Smaller companies still in good shape

In last week’s Budget, Gordon Brown once again talked about injecting more dynamism into the UK economy and his dream of turning Britain into the biotech centre of the world. Much of it can be dismissed as political piffle – after all, it was Harold Wilson back in the mid-1960s who first became obsessed with Britain leading the world in what he called the “white heat of technology”. The result? We got Concorde, but we also got the Morris Marina.

But that was the era of statism, planning and grand projects. Gordon Brown is somewhat more sophisticated than that, and maybe, just maybe, his reforms are creating the conditions in which small high-tech companies are able to flourish in Britain.

Even as recently as 10 years ago, the Hoare Govett Smaller Companies Index still had a high proportion of stocks that weren’t about growth but steady shrinkage, reflecting the relentless decline of manufacturing.

“The index is very different to 10 years ago, when there was a big bias towards textiles and manufacturing,” says Roger Whiteoak, manager of Framlington UK Smaller Companies. “Today biotech and health make up 9%, tech is 10%, telecoms are 5% and media is 6-7%. Around half of the market is now growth-orientated stocks.”

Whiteoak runs the number one-rated UK smaller companies fund right now. It’s top of its sector over one year, and, better than that, it’s in the top five of all unit trusts and Oeics over the past year. Over the past year it is up 43.4%, and over three years it is ahead 94.2%. The average UK smaller companies fund has done well – up 24.7% over one year – but Whiteoak has few rivals in his sector breathing down his neck, with the exception of First State British Smaller Companies. No wonder money has been gushing into the fund over the past few months, and it now stands at £160m in size.

One would expect that any fund that gets to the very top of the table must have taken a small number of big bets. But Whiteoak is different. He holds 150 stocks in the fund, and won’t allow himself to invest more than 3% of the portfolio in any one stock. “It’s about getting the small things right and across lots of different areas. This is not about a risky, highly traded portfolio of a few racy ideas,” he says.

He is a growth investor, but several times repeats the ‘growth at a reasonable price’ mantra. Even after the closure of the valuation gap in the smaller companies sector – the market now trades on 13x P/E, or close to the main market – he still says he can find good value stocks. At times, though, that will mean buying growth stocks on P/Es in the 20s, 30s and even 40s.

He is ably assisted by two rather better-known fund managers who sit close to his desk – George Luckcraft and Nigel Thomas: “We all put ideas into each other’s funds. And we do work hard at looking at as many companies as possible.”

In total, Framlington manages about £800m in smaller companies, which makes it a big player in this market. But Whiteoak is more focused around the bottom end of the market, occupied with companies with a market capitalisation of £10m to £500m.

He’s not afraid to buy on float, and indeed his best performer of recent months was a stock that was floated only last October. The stock is D1 Oils; it’s now his third largest holding and he has around 10% of the stock: “It struggled to get away at a floatation price of £1.50 a share. But since then it’s more than trebled to £5 and I still think it’s a good long-term story.” D1 Oils isn’t some resource stock buoyed by the continuing high price for crude. It’s a bio-fuel company that would sit proudly in any ethical investor’s portfolio. It has bought plantations and converted them into fields that produce bio-diesel or ‘green petrol’.

Even the Saudis, with their immense oil reserves, have bought in. They pump their sewage into the desert, where it is used to grow stuff that makes bio-fuel, then use that fuel to power their water desalination plants. You don’t get a lot more environmental than that.

In the software tech arena, Whiteoak is a big holder of Neteller, which handles transactions for on-line betting companies. He’s also invested in Aveva, a British company which designs software to enable people to build ships. Its big customers are in China. It’s comforting to know that the ship-building industry may have collapsed in Britain and transferred to the Far East, but not all the work has been lost. Aerospace technology is another of his favourites, with logistics company Umeco his second largest holding.

But a major issue for investors is that after last year’s re-rating of smaller company stocks, isn’t it time to move on to other sectors? And how confident should one be about the long-term prospects for the sector? After all, the Hoare Govett index has yet to catch up with the average returns from the wider market over the course of its 17-year life.

“The whole of this market has been re-rated upwards, and if you want to continue to see 20% returns, you will have to be in growth stocks. I’m pretty negative on property, retail and car dealerships,” says Whiteoak.

But he’s not so infatuated with tech to have missed out on the great oil/commodity/resource story of the past few years. His biggest single holding is Dana Petroleum, which has a decent amount of North Sea oil production that isn’t hedged, so has done rather well from the recent strength in oil prices. But he thinks the market is undervaluing exploration prospects in Mauretania, Kenya and Australia.

The blip on the horizon is uncertainty ahead of the general election: “The small companies sector has been very strong and is due a setback in the short-term. An up and coming general election, along with possible interest rate rises and weakening consumer spending may have an impact on sentiment – and property prices and retail companies.

“But we continue to believe growth opportunities are still attractively valued and have good fundamental prospects over the next few years.”