Mark Dampier: Don't write off small, well-run British firms

The Analyst

There seems to be a strong tendency for UK investors to write off their own stock market and economy very quickly. It is possibly because we are so close to it and see the damage that politicians on all sides do, so why would we invest? Yet despite the politicians and bureaucrats, many British companies prosper. There is natural inclination to consider the large firms in the FTSE 100, but a sector that really rewards the hardworking stock-picker is smaller companies. Ask anyone in a fund management's marketing department and they will say that UK small caps don't sell. This is extraordinary given the number of high-calibre managers in the area, some of whom I have highlighted before in this column. It is also a slightly confusing sector because some smaller companies' funds have a greater proportion in what are really medium-sized companies.

One fund that is genuinely small cap is Investec UK Smaller Companies, managed by Philip Rodrigs. The fund is benchmarked against the FTSE Small Cap index, though it has the ability to run its winners as they progress into the FTSE 250 where they can often get an extra leg up as they appeal to a wider investment audience.

Investec has its own screening process known as the four-factor model, which it runs weekly to narrow down the universe of about 800 stocks available to the fund. It looks to identify higher than average quality companies, better than average value, an improving expectation of current profitability and current share price strength. These four factors, if found together, tend to be strong indicators of future company strength. No system is perfect though, and like many it tends to work less well during inflection points in the market when momentum shifts from positive to negative – or vice versa.

In the first quarter of 2009, the system suggested buying strong, defensive stocks. The market was also writing off indebted firms as it was thought they would struggle to refinance. However, Mr Rodrigs found that on the ground companies were seeing things differently. Good companies could get finance but at a higher price, and there was little chance of them going bust. Therefore, he ignored the model and positioned his portfolio far more aggressively; using 10 per cent of the portfolio for much higher volatility plays that should increase far more than the market average. There is little doubt that he has been well rewarded by taking this initiative as the market rebound in this area was very strong.

The fund has had a strong 2010 too, up 32 per cent year to date. Given such strong performance you might think the story is over, but Mr Rodrigs believes there is significant potential from here and likens the present time to August 2004, a slight pause in the market just before it took off again. Encouragingly, he says corporate profitability is very strong and valuations are inexpensive. He believes his own portfolio is on an average price-to-earnings ratio of nine, and with the market trading at around 10 times he can find plenty of cheap companies he wants to buy.

While I remain a fan of the big, defensive blue-chip stocks for their excellent yields in a low interest rate world, investors should not ignore this part of the market. Many of these smaller companies are global players in their respective niche areas, and I think we will see plenty of merger and acquisition activity going on. Well-run, solid companies have little problem in gaining access to funds if they need it, and they make attractive targets for larger firms both at home and overseas. Many investors are loading up on emerging markets (an area that I have always liked too) but UK small caps have been quietly providing similar returns but without becoming fashionable, something I think investors should take advantage of.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent