Austerity measures in the UK should not present a problem for small-cap investors, despite this end of investment universe having a more domestic focus than indices such as the FTSE 100, according to Giles Hargreave, fund manager of the Marlborough Special Situations and UK Micro Cap Growth funds, which are among the top performing small-caps funds with strong positive returns over the last five years, well ahead of their benchmarks.
"We tend to invest in companies which are not very UK economy focused, because the austerity measures are not good for consumer spending," says Mr Hargreave. "We only own one retailer, Supergroup, and hold no banks or house builders. The two small property companies we own, Helical Bar and Conygar, are more focused on property operation and investment."
"The Alternative Investment Market (AIM) is full of companies that operate outside the UK, for example, there are many engineers listed on this market which operate internationally, and we hold quite a few of these."
Examples held in the Marlborough UK Micro Cap Growth Fund include Titan Europe and Pressure Tech.
"If these companies are left to their own devices they should benefit from growth in economies which are growing faster than the UK, so their prospects are very good," he adds. "Sentiment towards equities could change, though just now they are preferred to bonds and most indications are very positive."
That said, Mr Hargreave anticipates a market correction after a strong rise for smaller companies over 2010. "Because valuations are quite a lot higher we have to be more careful with stock picking as this end of the market is more vulnerable to a sell off," he says. "If we buy a stock on a higher price-earnings ratio (PE) we have to have a good reason for doing it."
"But in general you have to be more discriminating when investing in smaller companies because a mistake is much more painful than with big companies. For example, smaller companies' share prices quite often fall 50 to 60 per cent just because of a profit warning, whereas larger companies are more stable. The more initial research you do the better, so you can anticipate something before it goes wrong. Liquidity in the stock is also quite relevant among smaller companies because there can be great variations."
The right ones
When looking for a stock Mr Hargreaves and his team look for a combination of growth and value potential. He heads a team of eight including two full time analysts, who focus on researching companies. "Having a large team enables us to cover many more stocks than others might be able to," he says. "When an interesting stock comes to our attention it is rare that somebody on the team does not know something about it. Whoever knows the most about the stock will do the main research on it and then discuss it with me. We also have more formal meetings at which we discuss many stocks."
Mr Hargreaves and his team use various measures and criteria to decide whether to buy a stock. These include the price/earnings to growth (PEG) ratio, how sustainable the stock's growth is likely to be, whether it is generating cash in line with its profits, and if not, why not.
They also look at a company's debt profile, the quality of the management and how long it has been there, and whether the company's growth is driven by acquisitions or sustainable internal growth. Mr Hargreave generally prefers the latter, but adds: "If you find that a company is growing reasonably on its own, what does it do with the cash which just now yields nothing? In such a case maybe it is better that the company makes acquisitions, especially as you can buy them for low valuations just now and increase earnings."
Triggers for selling a stock include when there has been a change, for example, if a previously good management has retired. A stock becoming over priced is also a sell trigger. "But we are careful here - maybe you want to excuse this in very good companies because you may never get the opportunity to buy them back at a good price," adds Mr Hargreave.
The team also ensure their holding does not become too large. "We generally don’t hold more than two per cent of a company, and never more than three per cent," says Mr Hargrave.
From the top
A focus on UK companies which operate overseas is one of the top down views Mr Hargreave and his team have at the moment, although he points out that when selecting stocks they combine top down and bottom-up analysis.
"We do have some UK operators but have to be careful here," he adds. "Regarding sector views, we have been reducing exposure to gold companies a bit as the price comes down, because if interest rates go up globally it will not be good for this asset. However the reduction in exposure has been very modest."
A sector the team likes is oil exploration companies. "Oil is at around a $100 a barrel while the cost of production is below $30 a barrel," explains Mr Hargreave. "So when a company makes a discovery its share prices goes up a lot."
Nautical Petroleum, for example, has enjoyed a steep rise in its share price since June 2010, during which time it has risen from around 50p to near 500p.
Other oil company holdings include Encore Oil, Premier Oil, Egdon Resources, Valiant Petroleum, Providence Resources and recent acquisition Salamander Energy.
|Giles Hargreave CV|
Giles Hargreave has been fund manager of the Marlborough Special Situations Fund since 1998 and also runs the UK Micro-Cap Growth Fund. He is co-manager of the Marlborough UK Leading Companies Fund.
Mr Hargreave is chief executive of stock brokers Hargreave Hale, which runs two AIM venture capital trusts (VCTs). He founded Hargreave Investment Management in 1986, which was merged with Hargreave Hale in 1988 when he took over as chief executive.
Mr Hargreave started his career in 1969 as an analyst with James Capel, after which he became a private fund manager at Management Agency and Music in 1974.