The ability of UK small-cap investors to focus their returns on the performance of overseas markets looks increasingly important, writes Paul Jourdan of Amati Global Investors
Conventional wisdom has it that UK small-cap funds are focused on the domestic UK economy, in comparison to large-cap funds which have inherently more international exposure. With the non-UK earnings streams of the FTSE 100 Index stocks currently running at around 80% this has rarely looked more true. Some small-cap sectors, such as engineering, have always had a large global component.
However, following the last recession in 2003 the UK small-cap market has been through a period of rapid internationalisation in terms of the underlying companies themselves. This was partly due to the expansion of the natural resources sector, but also to the rising cost of listing in the US following the Sarbannes-Oxley reforms. For a few years companies from the Far East in particular worth less than $1bn came to see London as the listing destination of choice. A large proportion of the massive expansion of AIM during 2004-2007 was due to this phenomenon.
Opportunity
While some UK small-cap investors are wary of non-UK companies, I have always seen this dimension of the market as an opportunity. Over the next few years I believe it will be more important than ever. With the outlook for UK GDP growth looking curtailed for the medium term the ability of UK small-cap investors to focus their returns on the performance of overseas markets looks increasingly important.
China
In 2007, with over 50 Chinese companies listing on AIM I decided to join a research trip following the East coast of China up from Hong Kong to Beijing, visiting many companies and institutions such as the Shanghai Stock Exchange along the way. The trip made a huge impact on me, bringing home the extraordinary pace of industrial development in China, and the sheer effort and hard work going on to produce this. We have all been beneficiaries of this for a prolonged period. For example, the clothes we buy today in many cases cost less than they did 20 years ago. This applies to most other mass-produced items.
As we travelled North of Hong Kong into China, one of our party, who had served as British Ambassador to China many years previously, explained to me how nearby there was a single factory that produced 25% of the world’s kitchen microwaves. He told me, as we arrived in the bewildering chaotic metropolis of Shenzhen, home to around 18 million people, how this had been just a fishing village 25 years ago. We arrived in Shanghai at night and I was staying on the 54th storey of a hotel. As I looked out over the dense construction of high-rise blocks as far as the eye can see in every direction I was dumbfounded. Because tourism to China from Europe is still in its early stages there is a strong tendency in the West to underestimate the significance of what is happening there, a tendency only partially redressed by the 2008 Olympics.
Investing in China is not easy, however. The natural resources sector has for several years been an effective way of investing in Chinese growth indirectly, and one which we have used extensively. But does the London small cap market provide a worthwhile means of making direct investments?
AIM since 2007
Shortly after my visit to China the flow of Chinese companies listing on AIM halted as the Chinese authorities changed policy in favour of local listings. What has happened since then provides a good case study for the wider market of international listings on AIM.
As investors sold out of smaller companies through the credit crunch, international and secondary listings fared particularly badly. As a group, the 50 odd Chinese listings contained only a few companies of proper scale, and among those only a handful would have an acceptable level of transparency in corporate governance. Few London-based investors would be eager to do the required work to sift these out. As a result this basket of companies de-rated heavily, selling down to absurdly low levels. The whole group has bounced, and the best have returned to previous highs or made new highs now. Strikingly, however, even after strong rallies these companies trade at a significant discount to Chinese or Hong Kong listed equivalent companies. Thus an arbitrage has begun where companies listed on AIM seek a second listing in Hong Kong, and typically achieve a substantial re-rating.
Significant discounts
In short, globally minded small-cap investors can find significant discounts present among international companies listed on AIM, and this provides a compelling way to build up an exposure to high growth companies in the Far East or other developing markets. Examples from our portfolios where we still see pricing anomalies include: Asian Citrus, China’s largest independent orange grower, and my favourite Chinese company listed in the UK (although now dual listed in Hong Kong); and China Shoto, manufacturer of back-up batteries for telecoms equipment. Similar situations exist in other markets too, for example, Skywest (now dual listed in Australia), which operates flights on monopoly routes in Western Australia, and on charter routes for mining companies.
So what are the pitfalls? The first and foremost is the danger you may be backing management exiles. By this I mean managers who have exasperated local investors who go to an overseas market where nobody knows their reputation, and raise money with highly promotional stories and little chance of success. The second, related pitfall, is the difficulty of obtaining adequate due diligence and timely news on small companies operating a long way away, under different legal and market practice frameworks, and the potential for these to change without notice. The third, often overlooked point, is the absence of protection under the Takeover Code for companies not incorporated in the UK.
The test of time
The best test for each of these is time. We look for companies which have a track record of looking after shareholder interests, and where companies have been around for long enough for poor management to be revealed. Over the next two - three years I expect the rewards from the best of these companies to be well worth the additional risks and extra research effort. The presence of such holdings in the CF Noble UK Smaller Companies fund and Noble AIM VCT, which we manage, has allowed us to diversify away from the domestic UK economy to a surprising degree.
Paul Jourdan is CEO of Amati Global Investors
