Fund Managers’ Favourites: Need-To-Know Small-Caps

So, Mike, thanks for coming in.

Mike Prentis: Hi, Alanna.

Petroff: Now let’s talk about your investment strategy more generally. Are you in it for the short-term, long-term, small-cap, large-cap? What are you going for?

Prentis: Yes, we invest in small and medium-sized UK-listed companies and companies that we believe will become much larger in the medium-term, and if they deliver to our expectations, we hold them for the long-term.

Petroff: Okay. So, looking for long-term kinds of holdings?

Prentis: Absolutely, we’ve held some holdings for 10 years for instance.

Petroff: Okay. Now, let’s get into your top picks: we have Victrex, AZ Electronic Materials and Dunelm Group. So, let’s start with Victrex, what are they do?

Prentis: They manufacture high-performance plastic called PEEK and the attraction of PEEK is that it is replacing metal in lots of applications. It has some very attractive characteristics, which allow it, for instance, to win positions in the Boeing 787. So you find a ton of PEEK in a Boeing 787, because it’s light. So, it replaces – it can replace heavier metal and it allows for greater fuel efficiency. You find it in iPhones and iPads, because it’s hard-wearing and it copes with heat well, and you can find it in spinal implants, for instance, because it does wear well. So, lots of different applications; also in automotive, in oil and gas… In fact, the company has more than 2,000 specified applications that generates widespread revenue for it.

Petroff: So, the plastics theme is what we’re investing in essentially here.

Prentis: Absolutely, yes.

Petroff: Moving on to the next company AZ Electronic Materials, what do they exactly?

Prentis: They make high purity chemicals used in the semiconductor manufacturing process, so their customers are the big semiconductor manufacturers around the world. If you think of semiconductors, they are getting smaller and more complex, which means they have more layers and between each layer you find chemicals which AZ make, and they are sort of insulating materials and anti-reflective coatings critical to making the semiconductor work effectively.

Petroff: So, as more companies are using semiconductors in different kinds of products and there is a proliferation of semiconductors, you’re seeing better business conditions for AZ, is that right?

Prentis: Absolutely yes, and there are more and more requirements for semiconductors these days in all sorts of areas and they are gaining market share as well.

Petroff: Now, let’s move on to Dunelm Group, a very different kind of company. This operates in the UK retail sector. I don't have much faith in this company, but convince me … Why I should invest here?

Prentis: We are very sceptical about the retail sector too and we are very wary of companies with long leases, for instance, and the exposure that brings with it. The nice thing about Dunelm though is that it's had a fantastic record of success since it was founded 30 years ago. What it does is supply a whole range of home wares from the relatively inexpensive to the quite expensive. So there is something for everybody. They have this network of stores around the UK, which is still being rolled out. They don't have many in the South of England for instance.

Petroff: So, that could be an opportunity for them?

Prentis: It is absolutely an opportunity. And if you look at their performance relative to many retailers, they are consistently achieving good like-for-like increases and also gross margin increases. That has meant that profits have been going up. I suppose in a way probably the most attractive thing for me is that they have self-funded their own growth since they founded 30 years ago.

Petroff: No debt?

Prentis: No debt. They generate a lot of cash. They are actually in the process of paying cash back to shareholders, excess cash, which they think they are going to need even though they continue to expand. So, it’s a very attractive story that for me. Tt's self-funded growth.

Petroff: That is definitely a convincing argument. Now, let’s go over the key risks for each of these companies. Let’s start with Victrex. What would be the key risk here?

Prentis: The key risk really is some kind of destocking by its customers. We think – this did actually happen in late 2008, when you saw a number of customers destocking at the same time. We think now that control of inventory in the pipeline is much better than it was then, and the likelihood of that severe destocking, we don’t think that sort of environment is around at the moment, but it remains a potential risk, but a smaller risk than was the case.

Petroff: And for AZ Electronic?

Prentis: Much the same actually of destocking. I mean if you think they are supplying into the semiconductor cycle, which is notoriously cyclical, you can get quieter periods when the semiconductor companies will just decide to reduce the amount of chemicals that they’ve got. But again, the management have got very good control I think of inventory in the pipeline. So I don’t see that as a great risk.

Petroff: Okay. For Dunelm Group, what would you say is the key risk there?

Prentis: Well, they have coped so well with the difficult economic climate we’ve had in the UK over the last sort of three to four years, they’ve grown through the recession. So, it’s hard to imagine, what would derail them at the moment. It would have to be a very severe setback I think to the UK economy, which actually we don’t expect.

Petroff: Hopefully, not. Fingers crossed.

Prentis: Fingers crossed, yes.

Petroff: Okay. Thank you very much for coming in today.

Mike Prentis: Thank you, Alanna.

Alanna Petroff: That was Mike Prentis from BlackRock, I’m Alanna Petroff and thanks for watching Morningstar.