Fund Managers’ Favourites: 3 Small-Cap Picks

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Video Transcript:

Alanna Petroff: Small caps are often overlooked by many investors, which means that if you are willing to do your due diligence you can sometimes find good companies for cheap in this space. Joining me now is a small cap specialist, Neil Hermon from Henderson. He runs a trust and a fund that specifically focus on investing in UK small-caps and he is joining me now to talk about his top three equity picks. So Neil welcome to the show.

Neil Hermon: Good morning, Alanna.

Petroff: Now, let’s go over what your investment strategy is first, and then we’ll get your top picks.

Hermon: As you said, I’m a small-cap specialist. That means I am actually a bottom-up investor, I focus on the individual attributes of companies and their growth potential. Although macro plays a part, it's much more a focus on the individual companies that really count for me. I’m a growth investor. I do believe investment in equities is about growth, it’s about the future. However I’m a kind of a GARP: Growth at the right price, growth at a reasonable price. Valuation is important to me. I’m also very long-term. The average holding period of stocks in my portfolio is five years. We tend to run our winners.

Petroff: That’s what we like to hear, we’re looking for more long-term investments.

So your top three picks right now: we have Oxford Instruments, Ashtead Group, and Senior. Now let’s start with Oxford Instruments. In the last five years, their shares are up roughly 500%, which is not bad. Do you still think that they have room to grow and why do you like this company?

Hermon: Oxford Instruments has been a very long-term winner for our fund. We still believe in the company very heavily. It’s a manufacturer of high technology tools and systems for the research and industrial markets. It operates in areas like material analysis and nanotechnology, which is the analysis of particles at a molecular scale.

Great technology. It was spun out from Oxford University in the 1950s. It manufactured the first full body MRI scanner in 1980. Great technology but slow financial returns until a new management team was appointed in 2005 who have really improved the fortunes of the company. They’ve rationalised the manufacturing base, improved the sales process and focused on product innovation.

They've got a plan in place to improve margins further to 14% by 2014 with 14% growth, and they call it 14-Cubed. That plan is on track. We think there is more to go for. Great growth markets it operates in, global reach and business that is well-positioned for the future.

Petroff: Okay, moving on to Ashtead Group, why do we like that company?

Hermon: Ashtead is a plant hire company, majority of earnings come from the US. Plant hire is the rental equipment to the construction industry. It had a very difficult recession as demand fell, but a very strong recovery since then.

It’s been driven by structural factors: the credit crunch has meant that its customers haven’t had the ability to buy their own equipment, they’ve had to rent it from people like Ashtead. Additionally their competitors are small mom-and-pop operators that have gone out of business, meaning that Ashtead's gaining market share. So Ashtead's grown its profitability very sharply in the last few years. We think they've got further to go. Additionally the US construction market at some point will recover, giving a further leg-up to Ashtead’s profitability.

Petroff: I heard that they had some problems with their balance sheet in the past especially when the great recession hit. How’s their balance sheet doing now?

Hermon: Much better. They’ve got a very flexible borrowing position with the banks, and actually debt's come down as profit has recovered so net debt-to-EBITDA is only two times now, so it’s actually reasonably well financed.

Petroff: Moving on to Senior, your last top pick, why do you like Senior?

Hermon: Senior is a manufacturer of components for the aerospace and land vehicle markets. It’s an engineering conglomerate. We like it because its main exposure is to commercial aerospace, particularly to Boeing and Airbus. Both those companies have got very long order books, giving great visibility to Senior.

Senior also, through good customer service and product innovation, is growing its value per plane. It ships at value, so giving good growth in that market. Additionally management team are very strong, they’ve grown the business through good acquisitions in the last few years using the cash flow from their aerospace activities to grow the company. It's tripled profits over the last six years, very good growth, and I think that can continue given the structural cyclical factors in play. And you’re only paying 11.5 times earnings for that company.

Petroff: Do you think that's cheap now? It sounds okay.

Hermon: Yes. It is very cheap actually. I think there are concerns currently about the industrial markets globally, but I think Senior will come through pretty unscathed and it’s good value.

Petroff: Now let’s talk about the key risks for each of these companies. One key risk per company, and we’ll start with Oxford.

Hermon: Oxford Instruments has grown significantly in the last few years, as you mentioned, a lot of the growth’s come from Asian economies, particularly China, which is its fastest growing and largest market. I think if you saw a hard landing in the Chinese economy or a shift to spend away from the research and development area, that would hit Oxford quite badly.

Petroff: And Ashtead?

Hermon: Ashtead heavily relies on the US construction market, if we saw a downturn again on that further than the current depressed levels, but if 2013 saw another downturn prompted by the fiscal cliff, then that could have an impact on Ashtead.

Petroff: Now Senior?

Hermon: Senior heavily relies on the commercial aerospace market, and Boeing and Airbus in particular, if we saw a downturn in commercial aerospace that would impact them. That would really require some macro-economic shocks such as 9/11, which did impact demand, but we think it's not going to happen.

Petroff: Okay. Sounds good. Thank you very much for joining me today.

Hermon: Thank you for your time.

Petroff: That was Neil Hermon from Henderson and the top picks that he’s chosen today have actually been chosen by some other fund managers I have spoken with in the past. So to look at those videos, just click on the links below. Thanks for joining me. I'm Alanna Petroff and you’ve been watching Morningstar.