Smaller companies: finding the best

Roland Arnold, Portfolio Manager of the BlackRock Smaller Companies Trust plc, explains how he uncovers companies that could grow their earnings for the long term.

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.

In the short term, share prices for individual companies may be driven by a variety of unpredictable and erratic factors - from fear, or greed, to investor confidence or fund flows. However, in the longer term, share prices largely follow company earnings. If a company can grow its earnings sustainably over time, this will drive share price performance. Identifying such companies is the simple goal of our investment approach.

Over the very long term, since 1955, smaller companies have delivered around 4% better return than larger companies. Compounded over many years, this could make a significant difference to an investor’s returns, however, it is worth noting that this is an average. Active managers may deliver a higher return if they get their stock selection right, or a lower return if they don’t.

The case for smaller investing

With this in mind, we focus considerable resources on stock selection. Our bottom-up research process looks to find those companies that can grow their earnings over many years. These are companies that we can buy early in their development, with a goal to hold them through their growth into larger companies. However, please be aware that past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy.

Finding growing companies

The 100-120 companies that sit in our portfolio score well on the five key criteria at the heart of our investment process. The first is to assess the quality of the management team, whether they have a track record of delivering on their promises. We also look at the market position for each company - are these businesses capable of leading and shaping their markets long term?

We examine the balance sheets in-depth: this has been particularly relevant over the past year. Do they have the capital to survive through difficult and unusual market conditions? Cash flow is also important. A company needs to have the cash flow to support its organic growth, rather than being forced to keep coming back to shareholders for more capital.

We also look at the track record. History can be a guide to the future. Has a company consistently met or beaten expectations? If it has, it tells us something positive about the management team or the market position or the products.

What sectors do we find appealing?

Where we find these opportunities will change over time. However, our core holdings have remained relatively similar in recent years and through the pandemic. Management teams have rewarded our faith in them during this crisis, responding flexibly and skilfully to a changing world, reshaping their business or strategy where necessary.

The three largest sectors in the portfolio today are media, investment banking/brokerage and consumer services. The media sector suggests a conformity in exposure, however the stocks that sit in the portfolio have a variety of specific drivers, some are geared to reopening, others to structural market shifts. The ‘investment banking/brokerage’ sector is poorly named and doesn’t reflect our exposure, which is focused on asset managers. We believe the market has further to run as economic recovery builds and this sector is well-placed. This is particularly true for those with expertise in the sustainability sector.

On the consumer services side, there are many businesses in the retail sector that look interesting today. Many have fundamentally shifted their distribution mix during the pandemic, shifting to a multi-channel offering that will endure. Sadly, many retailers haven’t made it through Covid, so the ones that are left are in a much stronger position.

The broader outlook

We see three key themes emerging, which will help guide our stock selection from here. The growth in consumer spending as the economy reopens will be important. Labour shortages are leading to increased pay, whilst furlough and government support have allowed consumers to build considerable savings, which could be very beneficial in boosting the recovery.

The industrial cycle is another area of focus. We see the demand continuing to build with recoveries in manufacturing, automotive and, ultimately, aerospace. We also think companies are re-examining the ‘just-in-time’ model that is commonplace, but has been proved to be a very difficult way to manage supply chains in the last two years. Both the US/China trade war and the pandemic exposed the problems with companies not having the stock they need to maintain production. We believe two things are likely to happen: the first is a general industrial recovery, but the second is an inventory restock as companies rethink their supply chains. It will create a leveraged effect for certain industrial companies.

We’re also positive on the UK construction sector. This is seeing strong demand from both the private sector (such as housebuilders), and the public sector (from infrastructure development). This is a sector that has changed in the last few years, with a far better contract environment.

Equally, we are conscious of emerging risks. We continue to consider how inflation or labour shortages may affect our portfolio holdings. However, our focus is on market leading businesses, which have natural pricing power. This can help mitigate against inflationary and competitive forces.

We will keep looking, trying to find more companies that can deliver strong earnings growth in the years ahead. Ultimately, we want to find the strongest 100-120 companies in the UK market. Most of all, we are optimistic from here – we believe in the market recovery.