When a sector has had a good run it can be an indication to investors that it is time to take profits. But, although FTSE Small- and Mid-cap indices have done well over the past year, their time is not over yet, according to Neil Hermon, manager of Henderson Smaller Companies Investment Trust (HSL). He says mid-caps in particular are the place to be.
"UK mid-caps look extremely attractive," says Mr Hermon, whose trust won the Best UK Equity Growth Fund award at the Investors Chronicle's Fund Awards 2013. "Corporate balance sheets and earnings remain strong and we continue to find the best-quality stocks in the mid-cap area of the market. Over the past few years, we have seen a difficult macro environment, particularly in Europe, but this seems to be changing, with the outlook for economic growth improving – not only in the UK, but globally.
It is not just the improving macro backdrop that provides a reason for optimism. There is also the prospect of sustained merger and acquisition (M&A) activity. Global M&A reached its highest level in four years in the final quarter of 2012. Large companies have excess cash on their balance sheets and access to historically cheap financing, which provides an encouraging environment for smaller companies. Many of these larger companies are willing to pay a significant premium to the trading price for suitable small-scale acquisitions, offering a potential uplift to investment returns."
Foreign companies, in particular, are seeing value in UK businesses, and if markets continue to improve Mr Hermon expects to see more M&A, including acquisitions of portfolio holdings. Over the past two years, 18 of his holdings have been taken over.
But he doesn't pick shares because of the potential for a takeover: fundamental value opportunities drive his approach. No one valuation measure provides the answer, so he looks at a number of metrics, including the price/earnings ratio, EV/Ebitda, free cash flow and dividend yield.
Henderson Smaller Companies Investment Trust is heavily weighted to mid-caps, with 77 per cent of assets in this area, despite its name. "I place a great deal of importance on the quality and consistency of the stocks I buy," says Mr Hermon. "The best quality stocks are concentrated in the FTSE 250 area of the market – hence my focus on mid-caps. We remain disciplined in our pursuit of quality and I would expect many of these stocks to grow into large-sized companies in the coming years."
He looks to hold shares for the long term, with an average holding time of five years.
As a result of his pursuit of quality, around 85 per cent of companies in the portfolio pay dividends, not an attribute associated with smaller companies. "I like companies with good profits and cash flows, hence dividends," he says. "Yields on UK gilts are meagre in comparison to the dividend yields of soundly financed global mid-cap growth companies. This dividend stream is also growing robustly, driven by strong earnings and cash flow growth. That said, although the dividends should grow, not many of the portfolio companies are high yielders."
Examples include aerospace company Senior (SNR), which yields 1.73 per cent. "This has been great over the long term and is growing quickly," says Mr Hermon.
Although small-caps look cheap, he says that mid-caps offer higher-quality growth. But there is still an argument for small-caps, which have grown faster and better than the All-Share and, he argues, indices such as Numis Smaller Companies are not expensive relative to their history and have further to rise.
Mr Hermon largely picks shares according to a company's individual merits rather than sector considerations, but the fund has around 40 per cent of its assets in industrials as he is finding good opportunities there. "I like engineers operating in a market niche and which are diversified globally, including in China and Asia," he says. "Spectris (SXS) and Rotork (ROR) are examples of high-quality UK engineers."
Housebuilders, meanwhile, have done very well. "I like these because they have been remarkably stable over the past two to three years and their valuations were at a discount, although they have now moved to a premium. Bellway (BWY) and Taylor Wimpey (TW.) are among the trust's top 10 holdings, respectively accounting for 2.6 and 2.5 per cent of holdings."
Another portfolio success has been plant hire company Ashtead (AHT), which makes a high percentage of its earnings in the US. "This company had a very tough recession as US construction collapsed, but there has been a structural shift in the US market with an increase in the amount of equipment being hired," he says. "The US is also a fragmented market and its competitors are smaller, meaning they cannot invest and expand. So Ashtead has experienced a very good recovery."
Although the share price has risen more than 90 per cent in the past 12 months, with profits forecast to grow 60 per cent in the coming year Mr Hermon expects the price to rise further.
Another holding he expects to have a good 2013 is kitchen manufacturer Howden Joinery (HWDN). "This has been a strong organic growth story, taking 25 per cent market share since it started in 1995," says Mr Hermon. "It has pricing power and rising margins, while its main competitor – Magnet – is struggling and losing market share. Howden is exposed to the recovering housing market."
While he is underweight retailers and travel & leisure shares, he does hold Carphone Warehouse (CPW), Ted Baker (TED) and Greene King (GNK).
Sectors he doesn't like at all include food producers. "There is no value here and these are at the behest of the supermarkets. I don't like biotech because that struggles to make money."
But overall he is upbeat. "Clearly there remain hurdles – most notably the deleveraging of the financial sector and governments. But on the whole, low valuations, strong corporates and our proven stockpicking approach leave me feeling optimistic about the years ahead."
