Three American smaller companies to buy now

published 17 November 2014

Each week, a professional investor tells MoneyWeek where he'd put his money now.This week:Thorsten Becker, co-manager, JOHCM US Small Mid Cap Equity Fund.

With the US economy gaining momentum and the dollar strengthening, UK investors may want to cast their eyes across the Atlantic.

The US large-cap market is generally viewed as a highly efficient asset class in other words, investors are so well informed that it's almost impossible to make money by stock-picking.

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But further down the market-cap scale, diligent research can unearth hidden gems among small and medium-sized companies some of which will be corporate America's future trailblazers.

Take Guidewire Software (NYSE: GWRE). It builds software for the global property and casualty (P&C) insurance industry. It's part of the wider Software as a Service' (SaaS) revolution.

This is where companies shift from using software installed on their own servers to software accessed over the internet, and managed by third-party specialists.

This cuts the need for expensive in-house IT teams and the infrastructure behind them. The $2trn P&C insurance business is very competitive profit margins are typically just 5%.

Meanwhile, insurers spend around $15bn a year on IT. So cutting out back-office costs can have a huge impact on profitability.

Guidewire's highly customisable software is used by more than 180 P&C insurers, including Aviva and Admiral here in the UK, and has the potential to boost overall profit margins by up to 50%.

The stock might seem expensive at seven times current annual sales, but conservative estimates suggest Guidewire could see double-digit annual revenue growth over the next four or five years, if it doesn't attract a takeover bid before then.

Our post-financial-crisis world has been marked by increased regulatory scrutiny and more stringent capital requirements. The largest banks are generally reducing their activity and focusing on repairing their capital bases. That has left room for new regional banking winners to emerge in the US.

In the past, investors probably wanted to own banks that were being targeted for takeovers. Today, they should look to own the consolidators. We're talking about medium-sized, regional banks, armed with strong management teams and healthy deposit bases and that also haveregulatory backing.

These players are gobbling up small banks that are struggling to cope with an increased compliance burden and tight interest-rate margins. These regional predators, such as Ohio-based FirstMerit Corporation (Nasdaq: FMER), are buying these smaller banks at low premiums then typically cutting out up to 40% of their cost bases.

FirstMerit is enjoying rapid growth in profits attributable to strong loan growth it has now posted a profit every quarter over the past 15 years. The bank roughly doubled in size in April last year when it bought Citizens Republic Bancorp.

Lastly, you will no doubt be aware of the US shale energy boom of recent years. Rather than invest directly in the energy producers, we prefer to invest in the companies that support this industry, such as specialist drilling equipment producers and energy infrastructure companies.

In particular, we like Helmerich & Payne (NYSE: HP), an Oklahoma-based contract drilling company and technological leader in land-based horizontal drilling. Its rigs improve drilling efficiency and reduce well costs for its customers, allowing H&P to charge premium day rates, which in turn boosts profits.

The company has a full order book in the US for many quarters to come. This leading position should continue to strengthen while international growth is likely to accelerate.