Big profits from small companies

ALEX WRIGHT

In 2013 Alex Wright faced the daunting job of taking the reins of the Fidelity Special Situations fund, which has strong associations with superstar fund manager Anthony Bolton, although the fund was managed for a number of years by Sanjeev Shah before Mr Wright got the job. Excitingly, Mr Wright is showing that he may actually be up to the lofty standards set by Mr Bolton. As well as the Special Situations fund, Mr Wright runs Fidelity's top performing UK Smaller Companies fund. It's Mr Wright's role as a smaller companies fund manager that is the basis of his investment essentials.

As a contrarian investor, Mr Wright's three investment essentials have a leaning towards valuation metrics. He says: "Valuation is a critical component of my investment philosophy. It helps me to assess the downside risk associated with an investment, and the expectations the market has about the company's future. That said, I don't believe in the existence of a magic formula when it comes to valuing companies.

"Different industries and business models call for different approaches, and I will typically look at a number of different metrics for a given situation. Part of an investor's skill lies in developing a valuation model that is appropriate to the company in question, and the overgeneralised use of some metrics can create risks. [My investment essentials] are some of the tools I use most frequently, but it is by no means an exhaustive list."

A key theme in Mr Wright's investment essentials is his use of enterprise value (EV) in valuing companies. The great strength of EV is that it reflects the claims on a company from both its equity holders and the owners of its debt, which means it gives a fuller picture of the price being put on a company than market cap or share price.

While EV can often provide a great insight into valuation due to the inclusion of debt, it needs to be used with a bit of care. Firstly, because EV adjusts for debt, any profit measure that it is compared with to create a valuation ratio needs to be adjusted for the interest paid on that debt (or in the case of companies with net cash, interest received). This is true of the EV/Ebitda (earnings before interest, tax, depreciation and amortisation) ratio highlighted by Mr Wright.

What's more, a company's structure has a major influence on how investors should interpret EV. A prime example of this is the difference between the different values EV puts on companies that own property through freehold and those that hold properties through leaseholds - this is often relevant in the retail and leisure sectors. A leasehold company will tend to look more attractive on an EV basis because the long-term lease commitments associated with the premises it operates from do not show up in the EV calculation. By contrast, the liability associated with the debt used by a freehold owner to buy properties will show up in the EV calculation, which makes a freehold owner look more expensive despite the fact that the company also owns valuable property assets against its debt.

While there are issues that investors need to be aware of when using EV-based valuations, for anyone that's clued up it can be a great way of unearthing value that's being ignored by the wider market, as Mr Wright's comments attest. Looking at the whole business valuation also chimes with the view of investors such as the great Warren Buffett who believe equity analysis is best undertaken when an investor thinks like the potential owner of a whole company rather than the buyer of a small bit of paper.

Alex Wright's investment essentials

EV/Sales

Looking at a company's value compared with its sales is a classic and fantastic contrarian trick, which star investors Ken Fisher and Jim O'Shaughnessy helped to popularise in their respective books Super Stocks and What Works on Wall Street. The reason a sales-based valuation is so effective for finding contrarian plays is that it allows investors to look for value while ignoring the fact that a company's earnings may be temporarily obliterated, which can make recovery stocks look very expensive based on their price-earnings (PE) ratio.

Instead, by looking at sales it is possible to find companies that look cheap based on what is going to be the ultimate source of any profits - turnover (see Mike Prentis's comments below on the importance of rising sales and high and stable gross margins). Once a company is found that has a low valuation against sales, the question for the contrarian investor then is whether sales can be maintained, profitability can be restored or increased, and whether the company is financially healthy enough to make its way through to a recovery in earnings. If things go right with this type of contrarian play, earnings can recover extremely quickly and when the earnings-obsessed market sees this happen, the shares can re-rate spectacularly.

Mr Wright says: "My investment approach involves the identification of companies where the market's expectations are low but I believe earnings can meaningfully improve. I like to see companies that have underperformed and where historical decisions have increased costs and depressed operating margins. In these situations the market will often extrapolate historical poor performance into the future, and fail to anticipate any improvement in profits.

"An EV/Sales ratio compares the market value of the company's equity and debt to the total sales of the company, with a low ratio implying the company extracts low profits from its sales. When I meet company management I want to see evidence of actions taken to improve margins that are not currently reflected in the company's EV/Sales ratio. This could come from greater pricing power following changes in the industry, or actions taken within the company to reduce costs."

EV/Ebitda

EV/Ebitda or EV/cash profits is a very popular valuation ratio with private equity investors as it gives a full view of the total cost of a company. Looking at cash profits also gives a good underlying view of what level of earnings a company is producing. Another benefit of comparing enterprise value (EV) to profits at a time of ultra low interest rates is that EV will attribute a value to net cash which the market may otherwise overlook due to the minimal interest cash generates. However, when companies have net cash they often deploy it on earnings-boosting acquisitions or end up returning it to shareholders, which can quickly force the market to change its view on what was previously in clear sight on the balance sheet.

Mr Wright says: "While a favourite with many amateur and professional investors, a low PE ratio can give a false sense of 'value' in some situations, particularly where debt is a large component of the company's capital base. The 'P' in PE only reflects the market value of the company's equity, obscuring the debt position. Investing blindly in low PE companies could draw an investor into an economically sensitive company about to enter a downturn with a large debt burden. Investing in cyclical but highly geared companies is a recipe for sleepless nights as an investor.

"For this reason I prefer to use the enterprise value of the company rather than simply its equity value. The difference is that enterprise value includes the company's net debt position. Therefore if a company finances its activities from loans, this will be reflected in the valuation and an investor can make an investment in awareness. EV is often called the 'takeout multiple' as an acquirer of the company will take ownership of both its equity and debt."

Broker ratings/market cap

After almost two decades writing about equity investment it is a rare treat to have a new ratio sprung on one, but this one is new to me. Best let Alex Wright explain.

Mr Wright says: "This final ratio is not one you will find in any financial textbooks, but I have found it very useful throughout my career, particularly when looking at smaller companies. Generally speaking, if a small or medium-sized company has a large number of brokers researching it and pitching it to buyside institutions, the stock is likely to have a share price that reflects positive expectations for the future. As a contrarian investor, I am looking for the opposite - unloved stocks where there is little good quality research undertaken.

"By focusing on these companies, I know that I improve the chances of the Fidelity research team developing an informational 'edge' against the market. As you get further up the market capitalisation spectrum, you generally find that the greater liquidity on offer translates into more brokers covering the stock. But if you can find a company that has less attention than you would expect given its size, it is usually worth further investigation, as you may find evidence of a positive change that has so far been unrecognised."

HARRY NIMMO

Harry Nimmo has managed the Standard Life UK Small Companies fund since it launched at the start of 1997. Mr Nimmo has six rules (see box) that he follows for investing in smaller companies, a key aim of which is to buy long-term winners. Mr Nimmo says: "The beauty of getting on board with a business with long-term growth and visibility is that you can run with them all the way through to them becoming large companies."

An important part of Mr Nimmo's investment process is his use of a stock screening matrix. The matrix, as it is known, looks at a number of different fundamentals that form the basis of the 'investment essentials' that Mr Nimmo is sharing with IC readers (see below). The job of the matrix is to whittle down an investment universe of around 700 stocks to about 100 that are worth further research and it has been used by Mr Nimmo since the launch of the Standard Life UK Small Companies fund. Mr Nimmo estimates that the matrix is successful in generating outperformance about 75-80 per cent of the time.

Having a consistent approach to stock selection is regarded by Mr Nimmo as more important than trying to avoid inevitable periods of underperformance, although he does focus on understanding why the screening process is not working during poor patches. A great strength of the matrix is that it tends to aid outperformance during bear markets, which can be particularly savage for small-caps. The approach also tends to come into its own during the late stages of the economic cycle when investors are worried about the future and are investing in long-term businesses.

Harry Nimmo's investment essentials

Growth rates and earnings-forecast revisions

Mr Nimmo looks for good forecast earnings and dividend growth. He is also interested in whether analysts are upgrading or downgrading their forecasts, which he refers to as forecast 'dynamics'.

High and sustainable growth rates are often regarded as a good indication of a business's quality. Earnings and dividend growth also tend to drive share prices due to investors' tendency to value shares based on their dividend yields and earnings multiples. That means a rise in a company's earnings and dividend needs to be matched by an equivalent share price rise for the valuation to be maintained. Better still, if sustained growth increases investors' perception of a company's quality, the shares may 're-rate', meaning share price rises will outpace the underlying growth rate.

Paying attention to forecast 'dynamics' tends to be regarded as particularly beneficial when a forecast-upgrade trend develops. Once again, upgrades are both an indication of a business's quality and a share price driver. Persistent upgrades suggest analysts are habitually being too conservative about a company. As the market tends to pay a lot of attention to forecasts, each new upgrade can have a positive effect on the share price and increase the potential for a re-rating. This virtuous process normally continues to work even when an upgrade trend is common knowledge. Just as upgrades suggest future earnings could turn out better than what's officially forecast, downgrades are often a sign that things are going to turn out worse than expected.

Mr Nimmo says: "Dividend per share growth is getting more important with mega-caps cutting their dividends, which is putting dividend sustainability at the forefront of investors' minds. Most of our measures for dividend and earnings are forward looking and we prefer internally generated organic earnings growth to acquisitive growth.

"We look at three-month revisions to rolling one-year and two-year forecasts, putting more weight on year one. We also look at the earnings revision ratio using the Starmine analyst revision model. It is a qualitative look at analyst forecasts and gives credence to whether analysts have been accurate. At the end of the day, we are not bothered if forecasts are right or not. It's the dynamic of how forecasts are changing that we're looking at."

Director dealing

There tends to be a broad consensus among investors that when directors buy shares in their company it is a good thing because they are showing more commitment to the business, which incentivises them as well as suggesting trading is going well. The opposite view tends to be taken of director share sales.

The Standard Life team's research into director dealings leads Mr Nimmo to have a more nuanced interpretation of the phenomenon. But with the right combination of share price momentum and purchases or sales, Mr Nimmo believes director dealings can give a good steer as to where a share price is headed.

Mr Nimmo says: "We've found that for large-caps director dealings are not predictive of price movements. In small-caps directors dealings are predictive, but not as predictive as they once were. I think they have become less predictive due to increased scrutiny by regulators.

"We look for directors buying and selling and price momentum together. Big signals are buys into rising share prices and selling into falling share prices. We use moving averages to measure share price momentum because there is a lot of short-term noise, especially in mid-caps where there is a lot of ETF activity and other things.

"If the share price is going up, it is fair enough for a director to take profits. Selling on the way up tells us much less than when directors are taking money out when the share price is significantly down. Similarly, you often see a series of directors buying together after a profit warning when the shares are significantly down - that's normally just PR noise.

"If attention is drawn to a high Matrix score due to director dealings, we then look at who's buying. We look for the chief executive, the finance director or other directors who are operationally involved. We also look for a clustering of deals or deals that are very close to the start of a closed period. Non-execs tend to be less significant. A first purchase is less significant, especially if it is made by a non-exec, as directors tend to be under pressure to make a show of faith."

Altman Z-Score

For a broad measure of quality, Mr Nimmo is a big fan of the classic Altman Z-Score. This is a measure of bankruptcy risk invented in 1968 by Edward Altman at New York University. The score is based on five fundamental metrics that assess the efficiency of a company's operational performance and its financial position. The formula is:

A Z-Score of 1.8 and below is considered to suggest a high risk of bankruptcy, whereas 3 and above is conventionally considered to mean little risk. The main criticism of metrics such as the Z-Score that attempt to collapse a lot of data into a single number is that they lack subtlety, which can make them hard to interpret. However, as long as investors are aware of this potential pitfall, there is a huge attraction in combining so much important information into a single number.

The Altman Z-Score should not be confused with the Z-Score used to value investment trusts. The only thing the two metrics share is a name.

Mr Nimmo says: "We love the Z-Score. It is a composite measure which takes in a lot of important quality factors. It's a quality measure that works particularly well in a tough period.

"Quality growth has not been flavour of the month in small-caps over the past five years, which has allowed low-grade businesses to generate strong returns. But if markets continue to be difficult, as they have been recently, I think we'll be in a very good period for performance."

MIKE PRENTIS

Mike Prentis has been manager of the BlackRock Smaller Companies trust since 2002, when the fund was run by private equity giant 3i and was known as 3i Smaller Companies. During his time at 3i Mr Prentis worked for both its asset management and private equity businesses and prior to that he was a chartered accountant. For much of his career Mr Prentis has worked closely with Richard Plackett, another small-cap star, who stopped co-managing the BlackRock Smaller Companies fund in 2014. Mr Prentis has also co-managed the BlackRock Throgmorton trust since 2008.

There is an elegance in the interplay between Mr Prentis's choice of three investment essentials. Firstly he's interested in seeing businesses generating sustainable top-line growth. He then wants to know how effective the company is at turning those sales into profits. And finally he wants to see that those profits are being turned into cash. The clarity and commonsense nature of this approach provides a great stockpicking bedrock, which has helped Mr Prentis establish an enviable track record as a small-cap fund manager.

Mike Prentis’s investment essentials

Sales growth

Mr Prentis is interested in both a company's ability to grow sales and the management team that has overseen that growth. This means he looks for management longevity in conjunction with the top-line growth produced during the team's tenure. A number of qualitative factors also feed into Mr Prentis's assessment of management quality.

He uses top-line growth to get an idea of the quality and long-term prospects of the core business. The importance many investors place on sales growth comes down to the fact that, in the long term, rising sales is what drives sustainable profits growth. A long track record of rising sales also acts as a good indicator of whether a company has some kind of structural advantage, be that based on brand, technology, changes in the end market, or something else.

Mr Prentis is interested in underlying sales, which means ignoring the impact of acquisitions and currency movements on reported numbers. In investment jargon this is known as organic, constant-currency sales growth.

"The most important thing that we focus on is trustworthy management. The people who are running a company are absolutely critical," he says. "We want to see a management team that has been in place for a number of years and we want to see success in terms of organic constant-currency sales growth. We're looking for at least 5 per cent, but we'd prefer higher, and we'd like to feel it will continue into the future.

"It's where we start; the top line. If a company can't grow the top line without acquisitions then it's probably not a good investment."

Drop through

Once Mr Prentis is happy that a company has been growing, and can continue to grow sales, he looks for an indication that it can generate good profits. For this, where appropriate and possible, he likes to look at gross margins.

Gross margins represent the proportion of sales that drop through after input costs are accounted for. High gross margins are often seen as an indication of a company's pricing power and strong pricing power can suggest a business has particular advantages caused by the type of "economic moats" that Warren Buffett is famed for demanding of his investments.

The reason that Mr Prentis favours gross margins over other measures of profitability is that costs further down the profit-and-loss statement tend to be more flexible and can potentially be reduced as a proportion of turnover as a company grows. This can create a so-called 'operational gearing' effect, whereby a lower rate of cost growth to turnover growth magnifies the impact of rising sales on profit.

Mr Prentis says: "We want to feel that in addition to sales growth we are investing in very strong businesses that lead their markets and that are protected by sustainable barriers to entry and have brand or some other special property. That all gives a business pricing power.

"That tends to best be seen in high and steady gross margins. We look at operating margins if we can't look at gross. Gross margins are a measure of scaleability and the drop through of sales to profits. It is the drop through of marginal revenues to the bottom line that we are interested in and that's a function of the gross margin. Below the gross margin level you have overheads that hopefully will not rise as fast, giving us operating gearing."

Cash generation

There have been a number of seemingly high-growth small-caps that have massively disappointed over the past year, such as Globo and Quindell, and in many cases a tell-tale sign of trouble was poor cash generation. Mr Prentis is not too hung up on specific definitions of cash conversion and cash flow, rather he simply wants to see businesses that consistently generate surplus cash while also achieving growth.

Mr Prentis says: "If profits aren't converted into cash, it is no good. We tend to look at free cash flow. Essentially, we want to see surplus cash flow. What really matters is the ability of a business to generate cash and quickly be able to reduce debt and build up a cash pile to distribute to shareholders.

"Dividends are the outcome of this. What we like to see is a progressive dividend policy and special dividend payments. But what really matters is that the business generates the cash."

*The author owns shares in both the BlackRock Smaller Companies and BlackRock Throgmorton investment trusts