Finding growth in smaller companies

Every investor knows they should be doing it: investing in small- and medium-sized enterprises (SMEs). Over the past 50 years SME indices have outperformed those of the larger companies by at least 3%.

Small companies can grow faster than their bigger counterparts and when they grow, it can be in multiples of the original, not in paltry fractions. The rationale is well known and accepted

Yet investor caution is entirely justified. Rising interest rates exercise a tightening squeeze on sometimes inexperienced managements battling fiercely competitive markets, IT challenges and regulatory and shareholder demands. Small firms go bust more often and more quickly than large companies.

How do you secure the advantages of investing in SMEs while avoiding the hazards? Finding an experienced venture capitalist who is also an accountant and now backed by a bulge-bracket investment bank, is an attractive idea.

Richard Plackett has run the Merrill Lynch UK Smaller Companies unit trust for the past two years and at the end of May took over the responsibility for the recently revamped Merrill Lynch UK Special Situations fund (formerly the UK Value fund).

Plackett and his team cover a universe of about 1,000 companies in the FTSE 100, the Mid 250, Small Caps and the Alternative Investment Market (Aim). Why the FTSE 100? The UK Special Situations fund can invest in FTSE 100 stocks, but Plackett only buys them when they meet his stringent set of criteria, and when there are no SME equivalents.

Aim, he says, has greatly improved in recent years: "It would be wrong to exclude companies now because they are on Aim, as there are some quality names there. It is the overall quality and growth prospects of the company, irrespective of which market it is on, that are important."

The team meet at least 500 companies a year, the bedrock of a resolutely bottom-up investment process. "It is a big workload, but by far the best use of our time because these companies are changing quickly and it is difficult to assess them off sector trends," Plackett says. "You will find one IT stock will double, another will halve. So forming a view of IT companies as a whole is not very relevant."

Plackett's own extensive experience means he is already familiar with most of the companies he is likely to want to target. But, he says, there are always some that pop up through, perhaps, unusually good results. He adds: "We immediately want to meet them and get to know them.

"You can spot companies sometimes by just walking around - these companies are on the high street, in all walks of life. We also have good links with the broker community, and sometimes a broker you trust will suggest you meet a company, and that can be a flag."

However, Plackett never buys a company where he has not met the management. "The fundamental basis of our investment process is that we meet the company and try and understand it before we decide whether to invest in it or not," he says.

Each investment has to satisfy five criteria and because of the large pool of target companies, he feels no compulsion to hold or buy anything that does not match up. The Merrill Lynch UK Special Situations fund holds about 40 or 50 stocks, all at around the same weighting. The UK Smaller Companies fund is slightly more diverse, holding usually around 100 stocks, with generally no one stock accounting for more than 2% of the fund.

His most important yardstick is confidence in the people managing the business. "The smaller a business is, the more important the people are," he notes. "If a business is very large, even if the people running it are very good, they can only change it relatively slowly. The attitude, enthusiasm and the dynamism of the management of small companies is really important. That is why we will never ever buy a company unless we have met the management.

Where he can, he meets people throughout the business, citing companies such as Bloomsbury Publishing, Cafe Nero, and the manufacturing firm Videx as those with "a very positive culture". Giving management a stake in the business is a good way to promote good corporate governance, he adds. "We avoid lifestyle companies, where the entrepreneurs are paying themselves a lot but do not own any shares."

So what does quality management look like? For Plackett, it is a combination of salesmanship, control and strategic clarity. "They obviously have to be able to sell their products, otherwise they can not grow. Control is all about managing a business that may double its staff in a year. It may be opening new offices or installing IT systems. Management needs to be able to control what is happening, and take on a professional layer between the entrepreneur and the coal face when it needs to."

Strategic clarity means that companies stick to what they are good at. Plackett cites the example of Capital Radio, which six years ago thought it might diversify into a pizza restaurant chain. "It was a very disappointing acquisition because it soon became clear that running a pizza restaurant is different from running a radio station. However, it is now in talks with another radio station, GWR, and that is something I can be a lot more positive about."

Geographical diversification, he adds, can be as damaging as business diversification.

Plackett's second key criterion for buying is a company's market position. "Generally, if small companies compete head on with larger ones they will fail, eventually. They need to find a niche and then grow by maximising the potential of that niche," he says.

A favourite stock in this respect has been Detica, a company in the technology sector that supplies IT services to the intelligence services.

"It takes up to 18 months to clear Detica staff working with the intelligence services, so they are not displaced easily. It is a high barrier to entry for competitors. Another niche holder is Bloomsbury Publishing, with its Harry Potter brand. "There is only one Harry Potter author and they also have a fantastic business culture there."

In the industrial sector, Xaar makes printheads for commercial printing on retail packaging. It is specialised work and Xaar is the technological leader in its field, which means Chinese manufacturers, in particular, have to buy it rather than copy it. Plackett bought Xaar in June, since when it has delivered earnings upgrades of about 54%, largely on the back of Chinese demand.

The UK Special Situations fund can own large companies too and currently some 30% of the fund is invested in this sector. Plackett holds Tesco, whose massive buying power allows it to price competitively in the retail market, but the fund will not own large stocks just because they are large. "To make sure we only own companies if we believe in them, we are benchmarked to the 250 index not the FTSE 100," he adds.

Cash generation is the third demand, because if a company is trying to grow without generating cash, then it has to issue equity. "We want companies that are generating all their earnings in cash," explains Plackett. "They should have a 100% conversion of profit into cashflow and free cashflow yields should equal or be more than gilts. That is a good basis for the absolute appreciation of all the shares you own."

With the number of changes in accounting requirements in the UK recently - affecting accounting for options and pension provision and goodwill, cash is transparent and reassuring. "You can change the accounts and the profit figures can be the work of a clever accountant, but you can not hide the cash," Plackett notes.

He is content to wait to pay the right price as well. Twelve to 14 times earnings is his limit. "If there is a company that is at 25 times, which everyone loves, we will wait until it is back at 14 times. If it never gets there, we will never buy it. We can afford to miss a few." And he avoids "blue sky" companies that may have good ideas but no profits. "It is the share price we want to see growing, as well as the businesses," he says.

In Plackett's view: "If SMEs are on a growth curve they can sustain that for a long time, and if they are on a downward curve they sustain that for a long time too. So we stick with companies that are already displaying signs of good trading. We will never buy a company on the hope that things will get better."

The Special Situations fund will invest in recovery stocks when there is an identifiable catalyst for change in the business. Plackett bought Mothercare, a strong UK brand with poor management, after a change of the top team.

"It is important to differentiate between growth stocks, which you can hold for years, and recovery stocks, where you probably hold them until the early stages of the recovery - however long that takes. In the case of Mothercare, we bought at about £1, and held them until the share price was factoring in management expectations of an eventual recovery, at about £3.50."

Finally, a strong balance sheet gives any company protection, but even more so in the case of SMEs.

"We do not expect problems as they are all trading well, but things can change. With a strong balance sheet, management may have time to put problems right, but with a weak one they are immediately talking to the banks and things go from bad to worse."

Plackett likes to see 10%-20% of a company's net market capitalisation held in cash. He adds: "If they then want to make an acquisition they can do it without issuing shares, and you can get the next leg of the share performance as a result."

Is he expecting a lot of merger and acquisition activity ahead? Being a stockpicker, he is focused on individual companies rather than macroeconomic trends. But any company feels the wind from the wider universe. He says: "Clearly, the global trends favour companies linked to business investment. The cycle bottomed in March 2003 and has been gradually recovering ever since. Conversely, consumer stocks are starting to struggle after a consumer boom in the US and UK. That cycle there is not anywhere near the bottom. There has been a lot of evidence of that in the past few weeks, with profit warnings from companies such as MFI, JJB, Countrywide Assured and Courts Furnishings."

Plackett feels macroeconomic trends are no excuse for active managers to underperform. He says: "The global economy is good enough for good quality firms to be prospering and there are many companies out there achieving significant earnings upgrades. But the global economy is not growing so quickly that it is bailing out of bad firms, so it is all about stock selection."

The Merrill Lynch UK Smaller Companies fund has grown by +25% over the past 12 months and 72.1% over five years (bid to bid price, net income reinvested to 30 September 2004), making it one of the top performers within the Standard & Poor's UK All Companies sector and the UK equity market as a whole. It is also ranked seventh out of 60 funds in its sector over one year by Standard & Poor's.

The Merrill Lynch UK Special Situations fund has got off to a flying start under Plackett's management, outperforming its peer group each month that he has run it. Over the quarter to 30 September it grew by 4.5%, ranking it fourth out of the 303 funds in the Standard & Poor's UK All Companies sector.