Small-cap story has another chapter

Investor attention may have moved on to large-cap stocks but the small-cap sector is producing impressive returns, with Roger Whiteoak’s Framlington UK Smaller Companies leading the way.

The figures on Framlington UK Smaller Companies fund are extraordinary. It had a desperately badly timed launch, coming to the market in April 2001 and promptly falling by 30% over the following year. But since then it has flown.

In the year March 2003 to March 2004 it was up 93.2%, and in the following 12-month periods it was up 35.9% and 25.8% respectively. Run by Roger Whiteoak, who made his name managing the smaller companies fund at Rathbones, it is firmly top-decile.

The fund is coming up to its five-year record and will probably enter the table at number one. After all, on a three-year cumulative basis it is second out of 57 funds. Just don’t talk too loudly about the current one-year figure (up 30%), which, oddly for Whiteoak – voted UK small-cap manager of the year in 1999 – is only middling. His fund is ranked 21 out of the 57 trusts in the sector, a creditable performance but one that is rather pedestrian by his previous standards. Funds from Standard Life, JPMF, Old Mutual, Threadneedle and M&G have all enjoyed gains of 40%-plus during the same timeframe.

These are impressive numbers given the fact that the small-cap sector has suffered as investor attention has rotated into big-cap growth. The widely held opinion over the past year was that small caps have had their run, valuations are stretched and it is time to move on. But since then the average fund in the sector has gone up 28.1%, while the average big-cap fund in the All Companies sector is ahead 30.5%. The predicted sell-off in smaller companies never really happened.

But Whiteoak is cautious on large parts of the small-cap arena. “I don’t like UK domestic-oriented stocks,” he says. “I’ve not been in property and retail, and have been trying to avoid the UK generally because of a slowing GDP.”

Hold on. Surely the reality of investing in the Smaller Companies sector is that you cannot avoid the domestic UK economy. Don’t you have to go up the market-cap scale to find the big international beasts who make most of their earnings outside Britain?

Not so, according to Whiteoak, who is currently targeting growth companies with strong and predictable overseas earnings. “The UK Smaller Companies sector is very different from 10 years ago,” he says. “There is now a lot of telecoms, software, resources and aerospace, and a lot of very interesting niche companies.

“I’ve felt for a while that growth stocks have not been re-rated. In the UK you’ve got a high cost base, so you need pricing power, and you need to find companies with a high and sustainable margin.”

He adds that the sector is “generally not expensive” but is clearly uncomfortable at the compression in price/earnings ratios in this part of the market. An awful lot of companies are trading at around 17 times earnings and could be vulnerable to a market downturn. “The market is at a level where you need to be in growth to make money,” Whiteoak says.

Unlike so many other growth managers, he has resisted the temptation to concentrate his portfolio. He has 80% of the fund in 80 stocks, which he calls his “profitable and predictable type stocks”. The sex factor in the portfolio comes from 70 other stocks that are small but “when they work, they work very well”. And when they don’t, well, they are only a small part of the portfolio.

Whiteoak’s willingness to buy tiny companies means the fund holds more micro-caps than the typical trust in the sector. Currently just over 40% of his holdings are in the Alternative Investment Market and 7% are in the FTSE Fledgling index. Only 29.5% is held in stocks that make up the FTSE Small Cap index. His holdings range from companies with a market cap as little as 10m, up to a maximum of 600m, compared with the 50m to 400m range of stocks in the small-cap index.

His “steady and predictable” stocks pepper the top 10 holdings list for the fund. One of his favourites is Headlam Group, the fund’s second largest holding, whose share price is up from 380p in November 2005 to around 520p. It is the UK’s biggest distributor and supplier of carpets, tiles and woodfloors to independent retailers, but the reason you have not heard of it is that it operates under nearly 50 different brands.

The company has single-handedly consolidated the UK floorcoverings market, acquiring one local name after the next. But rather than imposing a single national brand it allows units to operate autonomously, backed by a central logistics operation. The strategy appears to have worked. Earlier this month it reported sales up 7% to 487m, and increased dividends by 11%, with the chief executive confident that sales momentum can be maintained, even in a difficult British retail environment. It helps that Headlam derives 15% of its sales outside Britain, primarily through distributors in France and the Netherlands.

Another steady-eddie in the portfolio is Findel, the fund’s third-largest holding, which is in the rather old-fashioned business of catalogue shopping. But its niche is educational supplies, and business is strong. Its last half-year figures show profit growth of 23%, on sales up 22% to 233m, powered by the educational division.

But carpets and educational supplies sound rather old-economy. Where are the future growth stories?

Whiteoak likes a lot of software companies that, unlike those start-ups, actually make money. SDL is a UK company in a part of the market you would not expect to find Brits leading the world: translation technology. Its turnover in its last full financial year was 78.5m, on which it made a profit of 7.5m. It is currently at 207p, below its recent peak of 229p but a long way above the 125p level it was at just 12 months ago. At one point Whiteoak owned 19% of the company, the biggest stake he has ever held in one stock.

About 13% of the fund is in technology stocks such as SDL, NetStore, RoyalBlue and Aveva. Mining and explorers make up the other big sector bet, with Toledo Mining, in the Phillipines, Whiteoak’s favourite holding. It is a nickel miner that he says is “massively undervalued”, with a 25m market cap and reserves worth more than 500m. It is the sort of story to set the pulse racing. And it goes to show that smaller companies are not the boring, yesterday story that so many investors think.