time to release bad news if ever there was one to deal with problems in their businesses. They shut tricky factories, got out of places they didn't want to be in, and improved their balance sheets. Now they are reaping the benefits.
Industrial fabrics maker Low & Bonar (LSE: LWB) is a classic example. It's a quality business that has got rid of the not-so-good bits and improved its quality of earnings by focusing on things it's good at and spending more on product development. It's run by a couple of sensible individuals and overlooked by the markets. It's on a low multiple, with a decent yield. It has lots of euro exposure, so if there is even a small tick up in euroland, it could do well.
Stuart: You've got to take a view on polymer prices though, haven't you?
Paul: Yes, but you could say that of the even more lowly rated but equally good British Polythene Industries. And it's a risk the industry as a whole has been managing much better recently.
Tom: I'll stick with the biotech theme. One of the few British players is ReNeuron (LSE: RENE), which basically drills holes into the heads of people who have had a stroke, and injects stem cells to try to revive the part of the brain that has been damaged. It's early days, but so far the treatment doesn't seem to do these people any harm and there is early evidence that it does some good.
The interesting thing is that Reneuron's experience is consistent with what has been reported from stem cell trials elsewhere, notably in America. Stem cell medicine is definitely something to keep an eye on, and is part of the emerging business of regenerative medicine.
Giles: I'm going to opt for a mid cap this time. Restaurant Group (LSE: RTN) is a beautiful company. It has around 400 outlets and thinks it can roll out another 300, so you've got ten years of roll-out ahead, at 20-25 new outlets a year. Competition is not what it was. In the old days if you were a restaurant manager you would go down the road to the bank, borrow a couple of hundred grand and open up in competition. You can't do that now. So competition is not great.
Cash flow is terrific and it's got a very small amount of debt. It's going to have a choice of buying back shares, increasing its dividends or accelerating the roll out. I don't think it will accelerate the roll out because the management team is comfortable with the current pace. So you will probably see share buybacks.
David: The free cash flow in that business is phenomenal.
Giles: It's a quality stock. If you think the British economy is going to go backwards then maybe you shouldn't buy it, but if you think it is doing rather better than people think, this is the place to be.
Paul: The big change from previous recessions is that a lot of people are still budgeting £25 for the cinema and £25-£50 for a meal at a Restaurant Group place, such as Frankie & Benny's, as part of their monthly treat. So it's done a lot better than you might have expected.
David: I'll go for Hill & Smith (LSE: HILS). Among other things, it does crash barriers and gantries on motorways. It also has a galvanising business coating metal with zinc, which is then used for fencing and so on. So it's sensitive to the state of the economy. But if you look at prospects for Britain's road programme, things are ticking up. That's important because they do crash barriers and temporary road works.
More importantly, if you genuinely believe that this government has to do something to get re-elected, then the most obvious thing to do is to put money back into the construction industry. One of the easiest ways to do that is by increasing spending on roads, because this can be targeted. So if you are looking for a company where there is potential upside above and beyond a normal economic upswing, this is a good option.
In any case, it's a thoroughly decent business run by a strong management team with a good yield of around 4%, which trades on a single-figure multiple.
Stuart: My final tip, sticking with the theme of America's recovery, is 4imprint (LSE: FOUR). The company focuses on the States and provides promotional products. Say you want a load of pens or umbrellas with MoneyWeek' on them for your clients 4imprint acts as the middle man. The product never comes through the business, it goes direct from the supplier to you. It's got lots of customers and suppliers, which is a nice place to be.
Better still, it's the clear leader in its market. If you look at the overall market, it's a cyclical industry, but 4imprint has grown sales by 15% a year for the last five years, during which time the market was flat. In the recession, sales only dipped by 3% in the US and subsequently next year were up about 15%, so you can see it has taken market share.
The really good news is that it's still only got 1% market share, so there are many years of decent growth ahead of it. You are getting about 15% profit growth per year and it's yielding 4.5% on a price/earnings (p/e) ratio of about 14, excluding cash.
Paul: Earlier on I mentioned that when stocks go from small cap to mid cap, they often get massively overvalued. Here's one on the cusp, one that may yet do that Vitec (LSE: VTC) . It does studio and image capture, everything but the camera. We are talking tripods, studio equipment, LED, spotlights, etc.
Think back to the glory days of a month or so ago at the Olympics: the underwater images of the swimmers going up and down Vitec kit. The image inside the Olympic flame Vitec kit. That's all in the second half. It's a business that's gone from 9% to 11% profit margins, and which we feel should be a high-teens margin business like many of the others I mentioned. It's definitely one to watch.
Tom: My third tip is Source BioScience (Aim: SBS). It has the only automated screening technology in Britain, which means it dominates the national market for cervical cancer testing. It's a profitable, financially sound business that's perfectly placed to profit from two important trends in medicine: DNA sequencing and diagnostics. It also has high hopes for its GenomeCubed' online catalogue of cloned DNA, RNA and antibody products, which can be ordered by researchers anywhere in the world.
John: Thank you.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
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