Small but mighty: The hidden potential of UK Smaller Companies

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  • 31 mins 01 secs
Rob Bailey talks with Dan Harlow, Fund Manager of the AXA Framlington UK Smaller Companies Fund about how he identifies companies with attractive valuations relative to their growth potential and how UK smaller companies as an asset class can perform in the current economic environment. Dan also discusses the impact of macro and micro economic factors affecting FTSE SmallCap companies such as their brand strength, tech disruption and innovation, regulation and more.

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ROB BAILEY: Hello and welcome to today’s AXA Investment Managers Webcast. I’m Rob Bailey. I’m Head of UK Wholesale Distribution at AXA Investment Managers and today I’m joined by Dan Harlow. Dan is the Fund Manager of the AXA Framlington UK Smaller Companies Fund. Morning Dan.

DAN HARLOW: Morning Rob.

ROB BAILEY: Today, we’re going to be focusing on smaller companies, talking about the potential within the small cap market and also talking about the small cap fund that Dan’s a manager of. So, Dan, UK Smaller Companies Fund, you’ve been running this again now for two years and I say “again” because you were manager of this fund several years ago. You went and spent a time running the American stocks focusing on mid and small. Looking at performance, the fund’s been very strong. I mean over the last five years the fund’s outperformed the peer group by some 40%. So a great long-term track record in the small caps. But coming back to you and your time in the US, what do you think you learned from that time managing US stocks that you bring into the small cap market?

DAN HARLOW: Well I was very fortunate, I consider myself very fortunate as to having those four years of experience working with Steve Kelly on the American growth funds. And four years looking at young growth companies, I think it’s given me a really good base knowledge insight into how faster growth companies operate, work, grow, and also particular strengths in terms of the tech and the healthcare sectors where I think the American universal stocks is that much stronger. And it’s been fantastic looking back at the last two years as to just how much I’ve really called on that US experience, those insights, in terms of analysing and getting to know investments and potential investments in the UK. Whether it’s customers, suppliers, competitors, it’s sometimes surprising just how often roads lead back to the States, and calling on that knowledge has been and continues to be very valuable.

ROB BAILEY: And when you look at the companies in the US that you focused on, what would you say were the key differences? What are the key dynamics in say the difference between a US small cap or a US mid cap and maybe a UK small cap?

DAN HARLOW: Well I think firstly, you know, I have to kind of consider definitions of small and mid, and certainly in the US our small cap kind of cut-off was over one or two billion dollars, and over half my fund in the UK is under £500m. So I think that potentially gives a little insight as to actually how they do differ. I think the UK base that I look at today, a little less experienced, a little more naïve in some respects in terms of how to forecast and manage their growth projections and how they actually sell their story, so actually there’s more opportunity I think for me and our team as small cap, UK small cap stock pickers to find anomalies, to find those unknown, under-researched names. The names we were looking at in the US have a bigger coverage, have a stronger investor relations presence and market just that much more efficiently and effectively.

ROB BAILEY: OK. So let’s talk about that team because I mean many of the names here are familiar to people watching this webcast. Particularly people like Chris St John, Nigel Thomas and so on and so forth, who are steeped in, I think, small and mid-cap experience. What would you say the dynamic is within the team about how you research and how important are those meetings that you regularly do with companies?

DAN HARLOW: They’re hugely valuable. And that’s why being part of a team with those faces is fantastic because small cap matters to Chris, to Nigel, to George, with his income approach, the barbell approach. So we’re constantly appraising and scouring my universe for opportunities, and between us we’re having many hundreds of meetings a year and we’re very collaborative in how we work. We share ideas, insights, experiences, and that’s hugely valuable. And we’re also there to challenge each other as well. I think there’s a danger of group think in terms of supporting each other’s ideas, and we very much need to play and do play devil’s advocate with each other and make sure that we’re not getting too close to a company. I mean that’s a danger in small cap, you’re there hopefully for the long term. You’re lucky enough to perhaps meet the companies twice a year, go and see them on their own turf. You can become perhaps a little attached to them. And actually having a team it can help make sure that that’s challenged and you don’t become too close.

ROB BAILEY: So, and we’ll come on and talk a bit about this later on as well, but I mean in terms of what you’re looking for in a small cap company, Chris talks very much about earnings growing over a period of time and how that is the most significant influencer on a share price. What would you say were the things that you look for when you meet a small cap company?

DAN HARLOW: I think the key for me when I sit down and meet a company, it’s thinking about how the company is differentiated. What it is that actually will drive the growth for this business. And what are the barriers to entry, what’s the ability to handle out pricing power, to manage that, some of those pressures. So it’s thinking about competitive challenges, thinking about how unique the proposition is. I want to be clear that the company has a track record of execution, but I’m also looking for lots of opportunity, lots of growth opportunity. And very fortunate in the UK market that there are plenty of, it’s a big universe, there are plenty of opportunities. It’s making sure we’re in those names which have the best chance of succeeding over the longer term and challenging yourself on the competitive position, and the uniqueness of the service or skillset is particularly important.

ROB BAILEY: So let’s look at some of those attractions in a bit more depth here. Because we’ve had plenty of questions from clients over the years about why would you invest in UK small cap, when you’re in this time of uncertainty around Brexit and the macroeconomic uncertainties and the uncertainties around the UK consumer, why would you look, what are the attractions of small caps?

DAN HARLOW: I think the main attraction to small cap is the fantastic universe of names we have exposure to and the potential to invest in, and the ability of some of those names to deliver fantastic growth over the medium to long term. So I’m looking at investments in the FTSE small cap and on AIM, and I’m hoping that those names are very much names that can grow into the mid-cap space over time, and the breadth of opportunity gives me the best chance of achieving that. And I think the long-term returns that small cap has been shown to deliver go a long way to supporting that thesis. I think what we do in small cap management has to be grounded in strong risk management. There is an inherent volatility to investing at this end of the market and we don’t want to add to that by having big stock specific weightings. So our holding size will reflect liquidity, will reflect risk, and also the evolution of that business. But with a portfolio of about 75 names we feel we’re able to give our investors really good exposure to a series of names across the economy, across the various sectors that are poised and well placed to prosper over the medium to long term.

ROB BAILEY: And actually on that subject of volatility, we actually have a question in about that, about how the market in general, so rather than specifically about your fund, how the market in general has dealt with the volatility that we’ve seen since the start of this year compared to maybe the broader market?

DAN HARLOW: Yes absolutely we’ve seen a marked pick up in volatility already this year compared to 2017 and I think that presents opportunity in many respects. We’ve seen clearly stock prices move and that gives me a chance to perhaps capitalise on some things that we’ve considered a little overvalued, perhaps, and also when we feel the sell-off is perhaps unreasonable, as we did in a few cases in early February, a chance to add to position. So we use it to our advantage and we ensure that our portfolio exposure is carefully managed with good discipline to ensure there’s no added risk at any point by having too great an exposure in any one name.

ROB BAILEY: And I guess with the small caps the reason that portfolio diversification is so important is because of liquidity issues and liquidity constraints. How do you see that, in moments as we’ve seen so far this year where the market is moving quite sharply, what’s the liquidity like? What the ability to get into and out of stocks like?

DAN HARLOW: I mean I’d really characterise small cap liquidity consistently as patchy. You can’t ever rely on it being good so therefore you have to manage your portfolio with that very much in mind. So perhaps I need to manage a position down if I feel a catalyst is played out and capitalise on liquidity that’s there to sell down a position. Similarly I might need to buy a new holding or add to a position a little earlier than perhaps I might want because I just can’t rely on that liquidity being there in six months’ time, so you’re constantly having to manage a fund to a bigger picture and to a bigger timeframe to accommodate liquidity. And with the fund size at £300m I can still get good exposure to smaller names. I don’t want any position to be less than 50 basis points in the fund, so a £1.5m position is achievable in companies, even £75-100m, but it requires patience, experience of patchy markets from liquidity perspective to achieve that.

ROB BAILEY: On this slide here, we’ve looked at earnings growth. And we had a quick conversation around that. Looking at the other factors that you focus on and the attractions of small cap, one thing that strikes me as being a particular dynamic at the moment is this decline of sell-side coverage; are you observing that materially in perhaps the availability of liquidity, the availability of research, and I guess that emphasises the importance of the team?

DAN HARLOW: I mean I think over the long term there has been less attention paid to the smaller end of the market. I think clearly with the new regulation, MiFID II that hit earlier this year, there is an expectation that that process will continue and perhaps accelerate over the next year or two. We’ve seen no substantial change in the first few months of 2018, but it is a market that is underserved. The research that is there is often paid for, so we question the objectivity of that research. It’s helpful perhaps educationally, but we need to sense check some of the expectations, the earnings forecasts that are there. So yes you’re absolutely right we need to take it upon ourselves to do the hard work and to really sense check numbers, to build our own models, to get comfortable as to a company’s growth expectations and their ability to hopefully not just deliver on those expectations but exceed them.

ROB BAILEY: And looking again at this list here, the bottom one that I think is quite interesting is the IPO market; what has been your observations of the IPO market and perhaps more broadly on M&A activity?

DAN HARLOW: With IPOs in mind, I mean we continue to see a fairly continual flow of IPO opportunities. I think back to the market, I think companies are being encouraged to float. The market is a reasonable one at the moment. I think the opportunities are there, but the market is I think being very firm and disciplined in what it will accept and pay for. But yes we’re aware of six or seven IPOs at our end of the market going around at present, and we’re assessing them very carefully. We’re wary when it comes to IPOs. These are companies that, perhaps, back to my opportunity and execution observation, have plenty of opportunity ahead of them, but we have very limited ability to measure execution, and measuring execution as a plc in the listed environment is important. How good are they at managing expectations, at being able to hit forecasts, it’s an essential element of being a listed company, and we don’t have that yet, so we’re careful. But there’s activity. And there’s activity as well on the M&A front as well. We’ve actually seen a pick up I think here today. In the space we’ve seen mid-cap names like Fidessa and FINA both being taken over. We’ve also seen in the small cap space Laird and Hogg Robinson, those aren’t names that this portfolio owns, but we’re encouraged by what we’re seeing that both trade and private equity are clearly appraising UK assets. And despite some of the broader concerns as to the state of the UK and what Brexit may or may not mean, M&A is being seen and actually we’ve seen a pickup in it here today.

ROB BAILEY: OK. Let’s move on a bit and have a look at evaluation because clearly, you know, M&A impacts valuation, but as does everything else. Talk us through this particular slide here what it represents and perhaps maybe we’ll come down and focus a little bit on the AIM market.

DAN HARLOW: OK. Well I mean really what this slide is showing and illustrating is on the X-axis, the horizontal axis, you can see the market cap spread. On the left-hand side, the big caps, the biggest FTSE 100 companies, scrolling down to the bottom end of small cap in the darker green down at £70m. And really you can just see that ultimately the bottom end of small cap shows perhaps the lowest valuations available in the UK listed market. And as a whole the FTSE small cap index is on about 13½ times forward earnings, and that’s for about a 10% earnings growth. So we think actually that’s a reasonable value. We don’t see kind of excess there, we see that trading at a kind of 10 to 15% discount to FTSE 250 valuations, which again is something that’s pretty consistent and pretty in-line with the historic valuations and that makes us reasonably comfortable and sanguine as to the outlook.

ROB BAILEY: On the right-hand side of the graph is the AIM market. And looking at the AIM market there’s some pretty significant stocks in the AIM market generally now, but when looking at this, certainly on the large cap end of the AIM market, the valuations look pretty extreme. What’s the dynamic behind that?

DAN HARLOW: So, as small cap investors we pay close attention to AIM, it’s an important part of our fund, about 40%, and we clearly also play a huge amount of attention to valuation, and as you’re observing, at the top end of AIM, you have some very highly valued stocks. You also have some of the highest growth stocks to be found in the UK markets. You’ve got the likes of ASOS, Boohoo.com up there, Fever-Tree similarly, and those have delivered fantastic returns for investors over a period of time and still have very robust and healthy growth outlook. So clearly you’re seeing some big earnings multiples there, and those, I do hasten to add, are companies, like a number of the companies we’re investing in, that are investing for growth. So the earnings aren’t necessarily all flowing through to the bottom line in the way they are for more mature businesses that aren’t needing to invest in building sales teams or building out new sites or distribution centres.

We, as I say, are very much involved in the AIM market. On new investments, we make kind of in the sub one billion space, and again there are some fairly highly valued stocks.

ROB BAILEY: And looking at the scale of those companies, I mean these are companies that would comfortably make the 250 index.

DAN HARLOW: Yes largely.

ROB BAILEY: Is there a likelihood at some stage that they will transfer to main listings or does the AIM market provide sufficient demand and a sufficiently comfortable environment for them to remain in that space?

DAN HARLOW: Yes, that’s a very good question and I think it’s something that’s changed over the last decade. I certainly think 10, 15 years ago you saw the likes of Domino’s Pizza stepping up from AIM to the full list, and it was a sign of maturity, it was a sign of growing up. Whereas today I don’t think there is that same need for companies. I think nearly all investors will look at AIM. They’re comfortable with the valuations they’re getting on AIM. And for some good reasons, tax, tax efficiency perhaps for holders and founders, it’s the right thing for them to remain on AIM. So yes I know our next slide is AIM and we’ll touch a little bit about on the coming of age to an extent of AIM in terms of just the fact that there are kind of six companies over a billion on AIM. It’s proven that it can attract good sound investors.

ROB BAILEY: Before we go any further, let’s just quickly talk about the fund itself because some 40% of the portfolio is in AIM stocks. I think it’s quite interesting as well looking here on the two doughnut charts on the right. You’re sitting there with a big exposure to the UK for sales. And understanding the dynamic of that relative to the broader market, it doesn’t look that much different to maybe the mid-cap market where it’s about 50% of it is UK domicile. Do you notice a different dynamic?

DAN HARLOW: No, it’s very consistent really in terms of that sales exposure for mid and small companies. It’s broadly about 50% of sales for the benchmark; clearly a shade more, it’s 54%. So while clearly it is a more domestic index, more domestically-oriented index than the FTSE 100, there are plenty of companies with big geographic exposure. And we’ve used that to our advantage really in the last couple of years where there has been a big wariness of domestic-oriented names as consumer has come under pressure, as inflation has picked up for various reasons, and there has been clearly a wariness of the high street stocks and touch on that maybe a little later. But we have a broad universe as I’ve kind of highlighted and we find some of the strongest opportunities of those companies that are looking to grow internationally now and have proven the model at home and are taking it overseas.

ROB BAILEY: And we always say with the small cap fund, because we run a mid-cap fund as well that this is very much a small cap fund, you still have, what, nearly 17% in the FTSE 250, those presumably are companies that have moved from being small caps into mid-caps, rather than mid-cap stocks bought directly.

DAN HARLOW: Yes, absolutely, you’re right. I mean this is a fund that, as I said earlier, we’ve got over half the fund in companies under £500m market cap and the cut-off today for small cap into the FTSE 250 is about £750m market cap. So those names, that 17% in the 250 are names that have grown up through the small cap index into the 250. You’re absolutely right. We’ve got a great mid-cap product. I will not be making any new investments in FTSE 250 names; I’m scouring the opportunities in the small cap and AIM for new ideas.

ROB BAILEY: OK. So let’s move on and talk about some of the individual ideas and companies that you have within the fund. Because we get asked a lot about the individual names and I think some of these names are familiar, some of them are less so. If we look at this circle that we have on this graph, going up towards the top right hand side, you mentioned Quixant earlier on as an outsourcing play. And this is one of the sort of several individual themes you’ve got running through your portfolio. What’s the attraction of Quixant? And tell us a little bit about them.

DAN HARLOW: So, yes, I mean it’s a niche outsource player in a market that historically has seen very little to no outsourcing skills or services. They are a supplier of manufacturing capability and knowhow to the gaming industry. And by the gaming and the games industry I really mean the Casino games market, so the big machines you’ll find on the floors of Vegas or Macau casinos. It in itself is a fairly healthy end market. You see a little bit of growth there, but what you also see is just a great replacement market, so those machines are being churned out and turned every five or six years. And what Quixant are enabling, the providers and the manufacturers of the games and the game content are to focus on what they’re best at, which is making the games.

So Quixant have really strong skills and expertise in the manufacture of the brains of that machine, ultimately the logic box, and the logic box drives the ability to run ever more impressive graphics, drives the ability of the screens to run four or five screens within one game. And that’s a regulated box, that box will control the payout, the randomness of the payout. It needs to be monitored, it needs to be cooled. There’s a lot of IP and expertise around it. And what Quixant have proved over a number of years is their ability to really move from a supplier to a strategic partner with some of these games manufacturers and enable the games manufacturer to attack different geographies which require different requirements from those logic boxes to do a great job. So they’re gradually improving their penetration tier three, tier two, tier one manufacturers and they’re now over 10% of the logic box market, so they are the biggest manufacturer of logic boxes out there and are really the only outsource provider.

ROB BAILEY: A couple of the other names, I mean let’s focus a little bit on brand strength, because brand strength’s quite an interesting concept in small caps, because you don’t imagine that small caps have massive brand strength and I mean they have names familiar with like Joules or Games Workshop. What’s the thinking behind those investments?

DAN HARLOW: So we like brands that we believe have longevity and are here to stay and still have scope for growth. And one of those brands you mentioned has been around for quite a long time and one’s quite young, and Games Workshop’s been around since 1975, so it’s not a new name per se, but actually what they’ve done over the last 40 years is generate a huge amount of content, build a strong user base. And there’s been quite a significant shift in management focus in the last three or four years where management has been historically quite reluctant to embrace social media as a form of messaging and a way of expanding the number of gamers that they have. And actually they’re having real success and real strength by utilising the likes of video, Instagram, Facebook and that content to drive strong growth among their base. Re-energise the original gamers who probably now are fathers of boys and girls in their teens that perhaps want to try it for the first time and you’re seeing really impressive growth there. Coupled with really strong dividends payouts, a company that’s happy paying out its free cashflow, it doesn’t need capital to grow, it has about 500 stores, and we’re quite excited about how that’s kind of reconnecting with its with its core base.

ROB BAILEY: And do you see the small cap market as an area where you get much in the way of dividend return?

DAN HARLOW: I mean for us, you certainly can is the answer, but for us, we like companies which often have use for that income and that cashflow. They’re still investing for growth. A name like this is something where we see a healthy balance, it’s actually, they’re at the moment expanding their site in Nottingham so it can move from £200m of sales to £300m, but given the size of the business, the fact it’s £70m of profit, it can still payout substantial amounts of dividend while having good scope for growth. A name like Joules is younger. They’re still expanding their store base domestically. They’ve got about 120 stores. They’ll be moving to 200. They’re investing in capability in the US and in Germany where they’re really growing a presence.

ROB BAILEY: OK. So we’re running to the end of time now Dan, so just quickly summarising your overall view of the small cap market, of your small cap fund, let’s work through this slide and perhaps you can just explain to us your overall view of the space.

DAN HARLOW: Sure, absolutely. I mean as ever we think for investors with a medium to long-term perspective small cap is a fantastic place to find strong stock picking capabilities and to identify the names that can successfully grow over the medium to long term and deliver strong capital returns. And I think as I said earlier history has proved that small cap effect. I think there are inefficiencies that, there always have been, those inefficiencies are only ever likely to grow with the onset of MiFID, so investing in a team that has strong experience, strong capability is very important, that ability to meet companies, to analyse them, to get out the office and meet the operational teams and assess and appraise how achievable the growth opportunities are is key. So that’s really interesting for us. You will find pricing anomalies as a result of that inefficiency.

We’re seeing M&A activity pick up. We think that’s interesting. I think that’s an endorsement of the quality and some perspectives of the valuations that are out there. And we think that actually what we achieve in small cap investing actually gives broader UK investors exposure to a bigger range of sectors, and tech and health are sectors that actually you struggle to find much of in the mid and large caps in the UK these days: 25% of the AIM market by market cap is tech and health. So that tends to be where our AIM exposure is. And again we feel those are interesting spaces that have long-term opportunities. And I guess we’ve touched on it throughout this chat, but I think this is a fund that stays true to its name, and we are very much small cap investors. We’re excited by the opportunities we find under £500m market cap and we do look to recycle some of the larger holdings and put that capital to work at the lower end of the spectrum where we find more of those pricing anomalies, where we find more names which lack that research.

ROB BAILEY: That’s great. Thank you very much Dan. And thank you for watching today’s webcast. Any questions that we’ve received, we haven’t covered during the course of this broadcast we’ll answer afterwards, but for now thank you from us for watching.

KEY RISKS – AXA Framlington UK Smaller Companies Fund

The risk category is calculated using historical performance data and may not be a reliable indicator of the Fund's future risk profile. The risk category shown is not guaranteed and may shift over time. The lowest category does not mean risk free.
Additional Risks
Liquidity Risk: some investments may trade infrequently and in small volumes. As a result the Fund manager may not be able to sell at a preferred time or volume or at a price close to the last quoted valuation. The Fund manager may be forced to sell a number of such investments as a result of a large redemption of units in the Fund.
Depending on market conditions, this could lead to a significant drop in the Fund's value and in extreme circumstances lead the Fund to be unable to meet its redemptions.
Further explanation of the risks associated with an investment in this Fund can be found in the prospectus.

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