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The outlook for the UK Growth sector

11 June 2013

Opportunities for growth investors in UK small and mid-cap stocks.

Martin Hudson and Guy Anderson, managers of The Mercantile Investment Trust

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The political imperative around the world is for growth, and the small and mid-cap sector is where jobs are created. Over the long term, this means the small and mid-cap sector is where the real capital growth is. It is a more volatile area, which is why you need a longer-term approach, but with correlations between stocks coming down, there are real opportunities for stockpickers to add value.

Our investment process is built on three tenets. We look for fundamentally strong companies with attractive end markets and sustainable competitive advantage; positive change – cyclical turns, restructuring plays or companies with operating momentum; and good value assets that are attractively priced, often driven by being misunderstood or overlooked by the market.

What is common across all three themes is that businesses must be adequately funded, with an appropriate capital structure or a clear plan to achieve one, and strong management who are focused on shareholder value. We meet over 300 company management teams a year, across a very broad spectrum, and while it is true to say the overall quality is better than it was 20 years ago, we still need to judge if they are the right people with the right incentives and a focus on shareholder value.

Our overarching theme is the balance between expectations and outcome. Current market prices are based on the former, with future prices based on the latter: it is this disconnect that we seek in our investments. It is not sufficient just knowing what everyone else knows; you need a differentiated view.

At a sector level, housebuilders have been our biggest theme for some time. Macro conditions have been poor – the downturn led to a collapse in confidence, as well as a lack of financing for builders and buyers alike. The listed housebuilding sector cut costs dramatically, reinvested in cheaper land and grew market share. The sector has consistently beaten expectations. At the moment, there is a lot of government stimulus, as there is a clear economic need to build more houses, as well as a clear lack of new homes in relation to the rate of new household formation. Each new house built creates 4.5 new jobs, so by stimulating the building sector, the government can drive GDP growth. The housebuilding sector covers all the three tenets of our investment process.

In terms of geographical exposure, one might think that small and mid-cap equals domestic, but only half of sales in our universe originate from the UK. The small and mid-cap arena contains a whole range of market leaders around the world, and, while there is more UK exposure than in the FTSE 100, there is arguably a better balance overall.

Our focus is on capital growth but the small and mid-cap universe does offer a good level of dividend yield and greater diversity of income, without the concentration issues you find in the main FTSE 100 index.

The closed-end investment trust structure works really well in the small and mid-cap sector. We are never forced to sell out at the worst time, and we can use gearing, which has added value in each of the past five years. For instance, at the beginning of 2009, we moved gearing towards the top of our 90-120% range. In 2011, at the height of the Eurozone crisis, we reduced gearing in advance of the summer sell-off, and increased it towards the end of the year in advance of the pick-up.

In summary, governments are doing all they can to promote growth. That does not mean there will automatically be growth – there will be hiccups, and nothing happens in a straight line, but overall we believe the growth opportunities in small and mid-caps to be compelling for the long term investor.

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