Small and mid-cap stocks with big potential

Each week, a professional investor tells us where he'd put his money. This week: Guy Anderson of the Mercantile Investment Trust selects three small and medium-sized firms with promising prospects that the market has missed.

Despite the significant political uncertainty that we saw in the UK over the past year, small and medium-sized companies based in the country outperformed their larger counterparts. This was not, however, an anomaly. In fact, over the past 60 years, UK small- and mid-caps have outperformed in roughly two out of every three years. What's more, this phenomenon is mirrored in other markets around the world.

We see small and medium-sized companies as offering a number of advantages. They have flexible business models that can adapt to change and enable the firms to innovate and grow rapidly. There are greater opportunities for mergers and acquisitions on both the buy and the sell side. And, because they tend to be less well researched by analysts, there is the potential for snapping up significantly mispriced that is, cheap stocks.

The small- and mid-cap sector in the UK is an incredibly diverse and dynamic part of the market, ranging from fledgling companies in exciting new industries to established global leaders in their specific niches. Within this spectrum of companies we search for those that are attractively valued, operate in growing end-markets, have sustainable competitive advantages and either are approaching or undergoing a period of positive change. We seek to identify opportunities where there is a gap between market expectations and the likely outcome.

Specialist insurers are continually innovating to avoid the commoditisation that affects general insurance products. Beazley (LSE: BEZ) was early to recognise the potential threat posed by cyber-attacks, launching an insurance product Beazley Breach Response in 2009. A number of high-profile hacks over the past 12 to 18 months has moved cyber-protection up the agenda for businesses, resulting in growing demand for Beazley's established and market-leading insurance product. This is helping to drive double-digit growth in premiums in a sector that is largely seen as having limited growth opportunities.

Bodycote (LSE: BOY), a global leader in thermal processing, has high fixed costs relative to variable costs, an attractive quality during a cyclical upturn. With the current improvement in industrial activity levels, the company can produce higher-than-average margins in the short term as demand for its products grows. The business has also been investing in a number of higher-margin specialist technologies that now account for roughly 25% of group revenues and are set to continue to grow materially in coming years, enhancing organic growth relative to peers. While it is not a cheap stock, at 19 times 2018 earnings per share, we see significant potential for the company to grow its bottom line faster than the market is currently forecasting.

Hays (LSE: HAS), the global specialist recruiter, is traditionally viewed as being driven by the staffing cycle. With a robust economic outlook globally, and tight labour markets, the company is well placed in this regard. However, changing cultural perceptions are leading more skilled candidates to choose flexible or project-based work, adding complexity to the hiring process and increased levels of outsourcing. This adds a further, unappreciated, dimension to the company's growth.