Managers of the Franklin UK Smaller Companies fund reveal their stock picks of choice and discuss the advantages of investing in the sector as small caps rebound from the economic crisis.
Smaller companies are having something of a renaissance. Appearing more and more on wealth managers’ favourite fund lists, the sector has rebounded sharply from the lows seen after the credit crisis.
The UK has led this small-cap recovery with the IMA UK Smaller Companies sector edging out small-cap funds investing in North America, Europe and Japan, although returns overseas have also been impressive.
Making a name for itself in the last year in the highly competitive UK arena, the Franklin UK Smaller Companies fund has rocketed into the upper echelons of the sector following the introduction of managers Richard Bullas and Paul Spencer.
Bullas and Spencer joined Franklin Templeton in 2010 following its takeover of Rensburg Fund Management. The group handed the portfolio over to the duo last summer, and it has been rewarded immediately.
The fund has returned 44.3% in the last 12 months to 25 October, according to Morningstar, versus a sector average of 34.5%, placing the fund in the top decile.
The key to the transformation in performance has been the adoption of the investment process utilised by the Franklin UK Mid Cap fund to great effect since 2006.
Together, Spencer and Bullas have created a concentrated portfolio of high-quality UK small-caps stocks, backing their ideas with conviction, and without reference to a benchmark index.
With the first year’s performance already attracting attention, and helping to boost inflows, the team is using incoming investment to pick up further attractive opportunities in the small-cap space. Here, they reveal some of the key stocks they have been buying, and why the wide range of companies available in the market means there is no shortage of long-term investment opportunities.
The past six months have seen an uptick in inflows for the fund following the turnaround in performance. Where have you been investing the proceeds?
We have been buying two-to-three new stocks for the fund. These are Sportech, a gaming stock which has a new management team, as well as WYG, and SuperGroup.
Sportech, which operates the Littlewoods Pools business in the UK, has a very exciting US business where we really see potential. It runs 50% of the horse-racing gambling services in the US, operating across 26 states, so is one of the main players there.
It also runs gaming venues, such as sports bars, so we like the growth prospects for the business, and we think the market has underestimated its growth potential. The stock could also see a potential windfall from an on-going court battle with HMRC which could deliver something of a lift.
The case revolves around its ‘spot the ball’ competition, which the revenue has deemed a game of skill for tax purposes and which has therefore taxed the company on.
The case is on-going, with a decision pushed back until next April, but with the case now at the final stage – having gone to the Court of Appeal – it could provide the business with an extra £90m in the form of a rebate if it wins. Such a win would allow it to wipe out its debts and expand even faster next year.
What is the opportunity in engineering consultant WYG which the market has not recognised?
A new management team came in a few years ago, and the stock subsequently carried out a rescue fund-raising.
We bought it this September, as there is now a clear turnaround plan in place. The business is moving back into growth mode now having raised cash previously, and this should start to feed through into margins soon.
Margins are currently only 1%-2%, and it is still attractive in share price terms at that level. But we can see the margin rising to between 7% and 9% on a three- to five-year view, which has not been factored into our valuations but which would be very attractive.
Our other new investment – clothing retailer SuperGroup – is a company which has been beset by problems, including a poorly-handled warehouse move, which saw its value drop by 40% last year.
However, now it has appointed more than a dozen senior directors across the whole business – a major change for SuperGroup, making it much more of a professional organisation. We established a new position last month.
Regardless of its previous problems, it has strong brand awareness, and it has the potential to become a very significant brand globally.
We think it can become the next Ted Baker in terms of its success.
Having been too entrepreneurial in how it was run previously, it is now a much better organised business. If it can deliver on its expansion programme from here, it could become a very attractive company, as there is considerable scope for market share gains.
Some investors may question the idea of investing in smaller companies at this stage after recent returns. After all, your fund has delivered nearly 50% gains for investors in the past 12 months. What can keep driving performance higher from here?
The market has re-rated, but essentially it has been playing catch-up, because small caps were heavily oversold in 2010.
Now it is fair to say it is line with other markets, so the obvious bargains are not there.
But given UK small caps have a huge domestic bias, and the UK economy is one of the few bright spots globally in terms of its recent recovery, there are lots of opportunities.
Earnings growth, for example, has not come through yet, and we think it will in 2014. We are playing that via our recovery stocks – worth 40% of the fund.
What kind of advantages do small-cap stocks have over large caps when it comes to finding opportunities? Is there much more scope to make a real difference via stock selection because of the breadth of opportunities?
Today, there is an average of 30 analysts looking at every mega-cap stock. If you move down the market capitalisation scale, you might get one or two analysts covering companies with a market cap of £200m.
The market in small caps is as under-brokered as it has been for a number of years. This is because over the past decade, the amount of analysts covering the sector has been decimated.
Companies which now have one-to-two analysts covering them used to have 10-to-12, these research teams have been wound down, as small caps have been out of favour.
That process has left us with a huge window to outperform compared to funds investing in mega caps. So little research is done by analysts that opportunities are everywhere for a team which has the research capability we do.
How keen are investors on small caps now? Is appetite returning following the jump in performance across the sector as a whole?
For us, following the restructuring last year, and the numbers we have produced, we are seeing our own flows pick up substantially, but there is also a general shift in attitude now when it comes to small caps.
Having seen the returns being made, investors are now becoming a bit more confident about the attractions of the small-cap space. Coupled with the confidence over the UK’s economic revival – where 60% of all earnings from small caps come from – it all makes for an attractive outlook for the sector.
The small-cap space is populated with some very good managers, so how does your fund differentiate itself from competitors?
For a start, we run a concentrated portfolio of typically 45-to-55 stocks, structured without reference to a benchmark index, whereas a lot of our peers will run between 70 and 90, or even more than 100 positions.
This is a best ideas fund, which means every stock has to play its part, and our minimum weighting in a company is about 1.5%. When we took over the fund, it had a large proportion in AIM listed stocks – and in particular resource stocks such as gold miners. But we sold about 50% of the fund, including the resources holdings.
We repositioned the fund in companies with a market cap of between £100m and £1bn, with 80% of the fund there now. So, it is a combination of having a best ideas approach, and our focus on a core area of the small-cap market which places us apart from competitors.
What areas of the market still look attractive to you?
While we assess different stocks constantly, at the moment we still think the market is under-appreciating areas such as house builders. It has not realised what benefit the house builders and related services can get from higher transaction levels in the coming year.
We have positions in stocks including Topps Tiles and estate agents LSL in our top ten holdings. Although they have already made an excellent contribution to the portfolio (since December last year both Topps and LSL have doubled in value), we think there is more to come.
So we are happy to play the housing recovery into 2014, because we think there is more earnings growth to come through here, and we have 10% of the portfolio in real estate.
Franklin UK Smaller Companies fund vs sector average
