Three strong small caps going cheap

published 10 October 2007

Every week, a professional investor tells MoneyWeek where he'd put his money now. This week: Chris Fontenla, manager of the UK Smaller Companies fund, Scottish Widows Investment Partnership (SWIP)

These are turbulent times in the UK equity market. Investors are worried about the fallout from US subprime lending and signs that the British economy may have reached a turning point. However, the recent market correction has left a number of small caps trading at attractive valuations. Our rigorous, in-depth research process identifies firms that are well managed and able to sustain a competitive advantage in growth markets, and which generate strong free cash flows.

In the current economic climate, the retail sector may not seem the best place to invest. But Land of Leather (LAN), which only sells leather sofas, is an excellent long-term play. The firm sources materials exclusively from the Far East, giving it a strong competitive advantage, and its working capital arrangements are favourable it receives its money from customers before it needs to pay suppliers. Its unbundled product offering typically undercuts the competition by 20%. Improved buying power and greater economies of scale have seen gross and net margins grow at an impressive rate.

Land of Leather's business is also hugely cash-generative and its ambitious expansion programme, which will see it grow from 100 to 160 stores over the next six years, will be entirely self-funded. The stock is now forecast to yield more than 7% with net cash on the balance sheet, and is cheap on all valuation metrics. While there may be a risk of a retail downturn, our research indicates that the group's robust business model, progressive margin expansion and strong management puts it in a great position to ride out the storm.

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Also attractive, although less of a household name, is Elementis (ELM), a chemicals producer whose management has impressed us. An infusion of new talent at the top has triggered a fresh strategic approach while delivering considerable improvements in operating efficiency. Much of its impressive growth has come from the performance of its high-margin speciality chemicals offering, but its cash-generative chromium business has also benefited from strong demand. The sale of part of its pigments unit for £70m has left the firm with an unleveraged balance sheet, which will enable the company to reinvest in other, more lucrative businesses, or return cash to shareholders. First-half results were strong and we expect more of the same in the months ahead. The level of infrastructure growth in Europe and Asia, which has boosted demand for the company's products, is likely to remain buoyant, while a capable research and development function will help to keep Elementis in a front-running position.

We are also bullish on Corin (CRG), which makes orthopaedic devices, specialising in hip and knee-joint replacements. It recently received regulatory approval to offer its new metal hip resurfacing device, Cormet, to the US market. We see enormous potential in this product: it meets a significant clinical need and only one other manufacturer offers anything similar. Moreover, Corin's US distribution partner, Stryker, is a major player in America, with a considerable support network that should help generate significant market share. Shares in Corin have more than doubled this year, but we believe investors are still underestimating their value. There are considerable barriers to entry in this field and demand from America is certain to grow in line with the country's ageing demographic.