13 hot small cap stocks

MoneyWeek regularly invites the best investors we know to dinner and ask them where they would and would not put their money now. Here, four small-cap experts discuss the US housing market, the UK economy, commodities, and tech stocks

John Stepek: We had a bit of a slump in May and stocks haven't recovered yet. Just a blip or is there more to come?

Giles Hargreave: You always have to be frightened of something. I think the most terrifying thing is the lending that's gone on in the American housing market. I'm told that institutions, pension funds and insurers have bought these packages of mortgages in the States. Currently the premium for high risk debt is not that high about 2.5% over [government bonds]. But house prices are falling. If that goes to, say, 5% over and there is a collapse in that market, it makes equities less attractive because of the returns available in the high-risk debt market.

Patrick Evershed: I absolutely agree. America is called the only superpower left, but there is record debt amongst individuals, a very high level of government debt and a record trade deficit very big potential economic problems. If these are realised there will be bad news absolutely everywhere.

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Stuart Harris: Certainly the May correction was instigated by a sharp rise in inflation expectations in the US. A sudden rise in risk aversion in global equity markets meant sectors where there had been a lot of momentum in share prices came off the heaviest. UK small company sectors are less factored into global growth than, say, the FTSE All-Share, though. In general they are far more exposed to the UK compared to international markets.

JS: If the US is hit by a house price crash, will that have a knock-on effect here?

Tom Bulford: I was in North America in August and the weak housing market is a big talking point. I have also heard from a couple of small manufacturers that they have seen some hesitancy in demand you can probably trace that back to US consumer spending. On the other hand, interest rates are higher than a year ago, and that means central banks have a lever to pull. If they start to worry about slow growth they can cut rates especially as falling oil and other commodity prices are reducing the inflation threat.

GH: My point is more concerned with what may happen in the debt market.

A collapse there is something small caps won't be able to withstand. The small cap environment in the UK at the moment is absolutely fine good management will perform unless they are completely blown away by something out of their control.

TB: There is always a macro threat out there. If you paid them too much attention, you would never buy a share.

PE: Giles was saying that he is relatively happy about the UK economy. I don't think I am. The savings ratio is way below previous levels; there is record personal indebtedness; house prices are so high that hardly anyone can get on the bottom rung; we have a record trade deficit and we have an amazing budget deficit. Normally when the economy is strong and you have fairly full employment you would expect the government to be in surplus. So if the economy slows and profits come under pressure and unemployment starts rising, you will see the budget deficit completely out of control and taxes will have to rise so I think potentially the British economy is in a very, very weak position.

MoneyWeek roundtables: We regularly invite City experts to roundtables such as these. Previous topics have included the best Latin American markets and investing in soft commodities.

TB: I am amazed the Conservatives don't talk about the budget deficit more often. If the government spends more than it raises in taxation then of course its spending will boost the economy. Whoever wins the next election will have to impose the hair shirt to restore the balance. This won't be fun for the economy.

JS: Getting back to stocks: commodities have come off sharply recently is this still a sector you would be looking at?

GH: That's a bit of a generalisation; parts have and parts haven't. I hold a couple of uranium companies because the mining experts in my firm are convinced the uranium price has only one way to go. Also a lot of small oil stocks' movements are not so much about the price of oil, as how they are doing with exploration.

TB: The resources boom seems to be over. It was good while it lasted, and had a good long run. The stockmarket does not move in sync with the real world. Plenty of companies will need more cash to progress their plans, and if the mood turns against them, they just won't get it. Traders are looking at slower economic activity in the USA and reading this across into weaker resource prices. Of course this is oversimplistic, but this is how it is. People see resource prices falling. They bail out of resource funds. Fund managers are forced to sell resource stocks it becomes a vicious circle. I would avoid the speculative end of the resource sector altogether, which is not to say that there will not be one or two spectacular successes within it.

SH: But there are other ways to gain exposure to higher oil prices it's not all about "is oil there or is it not"? At higher prices, old wells can become profitable. We would be interested in the companies that provide products and services to the exploration and production companies: drillers, rig owners and builders, engineers providing services, etc.

JS: Any specific stocks you would buy?

SH: We like MTL (MTI). It has had significantly enhanced returns on the back of its oil exposure. It plays into process engineering and intrinsic safety equipment their equipment goes into both upgraded and new-build production plants. Their prospects are sustainable on the basis both of high oil prices and continued investment in safety standards.

TB: The search for alternative energy is here to stay, whether the oil price is $30, $60 or $90. Tanfield (TAN) is a company that has staked its future on electric, battery powered and hybrid' vehicles (it still makes milk floats). It is doing very well, but its rating is still quite low.

JS: And are there any sectors that you would be avoiding at the moment?

PE: I would avoid housing for the reasons I've given. I would also avoid most of the retail sector.

GH: I don't own any retailers simply because I haven't come across any that I've found very attractive.

PE: ASOS (ASC) is good.

GH: Yes, I own ASOS but that's an internet stock. Internet stocks I like; although you must be careful there are a lot of charlatans and you can be duped.

PE: People who run media companies tend to be a bit wild and they don't seem to think about profitability and gearing.

GH: I will give you one media stock I do like. It's an internet marketing services firm called Tangent Communications (TNG). It is highly conservative and not very well known a lot of these companies sell on 25 or 30 times earnings and this is on about 15. Greene King is a client of theirs. Instead of all Greene King pubs getting the same marketing material, there will be different stuff for Scotland and East Anglia, and this can be provided via the web that's what Tangent do. It is run by two nephews of Michael Green, who happens to own 50% himself. So you've got the young boys running it who are extremely internet-savvy and you've got the grey hairs' on top it is not a highly geared company doing anything silly.

JS: Sentiment among fund managers is still very poor on tech stocks, but now some internet firms are making money. Is it a good time to start investigating these?

PE: I'm sure there's good value because investors tend to avoid any sector where there's been a problem over the last five years. You can probably buy a good tech company now at about half the rating you would have paid before 2000.

SH: The difference is you are now seeing a lot of businesses using the internet. Not just consumers but also businesses are ordering goods and services from other businesses. Six or seven years ago you were hearing, "Oh, it will make the world so much more efficient." The vision was good, but timing and valuation was not. You are really starting to see the value now and some businesses are really driving sales and cost savings as what used to be paper-based form businesses become more internet-accessed.

TB: The fact is we are all spending more time in front of the computer, thanks to broadband. There are big opportunities for companies that can, for instance, help marketers plan their online sales campaigns and monitor the results. SmartFOCUS (STF) is one example. Another big new growth area is spend control'. Big organisations have been very bad about controlling spending. All sorts of people have authorisation to order supplies from one source or another and the finance director really has no control over it. But if he insists that all orders are placed online, then he can see what is happening, impose limits, and permit dealings only with specified customers. An Aim-listed company providing this software is Proactis (PHD).

JS: As we're getting into individual share tips, what are your current favourites?

GH: I've got a cracker for you, but it's bloody illiquid. It's called Christie Group (CTG). It's a valuer and vendor of licensed premises. It's opened offices in most European capitals if there's a big hotel deal done, you will usually find them down as the valuers. It's capitalised at about £50m. The basic business made £4m in the first half. It has a stock-taking business too, which made £800,000 in the first half and should make a couple of million for the year. It also has a software business which lost £1.4m in the first half and is likely to do the same in the second half but at the very worst, it will break even in the following year and could start to make quite significant money two years out. So you could have a business capitalised at £50m making £10m. Plus it has £5m in cash, no debt and conservative accounting. So I think that could easily go up 50% or so from where it is.

Interested in share tips? See our section of expert share tips where top investor Paul Hill chooses the best and worst tips from the week's press and brokers' reports.

PE: My first tip would be Alternative Networks (AN.), which came to market at the end of 2004. It organises people's telephone systems, businesses' telephone systems, mobiles, internet everything they need. They have met or exceeded every single forecast, but despite that have underperformed the market by 25%, barely moving from the issue price, simply because of the weight of new issues coming in at lower prices. The other is BBI (BBI), which has developed a new way to analyse blood. Instead of taking blood and sending it to a laboratory and getting the results three days later, BBI's technology gives results in about 10 minutes. Its shares have gone up, and profits have gone up just as fast two years ago they were £90,000 and last year £600,000. This year they will be £1.3m, then £2.4m and then £5m a sharp progression. The shares are on a p/e of 16 falling to seven next. Most of that should be more or less underwritten because the firm has agreements with various companies, and is growing and expanding into different territories. The chairman has been successful before in launching biotech companies.

SH: One of our favourites is Synergy Healthcare (SYR) an Aim-listed healthcare company. We've talked about government overspending. Efficiency needs to be improved, and Synergy Healthcare provide outsourcing for sterilisation services for the NHS. It has a very good management team with a good track record of growing organically, winning contracts and acquisitions. It's reasonably well valued for a high-growth business with a very solid balance sheet.

TB: I like Invu (NVU), which sells an ingenious type of document management software to small businesses. Sage recently decided to market the product to its customers in the accountancy sector. Apart from opening the door to a dramatically larger audience, Sage chose Invu's offering only after looking at 50 others a major endorsement. The other I like is Worthington Nicholls (WNG), which installs air conditioning. Because it uses a gas containing chlorine which damages the environment, all air conditioning in the UK must be replaced by 2015. Add that to the fact that hoteliers, retailers, and other commercial property owners are deciding to install air conditioning and the industry is facing a bonanza. And many air conditioning companies were set up in the 1960s when air con was first introduced. These guys are ready to retire and sell out, presenting good acquisition opportunities. Despite this, shares in WN trade on about 11 times earnings.

JS: Finally, last November, both Giles and Patrick had tips for us. Giles, Egdon Resources (EDR) has positively shone. Would you still hold it?

GH: I do still hold it. I mean, I couldn't help but sell some, but I've still got about half my holding left. It's been fantastic. It's a gas storage business which has discovered these salt caverns about 4% of the gas the UK needs can be stored there. But they've still got to get planning through the local authorities. If they get planning later this year and start construction, there is probably another 50% in the share price.

JS: But maybe not a buy now?

GH: It's a hold. If, for instance, they were refused planning permission, the stock will halve and more. But there is enough upside to hold on.

JS: Patrick, you went for Clearspeed (CSD), which has come back a little. Do you still feel happy about it?

PE: Yes, definitely. Its microchips use 95% less power than other people's and are ten times faster. The firm has entered into agreements with IBM, Intel and Hewlett Packard over the last few months. It's developing less rapidly than I had hoped but it is still making progress.