Gervais Williams: the market is ripe for micro-caps

If you missed any of Merryn's past interviews, you can see them all here.

Merryn: Hi, I'm Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. Welcome to another one of our video interviews. We're on a roll at the moment. We've had some brilliant people on recently, and we have another one today.

With me is Gervais Williams who is manager of a variety of different funds, but two we're going to talk about in particular today are the Diverse Income trust and the Miton UK MicroCap trust. So, two interesting funds and an awful lot to talk about, if we're going to talk about microcaps, small companies, the market in general, income, dividends, etc.

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Where shall we start? Let's start with microcaps. We were talking earlier about a lot of inefficiencies in the market. You said the small-cap sector at the moment is displaying inefficiencies. What do you mean by that? What's the problem in the market?

Gervais: Well, as you know, the market's been pretty unsettled since the start of the year. It's been dominated by severe movements, very volatile movements, further dividend cuts we've probably had four or five in the FTSE100 already this year, and that's led to a lot of people pulling back, being a little bit more cautious about what they're doing. That's led to share prices probably being illiquid and moving more substantially than usual. And that's happened in the FTSE companies; they've moved back up to almost the same level as they were at the start of the year. But at the smaller end, they're small, they're kind of easy to ignore, and there are some share prices which just have been moving too far and have not recovered as much as they should, and so you've got extreme inefficiency at the bottom end of the market.

Merryn: Are you telling us that your microcap trust has performed really badly recently?

Gervais: Certainly not. Actually, it's actually been amazing.

Merryn: Excellent.

Gervais: I mean, we set it up only what? nine, 12 months ago. It was set up in April of last year, just ahead of the election. Clearly, the markets were quite a high at that stage. Nearly all markets around the world have come off a bit since then, and this is a fund which has not just generated an attractive return, but even in spite of the costs of investing it's made absolute gains in a period when most funds have gone down.

Merryn: OK, brilliant. Now, for readers who aren't experienced in this area of the market, can you define a microcap for me?

Gervais: That's a very good question.

Merryn: What's a microcap, a small cap and a large cap?

Gervais: Yes, the truth is that these are slightly fluid. What tends to happen is most people call small caps stocks which are a billion or perhaps a couple of billion in size.

Merryn: In market capitalisation, to be clear?

Gervais: In market capitalisation terms, yes. But there are quite a lot of big companies in the US, and there are quite a lot of what you'd call mid-size companies which some people call small companies.

What we're really interested in is companies which in themselves are less dependent on the world economy. They've got the ability to grow irrespective of a slowdown in the world economy, and particularly in the microcaps they might be more local businesses. They might still have a big world market position, but they're quite small, local businesses. They're able through their niche to continue expanding when the world's not growing, and that's the interesting factor. If the world's not growing, you need microcaps more often.

Merryn: OK. So this fund was launched in response to demand, or because you think that investors need these stocks?

Gervais: It has to be a bit of both. We absolutely have promoted it. We believe it's absolutely the right time. Microcaps are probably very under-represented in most people's portfolios where the mainstream benchmark stocks are the dominant part, quite a few midcaps, not many small caps, very few microcaps, so we think this is an area which is underserved. But most particularly because world growth has slowed, most particularly because companies are under pressure to maintain dividends or cut dividends in certain cases, we think that there's a greater interest in widening the opportunity set, including more names, including microcap stocks, and we think we can make absolute gain not just because these companies can resist the world pressure, they can grow when the world's not growing, but also on top of that because we think capital will be allocated away from bigness into smallness, in small size, and that will make a major difference in terms of the performance of the sector.

Merryn: It's interesting because there's been a lot of interest around the microcap sector recently and around start-ups, unlisted companies, etc. So we had Neil Woodford's patient capital and Baillie Gifford have a similar type of fund, etc. And of course there's the rise of crowdfunding, so lots of investors have become really interested in getting into smaller companies, getting into new companies, getting into local companies, and I look at that and I see it as symptomatic of two things. First, as you say, there being very little growth at the top and also a sense of distance, you know, big companies are now so big, so global, investing in them you have no real sense of connection to them. So is it partly that retail investors are feeling very disconnected from the wider financial world, from the stuff at the top and they want to come down to small levels and connect with things that they feel they really understand and they can share in the growth of?

Gervais: I think that's been true for quite some time, I think, with Isas and the ability for inheritance tax planning and those kinds of things, there's always been a good participation of private investors at the bottom end of the market, probably even more than institutional areas.

I think what's happening now is we find that the institutional interest, which generally has felt that these are too small to make a difference, they're now saying, well, actually, although we can't put a lot in there, just putting extra amounts in there not only enhances our return for our clients, but because they're less volatile and they zig and zag at different times they actually make a reduction of overall volatility for those clients who have a mainstream portfolio in the large companies, as well as holding a microcap interest.

So the reason this fund has been set up and the reason we raised new capital more recently is because institutional investors are joining private investors, holding companies at the bottom end of the market because they believe that the prospects, like we do, are more attractive.

Merryn: OK, so they see it partly as a diversifier anyway.

Gervais: It's a diversifier but, more importantly, the zig and the zag of some small micro isn't always in tune with the main market, and so having things which are zigging and zagging at different times means that the overall volatility of clients is smoother, and that's really important because with this volatility out there a lot of clients are really finding it very uncomfortable holding their assets and not sure whether they're going up or down every afternoon.

Merryn: They shouldn't be looking every afternoon.

Gervais: They shouldn't but, you know, they can't help it. It's on the news every afternoon. It comes on the market's up, the market's down. Would you believe it's gone down 3% today? Oh my goodness, it's up another four today.

Merryn: But you wouldn't worry about that kind of thing, would you? A long-time investor, you should be telling them to just go away and mow the lawn.

Gervais: Of course, but we're in the real world and it's people's wealth. They're very interested in making a return, but also they're very, very interested in having a certainty about it long-term not losing them too much and so it's very anxious. The market fell nearly 10% in about six weeks at the start of this year, which was really quite a shock. No one predicted it. It was all very sudden and what was causing it, etc. So it's been an interesting period because it's now recovered a large part of that, but the anxiety level is still very much out there.

Merryn: Do you think that pensions freedom has made people feel more anxious than it did before? In the past, people didn't have to worry quite so much about the way the market went and didn't go. If you had an annuity or if you were involved in a defined benefit system, whether the market went up or down was always entirely by the by. But now that people have so much more personal responsibility for their pension pot I hate the word pot but there it is the levels of anxiety among the retail investor are higher than they used to be, aren't they?

Gervais: Well, absolutely the tyranny of choice of course is that you can have too much of it, and then it's not just a case of making that choice, you've then got to decide, once you've made your general selection, to make more specific selections and you might make a decision which is very different from other people's, which turns out less good, or indeed badly, for you. So there are real pros and cons. I mean, you can still buy an annuity, but the returns you get on it are so very low that it really doesn't look very attractive.

Merryn: That's interesting of course because, getting rid of annuities may be bad policy, in that one of the reasons I strongly suspect that we ever had pensions freedom in the first place is because annuity rates were so low as a direct result of interest rates being too low, as a direct result of the financial crisis, in turn a direct result of interest rates being too low.

Gervais: Exactly.

Merryn: All these bad policy choices led us to a point where the soon-to-be-retired and the retired were complaining vigorously and constantly about very low annuity rates, which brought us to what may well turn out to be another bad policy which is pensions freedom. So it's an example of just piling them up until it all gets a bit out of control.

That wasn't the question that was a rant!

Gervais: No, well, I can understand it. Joking apart, there is a lot of anxiety out there, putting responsibility on individuals who sometimes feel they're not as close to the matter as they'd like to be in terms of making really quite major decisions about very substantial amounts of capital.

Merryn: Yes. Well, talking about what people need and what people think they need, what people need and what they believe they need more than anything else at the moment is income which they can't get.

Now, mostly people look at smaller caps and they look at microcaps; they look at start-ups and they think, well, I'm not going to get any income there, so they go to the large caps for income.

We've seen it over the last five, six years sales in income funds being absolutely the highest. You go look at anyone's ranking of sales, and income funds were always absolutely at the top. Of course now we're beginning to see that the very big companies of the UK that have been forced for years to pay up possibly too much

Gervais: Agreed.

Merryn: of their income as yield and being, beginning to think, well, they need to cut back on that. Obviously you look at dividend cover; it's not really high enough. It's time to cut back, but they're under quite a lot of pressure from the income fund managers to keep shovelling the income through. So you have two problems here.

One is that too much income is coming out and that that will probably end up being cut and, second, that as a result of that income coming out they're not, maybe not investing as well for the long-term as they should.

So the case for investing in large caps for income is beginning to fail, and I think you argued that there's a very good case in investing much further down the size scale and still getting, being able to get income.

Gervais: Absolutely right. To be fair, we shouldn't write off all big companies. You know, Legal and General reported a dividend of 17% or 18% this morning. It's been a great investment. It's now growing its dividend at about 20% compound for the last five years. No embarrassment, we absolutely hold that in the diverse income. We're very happy with it. So absolute, there is a place for big cap income, but there aren't too many of them. And so, widening the opportunity set and investing in small companies like, say, Amino a company I saw last week which is a company which is involved in sort of set top boxes. It's quite a market leader. It's doing terrifically well. It made an acquisition.

Merryn: Set top boxes, telly stuff?

Gervais: On top of tellies, yes. Think of videos coming over the line, that kind of thing. But it's made an acquisition, and it had a little bit of unsettlement following the acquisition. The share price came down, but it's trading fantastically well. It's probably on about just over 12 times just finishing in November this year, ten times next year, with a yield of five and a quarter percent, growing at 10% per year for the last five years, net cash on the balance sheet.

Well, we're not embarrassed to hold some of those, too, in the fund, you know. The share price is probably too low because of its wobble, but most particularly income and growing income will drag that share price up in time and as long as we spot those companies which have invested sufficiently, which have got the payback on that investment coming through, the productivity improvements, that's what drives return.

And we're finding that yes, in some big companies, but most particularly across the whole market, particularly in the smaller end of the market.

Merryn: OK, give us a couple more. I mean, you said earlier that there were quite a lot of small caps about whose prices have being pushed down quite a lot at the beginning of the year and hadn't come back as you feel they should've.

Gervais: Yes. I think the main driver is you've got to be in companies which are going to invest capital for commercial payback, so this is productivity. It can be manufacturers. So take, for example, Coral Products, which is a tiny company, about 20 million market cap. It does plastic products, injection mouldings; some of those Ocado big crates they carry around. Those kind of things don't come from China. They're too weighty. They've got too much air in them. They can just make them locally, so they make those kinds of things. Lots of other things, too. Superb acquisition earlier in the year.

Merryn: Where are they based? Are they part of our Northern Powerhouse?

Gervais: They are. They are part of the Northern Powerhouse. They've got a couple of factories either side of Birmingham and one near Manchester. But most particularly they are involved in making acquisitions, which in their case they made an acquisition from the receiver which they paid about £150,000-£160,000 for, which was three million turnover, making some profits. It was pension liabilities which put it into receivership, so that was a brilliant acquisition. And they've followed it up with another acquisition more recently that takes that acquisition, the first acquisition, and gives them greater access to market. So there's a business which is probably on ten times falling to eight times, with a yield growing from 4.5 through to perhaps six going forward, in only 20 million market cap, tiny, accepted, but what isn't it wonderful to meet companies which are investing and able to have the confidence to grow their business when the world's in an uncertain period at the moment.

Merryn: Interesting. Let's just step back briefly. You mentioned that they'd made an acquisition, a company that had gone into administration because of pension liabilities. Now, this presumably is a huge and not-going-away problem for a lot of the smaller and midcap companies. That you see the lower interest rates go, the bigger their pension liabilities get, the more cash they have to shovel into their pension funds, the less cash they have available for investing in the future and paying out as dividends. How much of a problem is that as you're seeing it?

Gervais: It's become a significant problem. Many small companies do have liabilities on the pension, so that's been a problem. Bizarrely of course, with interest rates as low as they are, one hopes they don't go much lower. We've seen negative interest rates in Japan. Let's hope we don't go anywhere there, near that in the UK. But what's actually pleasing, and I was talking with a company just yesterday about it, is they were actually looking forward to interest rates going up because their pension liabilities drift away.

Merryn: Well, exactly. That's what I was going to ask you, in that if you have a lot of companies that, where you approve of their core business and their core business is in very good shape but they have a big pension deficit, surely the trigger to buy them would be interest rates rising.

Gervais: Absolutely.

Merryn: So it would be wonderful to make a list of those.

Gervais: Well, interestingly enough, we tend to skew towards companies with a strong balance sheet anyway. So many of our companies have net cash or if they have net debt, it's very small amounts of net debt, lots of headroom. So most of our companies would be beneficiaries if interest rates then went up, not because they're going to make a lot from their interest, it'll just be slightly more, but most particularly because they can continue to invest than perhaps more geared companies are more constrained. And it's that difference between being quoted, the access to capital, risk capital, when perhaps mainstream, unquoted small caps are probably more constrained, which gives them the ability to get that productivity improvement, generate those cash paybacks and drive dividend growth.

I think dividend growth is really important. If you go back to the 70s and the 60s, one of the reasons why small and micro caps outperformed wasn't just that they grew faster than the main market, but they grew their dividends above main market. That's exactly what's happening out there right now and that's why we're so confident about the chances of small and micro caps for the companies particularly outperforming not just this year or next, but over the next five and ten years.

Merryn: Let's talk a bit more about the Northern Powerhouse. Investing in these companies you must be spending a reasonable amount of time visiting what we like to think of as the north, but is often actually the Midlands, right?

Gervais: Of course.

Merryn: Does the Northern Powerhouse exist?

Gervais: Yes, it does. What we probably overlook is, we are the fifth largest nation in the world in terms of GDP, but we still have quite a lot of manufacturing businesses up there. We still have a lot of service businesses. It's not just the automotive industry, we've got quite a lot of range of areas in the aerospace and some of the more technical areas like Formula One cars and that kind of thing.

There's a lot of areas where we're world leaders, and the companies which have survived have had to be good. They couldn't have not been good. The valuation of sterling has been high at different times. We've had a lot of sort of brain drains perhaps to the south and so only the really best companies have survived and it's so thrilling to meet these companies. And it's not just good companies, it's recovery stocks, stocks which are on the turn, stocks which are now seeing recovery and able to invest.

A company I just saw a couple of weeks ago was Avingtrans, which is a company which is a mainstream engineering business, heavily involved in the aerospace industry, doing things for Rolls Royce, just got a major contract in the last few days for Rolls Royce, and there's a business which does have a pension liability which is hopefully going to fall away. But most particularly because it's investing it's able to take on more orders and it's probably still only a P/E of 12, but is a mainstream world leader in its little area and can continue to improve. And, if anything, I think it just hasn't had the attention it deserves and hopefully people like us and other investors are going to start spending more time with these companies, allocating more capital so they can invest a little faster and grow their businesses in a more important way going forward.

Merryn: Interesting. And they can't borrow to do that?

Gervais: They can borrow, but I'm massively suggesting they don't because I don't know how bad it's going to get. We worry about whether China is going to recover very strongly or perhaps it won't. We know that perhaps the European area has not grown as much as we thought it would have done. Even in the US with rising interest rates there's quite a lot of inventory in the US at the moment, that may not grow quite that fast. So real growth is going to be very limited. It's going to be very spiky out there.

The last thing I want is a company to take on borrowings and then get caught out because it's got too much debt. Much better that they take on risk capital. They've got it for certain. They never need to repay it back and then if they can get that productivity, they pay a dividend and they grow that dividend and, as I say, that dividend grows, drags the share price up and they get a premium rating when they can raise more capital at a better rating in future.

Merryn: Now, are the kind of companies that you invest in less at risk from Brexit than big companies, in that we hear an awful lot from the large companies in the UK about how awful Brexit would be and what a disaster it would be, etc. But of course we know that one of the reasons it would be difficult for them is because they've spent an awful lot of time lobbying in Europe and they've built up a nice regulatory moat which have limited their competition, etc one of the reasons why we have such lovely oligopolies at the top of many of our sectors.

The smaller companies which don't do particularly large amounts of business with Europe and which are not involved in that regulatory lobbying anyway may find, post Brexit, that it either doesn't make much difference or that it's a positive.

Gervais: I'm not so sure. We call them small companies, but often these companies are quite international. They've got operations in Europe and the US. [] reported this morning, you know, it's got very exciting prospects. So there are plenty of companies which will have both sides of this argument.

My view is that probably the arguments both for in and out are probably exaggerated in the economic sense. It'll make a difference, but probably not a big, big difference either way. Probably a bit more uncertainty if we come out, but either way it won't be a big difference.

But most particularly we're going to continue to need to be nimble as a nation because, you know, three years ago none of us were talking about the oil price going down two-thirds. So there'll be many other factors which turn up which could have an even more profound influence, and we need to make sure that our capital is invested in those companies where the productivity improvement can come through.

Nimbleness, agility, those are the things we're looking for and we're looking for companies which can continue to take advantage of whatever change. So if we come out of Brexit, you know, it all kind of happens that way, then we will be making sure that we can steer our capital into those companies which can take advantage of that. Maybe there'll be more tariffs. Maybe there'll be more manufacturing in the UK. You know, we can invest on that.

If we stay in, then there's more certainty about being in for the long-term and we can invest in companies which are going to sell more into Europe. So I don't think it's, in itself it's the main issue. It'll continue to be a major issue, but I think we'll be surprised by other events which probably overtake it in the next three and five years.

Merryn: OK, interesting. So regardless of Brexit, if you had to invest in three companies for my children's education, which ones would they be?

Gervais: Well, I love companies which actually are, just have fantastic duration about them and growing the dividend. So an example of that might be Mucklow which is an industrial property business around Birmingham. It actually is probably the dominant player in that market.

Now, over the last 20 years we've seen a lot of people migrating manufacturing capacity to the Far East and other places, and so effectively their warehouses have hardly moved in price. Their industrial properties, you still get them for £5 or £6 a square foot, which compared with Bristol or Slough is ridiculously cheap.

Now, what they found recently is that people aren't moving to China in the same kind of way. In fact, some people are coming back into the UK. Of course Jaguar, Land Rover

Merryn: Reshoring is real

Gervais: That's right. And it's got real property. It's valued in their portfolio at about 7% yield. It's growing their rental levels, and a 7% investment portfolio growing its income at the top line is very exciting, and they're able to even put up new warehouses on some of the surplus land. So that's absolutely a company which has grown its dividend I think about 40 or 44 years in the last, you know, since it's been quoted. Four flat years, but generally growing.

Merryn: And that in a microcap fund?

Gervais: It isn't actually because it's probably a bit over 200 million market cap. So it's quite a decent size business, but it just shows what the opportunity is there. I mean, also, any company which has got the ability to recover, we love recovery stocks. Although you can make money out of technology, not everyone turns out to be an Apple. Apple is probably one of the few exceptions, so it's much better to buy recovery stock.

So an example of that might be something which is in the microcap trust which is Fulcrum Utility. It's a company which installs gas and electricity pipes into small housing estates, industrial estates, local authorities, that kind of area. They own the pipes afterwards, but most particularly it's a regulated led market. It's a recovery made led market. This company has already seen its share price recover as it improved its services, but it's still even now only on about 12 times PE. It's just declared its first dividend. It's got net cash of about 5.5 million on the balance sheet. It's probably about a 30-35 million market cap, and it's growing its dividend beautifully from zero. So it's the recovery stocks which are the best opportunities in our view.

Merryn: OK, that was two. You have to give me one more.

Gervais: Third one, I probably would go for something like, probably something which I've just seen actually, Seeing Machines. It's a lovely business. Its share price is very

Merryn: What's it called?

Gervais: Seeing Machines. It's got cameras in your, on your dashboard. You know, they've done deals with Caterpillar where now if you're driving one of those massive, great trucks in the mining area, it's very important you don't nod off because you were playing gambling last night or something, so effectively it keeps you on the road which is great. Now widening it to mainstream trucks, some railways, into aeroplanes.

It's an immature company in terms of it's not making profits. A bit unusual for us to hold that, but it's in a recovery mode. The share price is very, very undervalued in our view and so if you're looking for something which doesn't have the yield yet, but over three or five years should pay a dividend yield, then that's absolutely what would be in our portfolio.

And that's one of the reasons it's in the microcap trust because most of the holdings in the microcap trust are companies which aren't necessarily paying a lot of yield now, but in three and five years as their investment comes through, the cash payback on that could be great.

Merryn: How many companies do you see? You've mentioned pretty much every company. You said you've just seen them, or you've seen them a few months ago, etc. How many are you seeing a year?

Gervais: We're probably seeing within my unit we probably see between 100 and 140 companies a month. I probably see 40 a month, typically.

Merryn: You see 40 a month?

Gervais: 40 a month, yes.

Merryn: Do they come to you? Do you go to them?

Gervais: Typically they come to me. I go and see them as well.

Merryn: You spend a lot of time on the train.

Gervais: Yes, but I've already done, you know, a meeting already this morning. You know, I've got one when I go back, etc. I've probably got four meetings today with corporates, which is great. That's the real value added, getting involved in businesses, thinking about with them the problems they've got to solve.

Clearly the wonderful thing about fund managers, just occasionally we can write a cheque and that can make a difference to clients, to these companies, so it's effectively a very two-way dialogue. It's probably the best part of the job. Why wouldn't you do the best part of your job more?

Merryn: So you see yourself really as quite an activist investor?

Gervais: No.

Merryn: Active obviously, but activist?

Gervais: No, I don't think we do. I mean, clearly, you know, we have views about the way the company should be run, but we're only one shareholder. They'll have lots of other shareholders who may have other views. They need to think about it. They need to think about what's right for the business, and then they need to convince us as to why it's right for the business. Most of the time we agree.

If, for whatever reason, we take a different view, then we can sell our shares and move into another investment. There's so many pebbles on our beach. We don't need to be worried about whether this particular one is perfect in every way. We just need to make sure the risk reward ratio on each individual holding is particularly attractive and that that risk across our client portfolio is actually relatively low, and yet hopefully delivering a very attractive return. So we're not activists, but we are very engaged and we're very keen to do everything we can to help the companies be successful.

Merryn: Brilliant. Gervais, thank you very much.

Gervais: Thank you very much.