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 six rules for investing in smaller companies
1 Sustainable dividend growth
2 Concentrating effort (this is where the matrix comes in)
3 Quality
4 Run the winners
5 Management longevity
6 Valuation is secondary
Mr Nimmo's final rule concerning the limited importance of valuation may go against the grain for readers who identify themselves as 'value' investors. The approach has served holders of Mr Nimmo's funds well, though, not least because it has helped him avoid value traps and allows him to run his winners without too much soul searching on the often amorphous question of 'value'. That said, the matrix does give some weight to dividend yields and earnings multiples.
Mr Nimmo says: "There are very specific market periods when people are really interested in valuation, but we haven't found any long-term predictive power in valuation in small-caps. All too often when you go for value in small-caps you're buying yourself problems."
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."
