Launching a smaller companies fund may seem like an ill-advised move in the current climate as investors move towards safety and shun anything that comes with risk.
UK small caps have been hit particularly hard, with the average company quoted on AIM, for example, down 30% or so this year.
Yet these conditions make now the ideal entry point, according to Richard Penny, who has launched the TM CRUX UK Smaller Companies fund despite the present headwinds.
“There is undoubtedly a difficult backdrop for some companies economically, but there are a lot of factors at play,” he said.
Firstly, he noted that some of the worst performers this year have been cyclical stocks such as retailers and housebuilders, which are to be expected as experts anticipate a recession in the coming 12 months.
Yet not all smaller companies are purely domestic, Penny noted, with his “specialism” sitting in technology and healthcare.
These have not done well either, but he noted that stocks in these sectors “tend to ebb and flow with investor sentiment” rather than the health of the economy, and that now makes today an interesting time to buy these businesses for the long term.
“Buying on the dips can lead to significant returns and as a smaller companies manager, you tend to spend at least seven years out of 10 lamenting why you didn’t buy at the bottom,” he said.
This has been how Penny has invested in his career, taking big recovery bets when things seemed at their bleakest in the tech bubble, the global financial crash and most recently in 2020, as the below chart shows.
Performance of manager vs sector peers over Penny’s career
Source: FE Analytics
“In the tech bubble, I bought into cyber security and video conferencing, which were all multi-baggers, although I was running institutional money only back then,” he said.
“In 2008 I bought into 3D printing and data centres and in 2020 we had a gene therapy business that went up 12-fold from the bottom. Today we are starting with a clean sheet of paper and think that we are pretty close to the bottom.”
Launching now, he said that the fund has already avoided part of the down cycle and noted that even though experts are anticipating the UK will fall into recession next year, the market tends to recover six to nine months ahead of it.
He said investors are now moving away from harder-to-understand businesses, such as tech names and small caps, and focusing on larger stocks. This means it is a “buyer’s market” for those that have the money to add to the area.
The TM CRUX UK Smaller Companies manager said that one area of interest is technology, where stocks are at a “real discount” to their US counterparts.
However, unless there is a catalyst for this to change, then these investments will underwhelm.
“You need to get to about $1bn, then there is potential to float on Nasdaq, which was the catalyst for MaxCyte, where shares went from £1 to £12,” he said.
“There are three stocks where I think the technology is going to be relevant and there are specific catalysts. They are now £300m to £400m but I can see how they can get to the right size in two to three years.”
First is IQE, the Welsh technology company that makes wafers for semiconductors, a part of the market that has boomed in recent years as we have moved towards electrification.
“It is the leading global manufacturers of these wafers, so it might have broader appeal, which is important because you need a hook for when investor appetite recovers,” said Penny.
Shares are down significantly from their peak in 2017, as the below chart shows, but there are reasons for optimism.
Total return of stock over 10yrs
Source: FE Analytics
“A new manager came in who is credible and has made some signings. The management team thinks it can treble revenues and get margins up, and if it does, shares will go up by multiple times,” Penny said.
Another is WanDisco, which helps companies migrate data onto the cloud. It floated around 10 years ago to great promise, but “never quite delivered”. It has appeared in Penny’s portfolios in the past, when he made quick profits and sold, but now says there are reasons to own it for the long term.
“It has signed two or three record orders this year and has a strong order book, which are with global companies, not just UK regional services businesses. Today it is reassuringly expensive, in that the product is not cheap, but the prospect for growth looks quite exceptional,” said the TM CRUX UK Smaller Companies manager.
Lastly, FD Technology, formerly First Derivatives, has a business called KX Systems, which is about time-series databases.
“That is important for things like the huge network of smart meters, which require monitoring every 30 minutes or so. There is a vast quantity of data and therefore a need for these databases that is much broader than it has perhaps historically been,” Penny said.
Total return of stocks over 10yrs
Source: FE Analytics
The firm has recently signed a deal with Microsoft, but even excluding this, is growing at between 30 and 40% per year, similar to some of the most highly valued US tech names.
“Shares are pretty close to a seven-year low, but the prospects are as good as when people were paying £45 for them. They are £14.50 today,” said Penny.
It also has a UK consultancy business that works in the banking sector, so investors need to look at the sum of all parts before making a decision.