Bargain shares among the small caps

In the current uncertain economic outlook, Credit Suisse fund manager James Chapman favours small caps with defensive growth characteristics - he reveals his top three shares to buy now.

Every week, a professional investor tells MoneyWeek where he'd put his money now. This week: James Chapman, manager, Credit Suisse Smaller Companies fund

Small-cap shares are resolutely out of favour just now perhaps unsurprisingly, given their history. Small caps traditionally underperform large caps in economic downturns and are also seen as higher risk. The result has been a 25% fall in the FTSE Small Cap index over the past 12 months.

So has the nadir been reached? By historic standards, relative valuations look undemanding, but not outstandingly cheap. The Hoare Govett Index (HGI), which represents the lower 10% of the UK stockmarket by market capitalisation, trades on 13 times earnings. While far from demanding, this is a premium to the FTSE All-Share. In previous downturns, the HGI traded at a discount to the wider market.

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Another way to gauge whether a bottom has been reached is to examine the discount at which small-cap investment trusts trade compared with their net asset value. This stands at 17%-21%, much worse than the historic average of 10%-15%, but not yet at the trough levels of 25% seen in 2002/2003. So the evidence points to possible further falls in small caps before the bottom is reached.

That's not to say that there aren't some great opportunities. We've favoured small caps with defensive growth characteristics over the past 12 months. Given the uncertain economic outlook, we're happy to retain this stance.

One interesting-looking firm is Synergy Healthcare (SYR). Its share price has suffered recently due to several factors. There were fears that CEO Richard Steeves would be forced to sell a chunk of his 4% stake to avoid the rise in capital gains tax. This was resolved after he sold some shares then immediately repurchased them in his Sipp. A second worry has been Synergy's upcoming move from Aim to the main market. This requires a change in the shareholder base (as funds restricted to Aim stocks sell out).

Synergy serves a variety of defensive and fast-growing markets, which include surgical-instrument decontamination and sterilisation. The jury's still out on the purchase of decontamination business Isotron last year, but management has a good record of improving the performance of acquired businesses. Synergy could also be a major beneficiary of US healthcare equipment manufacturers outsourcing decontamination activities. Add in that it is a significant euro earner (good news for a firm that reports in sterling) and we think the shares look cheap.

Another defensive is Dechra Pharmaceuticals (DPH), an interesting combination of a low-margin, mature, but cash-generative veterinary-products distribution business and a high-growth, high-margin, veterinary drugs business. The distribution unit has strong UK market share and throws off cash for developing new treatments, but it's the pharmaceutical arm that generates the real excitement. Dechra plans to launch two of its established European pharma products in America this year, while the recent acquisition of Europe's VetXX has given it a European distribution network.

We also like Hargreaves Services (HSP), a mini-conglomerate with interests ranging from producing coal at Maltby Colliery to mineral trading and coke production at its Monkton works. Much of its production is tied into fixed-price contracts, but if current spot prices are maintained it should see a significant uplift in profits when these deals expire something that's not built into broker's forecasts.

The stocks James Chapman likes

Stock, 12mth high, 12mth low, Now

Synergy Healthcare, 902p, 566p, 620p

Dechra Pharmaceuticals, 430p, 293p, 377p

Hargreaves Services, 645p, 438p, 542p