Neil Hermon, the manager of the Henderson Smaller Companies investment trust, favours industrials over consumer stocks, and says small-caps will lead the way out of the recession.
Neil Hermon at Hendersons has tilted his Smaller Companies investment trust towards the industrials sector as a play against struggling consumer-facing stocks.
The £204m trust is about 40% invested in small- and medium-sized companies (those with a market capitalisation of less than £1 billion) within the industrials sector.
Hermon sees these stocks as more appealing than those in the leisure and retail sectors for example, which are more exposed to the difficulties facing cash-strapped consumers. In many cases industrials also benefit from doing much of their business with America and China, countries Hermon predicts will lead the world out of recession.
There have been both strong performers and detrimental holdings from the industrials sector within the man ager’s investment universe. Hermon points to two stocks that he sees as attractive recovery stories which will rebound when the global economy returns to strength. Victrex is a chemicals manufacturer supplying a broad range of industries including transportation and oil and gas.
“Demand came off sharply but we have now seen an upturn globally. Recovery will be sharp when demand picks up again,” Hermon says.
International Ferro Metals, a South African-based firm, is another stock for which the manager has high hopes. “It was also hit as demand collapsed, but the signs are that production is increasing. The company will be well placed to recover.” So far the stock has risen 17% as orders from Chinese steel mills have continued to increase.
Meanwhile, E2V Technologies has been a disappointing performer as its share price was hit when the firm issued a profit warning in March. E2V supplies sensors and tubing to general industrials and defence companies. “The problem is the company has too much debt and its balance sheet is stretched. The share price is moribund, but it has got good recovery potential if it can raise capital, which it will do soon,” he says.
Hermon notes that rights issues and equity raising have been widespread among smaller companies. By and large, companies have been successful in their efforts to raise capital. “Generally after that, companies do well because it removes the concerns about financing issues,” he adds.
“In September we will see [rights issues] return with a vengeance as companies position themselves for the upturn.”
Hermon argues that small caps will lead the way out of recession, pointing to the fact that his benchmark, the Hoare Govett smaller companies index, is up 50% so far this year. “This is a sharp recovery from very low levels in 2008. There is always a risk we will see it dip down again, but economic data shows the worst is behind us,” he says.
Another area Hermon has found interesting recently is property, where he has an overweight position. He says markets have fallen 50% from their peak and there is now the potential for upside in commercial property. Paragon, a provider of buy to let mortgages, reported that arrears had stabilised and its stock climbed 23%, reflecting a more optimistic view of the housing market.
Since taking on the management of the Henderson trust in 2002, Hermon says there have been a couple of big changes to the small-cap landscape in Britain. The first is the reduction in the number of investment companies in the peer group. “A lot of small-cap investment trusts have disappeared. The sector has shrunk from 30 to 20 as the weaker players have been eliminated,” he says.
The average investment trust in the smaller companies peer group typically trades on a discount to net asset value (NAV). Hermon says: “Historically the fund has been on a discount, while the sector as a whole has always been trading on a discount because it has been seen as illiquid – 12% to 13% is the typical historical discount.”
The Smaller Companies trust is trading on a discount to NAV of 22.1%, according to the latest figures from Wins Investment Trusts. The manager says this is a positive for investors, who can get access to an underlying portfolio of stocks for less than their true value.
Despite a shrinking peer group, the universe of small-cap stocks has expanded and there is now a broader range of companies in which to invest, Hermon says. The Henderson vehicle can buy Aim-listed fledgling companies, and has 9% in these stocks at the moment, with a further 67% in mid-caps and 24% in small-caps.
“The weighting of the portfolio is in line with the benchmark, which is also overweight mid caps,” Hermon says, adding that he has no immediate plans to drastically reposition the portfolio in the coming months. “We are pretty relaxed where we are and I don’t anticipate any big macro changes in the portfolio,” he says.
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