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Consistency and high returns from long term investing in smaller companies

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28 October 2015

Harry Nimmo discusses his investment process for UK Smaller Companies.

Harry Nimmo, Fund Manager, Standard Life UK Smaller Companies.

View the Standard Life UK Smaller Companies profile page

Our smaller companies investment process has been in place for more than eighteen years now. At least four economic cycles have passed since then and we have made a virtue of remaining consistent throughout that time. 

The process is stock selection orientated with no “top down” overlay. Our view is the way to make money in smaller companies is to hold great businesses for multiyear periods, sometimes in excess of ten years. For example Ted Baker, the branded clothing retailer has been in our smaller companies funds from listing in 1997 at £1.50 to the present day. The current share price is around £30. It is also our experience that, in smaller companies, “lower risk” equals “higher returns”. As such, our process tends to behave in a predictable way at different stages in the economic cycle, and in particular it provides a modicum of resilience in more difficult market conditions. A lower risk way of investing in what is sometimes seen as a higher risk asset class makes a lot of sense to us.

In essence we invest in high quality, growing companies with a high degree of predictability in terms of their future revenue streams and profitability. Our process also emphasises earnings and price momentum. We find that, with high quality companies, quite often the business momentum persists in the medium to long term.

Central to our approach is our screening process which we call “The Matrix”. A dozen or so factors are tracked that our quants analysts have found to be predictive in the back-testing exercises. The factors reflect quality, growth and momentum with a couple of secondary valuation factors. Each factor is weighted according to its predictive powers and it is used as a starting point for both buying and selling.

A shortlist is thus derived. The next stage is actually meeting with the senior management of the companies in question to test the resilience of the business model, the predictability and visibility of the growth. A by-product of our process is that, although the trust is mainly about capital growth, dividend growth is very solid and resilient even in economic downturns. In the last five years the dividend has grown at an annualised rate of 18.3%

Our largest holding remains Ted Baker plc. Even though this share has made many hundreds of percent of returns for the trust, the matrix score is still high. Ted Baker has harnessed the internet to project its brand internationally to the mass affluent population around the world, who are increasingly aspiring to similar fashion trends. As such Ted Baker has begun to internationalise their business with distribution via their own stores and department outlets in Europe and the USA.

Another longstanding holding is Paddy Power. This stock was first purchased in December 2004 and our returns since then have been more than tenfold. The most recent results showed that the business is still powering ahead with earnings per share up 31%. Furthermore, their proposed merger with Betfair was taken well by the market. This will make the combined entity a FTSE company and thus far too big for our trust. However it will bring to an end a highly lucrative investment for our Smaller Companies Trust. Their ability to make a success of the introduction of online methodologies was the game changer in relation to the traditional players in that industry.

At Standard Life Investments we have further introduced smaller companies funds exposed to different geographies, that of Europe and indeed more recently a global smaller companies fund. The process is the same as that of the UK Trust. The process works well around the world.