As the quality and independence of broker research has changed in recent years, stockpickers have increasingly focused on fundamentals and building relationships, according to Janus Henderson Investors’ Neil Hermon.
Hermon, director of UK equities and manager of the Henderson Smaller Companies Investment Trust, said during his time as a UK small- and mid-cap stockpicker, broker research has become increasingly more biased and corporate, especially after the implementation of MiFID II earlier this year.
This, has led his team to increase the number of hours they dedicate to analysing companies or go out to meet management teams to talk about the business, their prospects or their future strategies. 
“Broking firms’ research is much more driven by the corporate transactions, the IPOs [initial public offerings] or the M&A [merger & acquisitions],” he said. “Research is not that profitable for them anymore, so it has become more biased and more corporate.”
Hermon (pictured) referred to new MiFID (Markets in Financial Instruments Directive) II regulations introduced in January by the EU, which have imposed more reporting requirements and tests aimed at increasing transparency.
Under MiFID II, new requirements have been introduced to ensure research isn’t being offered as an inducement, with asset managers having to pay for investment research.
As such, the work managers investing in UK smaller companies have to do – given smaller businesses are often not as well researched as their larger peers – has increased significantly.
“Broking houses earn their money more from corporate work these days, as there is pressure on fees,” said Hermon. “We have to do more independent research to try to look at these things from that perspective.”
However, Hermon said underlying process behind how he finds the best small- and medium-sized UK companies has remained the same, although it has evolved to reflect the increased amount of data now available.
“The internet changes the way you can access information: your ability to look and find things as well as the source of data all become different,” he explained. “If anything, things become more instantaneous and there is a constant requirement from information.”
While noting overall negative sentiment towards UK equities given the current backdrop and pressures of Brexit, Hermon said there are opportunities for investors to access good companies at attractive valuations.
“Why would anyone want to invest in UK equities? Because with sterling being quite depressed it is quite a good time to get very good companies,” said the Janus Henderson manager.
But, he noted, getting the businesses right is key and has been key for them to deliver a strong performance. The team currently favours non-domestic stocks that could be beneficiaries of M&A.
He said businesses that fall in the middle of the pack between large-cap and small-cap companies have recently seen a rise in inward M&A by overseas companies, a trend that he believes is set to continue.
“We are seeing M&A of international businesses. They are not buying UK domestics, they are not buying the retailers, they are not buying pubs either,” Hermon noted.
“The UK market is very global which is due to the geographical weighting of the FTSE 100 and the FTSE 250. Although the UK economy is very slow, the UK could benefit from international markets, you get a very good diversification across the globe.”
According to the manager of the £681.3m Henderson Smaller Companies trust, the reasons for an increase of M&A transactions are various: these companies have low valuations, cheap debt and strong balance sheets.
He also noted the amount of leverage is quite low, with UK companies having been able to generate cash to invest in their businesses and reduce their leverage.
Not only that, but with earnings estimates for these companies looking the most robust in years, he maintains that the UK is not a value trap.
UK earnings
Source: Janus Henderson Investors
Despite the good shape in which these businesses are, Hermon also acknowledged stock pickers can – and actually do – make mistakes, and said he tries to avoid the same mistakes.
“We constantly make mistakes. Investors in 2000 forgot valuations, they thought internet was going to change the world,” said the manager.
“That teaches you about balance sheets and leverage in the system. But companies are much more cautious about leverage now and as an investor me too, because I have learnt the lessons in that period of time.
“When things turn down you can get caught up really badly. You constantly learn things but the fundamentals don’t really change.”
One mistake, he noted, was investing in the alcohol retailer and supplier Conviviality, which filed for administration earlier this year.
“Conviviality had done well, it was led by an ambitious CEO and literally came out with a shocking profit warning out of the blue,” he said. “Fundamentally their numbers were wrong, and these are things you can never foresee or see coming.
“We sold it immediately: it was down 60 per cent in a day. We took the view that our investment thesis had changed so we could no longer justify holding the company.
“It went from bad to worse, then went to zero and then went bust. But I’ve never had a company go bust at me.”
Over the time Hermon has been running Henderson Smaller Companies Investment Trust, it has delivered a 1401.09 per cent total return compared with a 777.92 per cent gain for the average trust in the IT UK Smaller Companies sector and a gain of 622.33 per cent for the Numis Smaller Companies excluding Investment Companies index.
Performance of trust vs sector & benchmark under Hermon
Source: FE Analytics
The fund is trading at a 10.3 per cent discount to its NAV, is 9 per cent geared and has ongoing charges of 0.41 per cent, data from the Association of Investment Companies shows.