Think small for long-term growth

Dan Whitestone, Portfolio Manager of the BlackRock Throgmorton Trust plc, explains why he believes that high-quality smaller companies are tapping into powerful long-term trends, including digital payments, business transformation and cloud computing.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Why are smaller companies an exciting area to invest?

There can be a wide spread of possible returns across small and medium sized companies. It is also an exciting area because it is so diverse. I get frustrated with people talking about the diversity from holding 20 companies in the FTSE 100. It’s just not reflective of the many trends taking place in the 1,600 companies not in the FTSE 100 index. Our universe is diverse, and it keeps changing.

There is so much idiosyncratic, stock specific risk. The rewards for success may be really high, and the consequences for failure and/or disappointment may be severe. As such, it’s not an area where we believe investing in the index as a whole works particularly well. It’s about owning the winners and absolutely avoiding the losers. Every year the index changes, companies are acquired, companies go bust, many new companies come in.

This is a universe that is significantly under-researched in our view. The combination of a dynamic company, doing something truly differentiated or disruptive in a large fragmented market can produce a range of outcomes for profits and cashflow that may be wildly different versus forecasts. A large range of financial outcomes with a lack of research can produce huge share price movements.

What makes the BlackRock Throgmorton Trust different from its UK smaller companies sector peers?

We believe it is unlike any other UK smaller companies focused trust on the market. The Trust has a ‘gross’ exposure of up to 130%. That means that for every £1 most people can invest, we can invest £1.30. It means we can magnify returns, but it could also amplify losses. We can also short shares (i.e., profiting from shares that fall in value) and use the short book to smooth out some of the volatility inherent within the universe of small and medium sized companies. The Trust is predominantly exposed to the world of small and mid-cap companies in the UK, however we can also invest up to 15% of the trust’s assets1 in companies not in the UK: We have many shares in the US, for example, some in Europe and one in Australia.

Risk: There is no guarantee that a positive investment outcome will be achieved.

Explain how the shorting element works in the portfolio

The real differentiator for this Trust lies in the fact that while gearing, which means borrowing to invest, for our competitors is limited to long positions (i.e., those that will benefit from rising share prices), the Trust can use a contract for difference to also take short positions. This means that the Trust can not only target differentiated growth companies that see their share prices multiply over time, but also shorts in companies that operate in challenged industries, with weak financial structures, that fall victim to industry change. Additionally, through a combination of long and short exposure, the Trust can be flexible with its net exposure to the market through time, which can be particularly beneficial during times of volatility as we experienced in 2020.

Risk: Risk management cannot fully eliminate the risk of investment loss.

What do you look out for when picking stocks?

There are really two types of companies that we focus on. The first we would define as “quality differentials” which are essentially differentiated long-term growth investments. These companies share a number of characteristics that we believe may lead to long-term compounding success. We spend a lot of time focusing on the quality of the management team, which is something that is often overlooked and the hardest thing to put on a spreadsheet. We are big believers in owning great management teams with great vision that have the resources to build on that vision. They set the culture and the pace. They don’t get delusions of grandeur.

We also like to see product strength. We want to understand what is special about the product, what gives the business pricing power and enables the company to sustain high gross margins. We also want to see what the business is spending on research and development and what percentage of sales are coming from products developed in recent years so that we can get a sense of how well they are spending on R&D.

We also like to find companies that operate in attractive industries with long term secular growth trends because when you find great management teams with a strong product in a fast-growing industry it can lead to long-term compounding success. In contrast, a difficult market - one with high regulation or irrational low-cost competition or changes in consumer behaviour - can undo a lot of good work.

Finally, we like companies with good balance sheets: we don’t want to see a lot of debt. If anything changes in the world, companies with a lot of debt can be plunged into crisis quickly. We also want companies that are able to convert their profits into cashflow. It tells us that the earnings are real, and companies can reinvest those cashflows back into the business at high rates of return to drive future growth.

The second type of company that we look to invest in are those that are leading industry change. We are living in a world where advancements in technology are accelerating many long-term industrial trends and this is fundamentally changing the way that both consumers and corporates purchase goods and services. As a result, we are seeing profound changing in consumer behaviour, corporate behaviour and manufacturing models, introducing lower cost unit economics which means that pricing architecture of legacy incumbents can be undermined. This can be great for the winners but can create catastrophic problems for the losers that aren’t able to adapt to the fast-changing landscape of the industry in which they operate in. 

This tends to lead us to certain sectors: consumer services, consumer goods, light industrials, specialist financials, technology and healthcare. However, there are still risks to picking small-cap stocks as smaller company investments are often associated with greater investment risk than those of larger company shares.

How optimistic are you feeling today?

There are so many secular growth trends, many of them accelerated by Covid. We are only in the foothills of areas such as digital payments, software-as-a-service, online learning, and cloud enabled audio and visual communications. These are such powerful trends, and we believe can generate significant returns for companies in those areas. It is an exciting time. For it’s not about monetary policy factors, not about the exchange rate, not about the yield curve, it’s about multiple battles being fought at the micro level for market share or significant secular trends.

1Source: November 2021