Three quality companies to try now

Professional investor Stuart Widdowson looks for smaller companies that are market leaders in their niche, with strong management teams and sound balance sheets. This way, he finds quality companies that deliver growth at a reasonable price. Here, he picks three stocks that fit the bill.

Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Stuart Widdowson, investment manager at SVG Investment Managers.

The best long-term returns from smaller firms come from quality businesses that trade on modest multiples of underlying cash flows. They should also trade at a significant discount to the price trade purchasers or private-equity houses would be prepared to pay to own 100% of them.

Downside risk can be mitigated by only selecting investments where there are multiple drivers of shareholder value (such as decent earnings growth and dividend yields). The firm should also be a niche market leader with a strong management team. The balance sheet must be efficient, but not stretched.

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This approach tends to flag either 'fallen stars', which are in the process of being turned around, or firms delivering growth at a reasonable price (Garp). The following three stocks all exhibit Garp characteristics, are market leaders with sound balance sheets and are managed by quality executive teams.

Allocate Software (LSE: ALL) is a leading provider of compliance management software and services global organisations with large, multi-skilled workforces. It is the clear European market leader in the healthcare workforce management market, and provides software products and services that help make nurses' and doctors' schedules more efficient. Until six years ago virtually all rostering was undertaken manually. So the scope for savings is huge the length of time taken to recover costs is estimated at six to 12 months. Allocate Software has seized around 45% of the UK market for nurses and there is room for growth as only 55% of the potential market has yet been penetrated. The firm has also won big contracts overseas, beating off heavyweights such as Oracle and Kronos.

We believe the company has many years of double-digit organic growth ahead of it, as well as scope to consolidate its fragmented global market. The current rating is low the shares trade on 10.5 times earnings and eight times operating profit.

KCOM (LSE: KCOM) is a leading provider of communications services to businesses and public-sector organisations in Britain and to consumers in East Yorkshire, where it is the main provider. This strongly cash-generative business saw significant management change in 2008. KCOM has since sold non-core assets, generated significant cash flow to reduce its gearing, and worked to reduce the risk posed by its pension deficit. The focus in 2010 has been on restoring modest growth within the main businesses. I believe that the group can achieve low double-digit organic earnings growth over the next five years. This isn't reflected in its price/earnings rating of eight, nor in its double-digit free cash flow yield. With limited incremental investment required to fund this growth, the current 4% yield could rise, given the dividend is covered three times.

Statpro (LSE: SOG) is a leading provider of portfolio analysis, asset valuation services, and performance measurement for the global asset-management industry. More than 90% of revenues are recurring, driving strong cash flow and profit visibility. It's redesigned its original core product into a package called 'Revolution', which meets the needs of smaller-asset managers and front-office fund managers. This is a larger target market than for the original product and, within a few months of being launched, Revolution signed up its first major client. Overall profits are being depressed by the start-up investment that's gone into the product, but with rising sales and core business growth, earnings should rise over the next three years. In mergers and acquisitions terms, Statpro is cheap, measured on a multiple of recurring revenues.

Stuart Widdowson

Stuart is a professional investor and Managing Partner at Odyssean Capital LLP. Prior to this, Stuart was a fund manager of strategic funds at GVQ Investment Management Limited for just over 10 years and then he spent 6 months as a partner at Harwood Capital to establish a new fund management business. He has been at Odyssean Capital LLP for just over 5 years and he has contributed to MoneyWeek’s share tips.