Leading fund manager Harry Nimmo reveals his investment process in this exciting but higher risk area.
22 Jun, 2017HL.CO.UK
Smaller companies provide some of the most exciting and dynamic investment opportunities in the market.
Small firms can exploit expanding niches and increase profits rapidly. They are typically nimble, entrepreneurial, and able to react quickly to change. As a result they are capable of spectacular performance. It’s easier for a company to double a £10m profit than £100m, and this can have a significant impact on the share price.
The rise of the internet and improvements in distribution mean it is easier than ever for smaller companies to gain attention, acquire customers and achieve success. Importantly, these businesses are often less well-researched than larger firms; this scarcity of information presents opportunities for fund managers to obtain an advantage.
However, while some offer potential for growth, others will inevitably fail. Their focus can be a strength, but it also means their fortunes may rely on the success of just one product or service. All this makes smaller companies a higher-risk proposition.
Many investors like to choose their own smaller company shares – and some do so very successfully. However given the higher risks involved, many choose to invest via a fund – a diversified portfolio with the shares selected by a proven stock picker.
Harry Nimmo is one of the UK’s most successful smaller companies investors. He seeks to invest in robust companies with strong balance sheets and low levels of debt. It is an approach that has stood investors in good stead and has built a superb track record with his Standard Life UK Smaller Companies Fund.
Below, Harry Nimmo reveals the five rules he follows when investing in smaller companies and shares some examples of companies which meet his criteria. Please note that Hargreaves Lansdown does not necessarily share his views on these stocks. As ever investors should conduct their own research when buying shares.
There are two sides to this rule - growth in the business and growth in the dividend. A growing dividend is often evidence of a strong business, one that has excess cash it is able – and confident enough – to distribute to shareholders. However, it is also important to identify growing sectors and the companies best-placed to benefit – often those with a durable competitive advantage over others.
An example of this is First Derivatives - a specialist in ‘Big Fast Data’ which has carved a niche in the financial services sector. Its software has helped businesses detect insider dealing and market manipulation. Harry Nimmo expects increased regulatory requirements to provide further opportunities for growth, and feels the company is well-placed to move into other areas such as market analytics, aerospace and utility analysis. The business has also paid a steady and growing dividend over time, though as always there are no guarantees this can continue.
Only invest in companies with a strong balance sheet and steady cash flow, and avoid those which have high or unsustainable levels of debt, or are unprofitable. Also avoid ‘blue sky’ or ‘concept’ companies – a good idea doesn’t necessarily translate into profits down the line.
Ted Baker, another holding in Harry Nimmo’s fund, has achieved a strong track record of profitable growth since it listed on the stock market in 1997. Originally a UK brand, it has diversified overseas and around 50% of its sales are international. Sterling weakness and a flagging UK economy are just two of the challenges facing UK retailers at the moment, but Harry Nimmo feels Ted Baker's growth is relatively predictable and steady.
Exceptional companies often demonstrate a persistent, competitive edge. If you believe you’ve identified a long-term winner, why not be a long-term investor?
JD Sports has performed well over the past few years as it has benefited from the ‘athleisure’ trend (wearing sportswear outside of the gym), but Harry Nimmo continues to hold the stock as he believes it has further successes ahead. Building on the success of its UK offering, the company is now growing earnings by expanding internationally. However, it’s worth remembering that European expansion isn’t always as straightforward as it seems, tripping up rival Sports Direct in the past.
Long-term management teams offer investors experience and stability. Ongoing founder involvement is another strong signal, typically bringing an entrepreneurial mindset and close alignment to the success of the business.
Dechra Pharmaceuticals manufactures veterinary pharmaceutical products. CEO Iain Page joined NVS – Dechra’s former services business – soon after its formation in 1989 and was an integral part of the management buyout in 1997. Dechra is one of the leading players in its field and continues to benefit from Iain Page’s clarity of vision and experience. From its UK base, the company has developed significantly, now operating internationally with distribution channels across the UK, Europe and North America. As with any high-growth company, however, if results fail to meet the market’s lofty expectations, the share price could suffer.
Investors will look at a company’s valuation – the amount you pay today for future expected earnings – to help drive investment decisions, aiming to avoid companies which look expensive. However, Harry Nimmo feels valuation is a poor metric to use when investing in smaller companies – a low valuation often indicates major issues within the firm, and it can often be worthwhile to pay a premium for quality.
Accesso Technology is a world leader in ‘virtual queuing technology’ for theme parks and attractions. The company is highly valued by investors and, as such, expensive to own. However, Harry Nimmo feels the technology is a game changer for the entertainment industry. Innovation in areas like this means the formulas applied by analysts to predict future earnings cannot be applied. So while the company might appear expensive, he believes the potential for growth ahead of expectations means it is worth paying for.