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Six golden rules for investing in small-cap stocks

11 February 2019

Gresham House's Ken Wotton explains how investors can go about finding the fast-growing, innovative and disruptive companies in the small-cap space.

By Ken Wotton,

Gresham House

With many smaller companies trading at sizeable valuation discounts to larger counterparts, smaller caps offer a fertile ground for investors.

As this area of the market attracts less attention from professional research organisations and brokers, many investors are unaware the UK is home to a vast number of high-quality smaller companies. This presents an opportunity for dedicated investors to back some of these fast-growing innovative and disruptive companies.

However, selecting such winners requires patience, as well as a commitment to invest in the resources necessary to research such a diverse group of businesses. At Gresham House, every stock considered for investment is thoroughly interrogated utilising proprietary research. A ‘conviction score’ is awarded to each potential stock based on six key fundamental components.


Management and shareholder structure

We place a significant focus on entrepreneurial and high-quality management teams as a key driver of business growth and shareholder value creation. We also analyse shareholder structure, management ownership and incentives, and alignment of interest with our objectives as investors.

Long-term corporate strategy

We assess the company’s strategic positioning and how management is looking to enhance strategic value. We measure the clarity, simplicity and deliverability of the business strategy and how it links to long-term value creation.

Realistic market opportunity

We seek to understand the size of the company’s realistic addressable market and the trends and sector dynamics likely to affect this over the life of our investment. We also look for a company’s management to be able to clearly define its opportunity, including ways to expand its addressable market through international expansion, new product development and/or acquisition.

Market position and business model

We seek to assess the market position of the company, its customer value proposition and its sustainable competitive advantages. We also evaluate the key levers of the business model and how the company generates its returns.

Operational and financial performance

Our evaluation focuses on operational and financial performance, considering the profit and cash flow growth potential over the anticipated life of the investment. We also consider visibility of revenues and earnings, concentration risks, vulnerability to external shocks outside the control of management, as well as the key value drivers of the business.


Valuation and liquidity

We use an earnings-based approach to valuation analysis. Each investment is assessed on absolute and relative metrics applicable to the individual characteristics of the company. Valuations are benchmarked against selected listed peers, long-term average sector multiples, appropriate situational comparators, as well as public and private company M&A multiples.

This process acts as a quantitative output, providing a way of rating our level of conviction in the stock, as well as ranking it against other potential stocks. Higher conviction scores command a higher weighting within the portfolio subject to investment strategy and risk parameters.

One stock rated highly on our scorecard is Filta Environmental Kitchen Solutions, which provides cooking oil micro filtration services to restaurants and other food establishments around the world. Filta services more than 7,000 customers every week and has recycled more than £500m of oil over its history. Not only are there numerous environmental benefits to recycling oil, which often ends up going down the drain, but Filta’s service addresses a major health and safety risk for commercial kitchen operators by taking a hazardous activity away from casual workers and into the hands of a trained professional.

By following our six steps, we seek to screen out a substantial proportion of the investment universe carrying binary investment risk. The combination of focusing on our key sectors – business services, consumer, technology, media and telecommunications, as well as healthcare and education – and filtering possible opportunities by underlying profitability, helps to mitigate some of the inherent risks of investing in smaller companies.

Ken Wotton is manager of LF Gresham House UK Micro Cap and LF Gresham House UK Multi Cap Income funds. The views expressed above are his own and should not be taken as investment advice.

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