Neil Hermon, manager of Henderson Smaller Companies trust, on the four considerations that shape his portfolio choices
The first ‘M’ in the checklist that Neil Hermon, manager of Henderson Smaller Companies trust (HSC), uses to select shares refers to a company’s business model, which encapsulates its pricing power and competitive advantage. The second ‘M’ relates to its management. ‘This is very important for small companies,’ says Hermon, ‘as they’re often led by a couple of key individuals.’ He sees the companies he invests in at least twice a year to assess their strategy, motivation, vision and corporate governance, and whether they are aligned with the interests of their shareholders.
To determine whether the interests of the executive managers are aligned with those of shareholders, Hermon asks them key questions. Do they own equity in the firm? Are they incentivised correctly? He also looks at the managers’ track record and asks whether they have shown their ability to deliver on their promises. More specifically, do they have ‘the ability to under-promise and over-deliver’?
The third ‘M’ refers to money. Hermon says: ‘There are three of us in the team, and we’re all accountants by training. Hopefully, we have the skills to analyse balance sheets, so we look for strong cash flows.’ The final ‘M’ refers to earnings momentum. ‘We look for companies that will over-deliver against market expectations.’
The Henderson team’s approach has rewarded investors handsomely over the long term. Between 2002 and the end of May 2018, HSC returned 1,213 per cent – an annualised return of 18 per cent a year – well ahead of its benchmark, the Numis Smaller Companies index, which returned 13.7 per cent a year over the same period.
Hermon says he is a growth investor, buying companies to hold for an average of four to five years. He has held some for more than a decade. One such holding is Victrex, a supplier of polymers such as PEEK (polyetherketone), a plastic used to replace metal and less durable plastics where lightness and strength are key . Another holding he has retained for a long time is engineering firm Renishaw. With 110 holdings in its portfolio, the Henderson trust is ‘reasonably diverse’, says Hermon. ‘The macro level is important, but the micro is more important,’ he adds. He is looking for ‘quality companies’ .
The trust currently has 35 per cent of its holdings in industrials and 22 per cent in financials. Hermon says: ‘It’s a broad fund and the sector distribution comes out of our stock selection. Ultimately, it’s the stocks that count.’ As a growth investor he is more likely to gravitate naturally towards growth sectors such as software, electronics and healthcare. The trust is likely to be underweight in sectors such as real estate, food production, retailing and mining, more value-biased areas.
Hermon says: ‘We like companies that have grown or will grow beyond the UK. Half the earnings of the companies I own come from international markets away from the UK, spread between North America, Europe and Asia.’
More than 70 per cent of FTSE 100 earnings come from overseas, but further down the market-cap scale there is a greater domestic focus. However, Hermon says: ‘Even the small-cap portfolio I have has a very international weighting to it.’ He adds that in the context of the macro outlook today, with the UK economy growing at the slowest rate of all the G7 economies (the fairly weak currency and Brexit being the elephants in the room), ‘it’s not a bad idea having a strong international outlook in the portfolio’. But he is quick to add: ‘This doesn’t mean we’re ignoring the UK; we still find great UK-focused businesses.’
Hermon says his trust gravitates towards larger small-cap and mid-cap businesses, and that up to 500 investments are liquid enough for a substantial trust such as Henderson.
Another interesting source of new investments is the initial public offering (IPO) market. Hermon says: ‘We see firms before they get to the market, and we get to know them pretty well.’ Earlier this year, he bought IntegraFin when it came to market. The company is a business-to-business platform for financial advisers, ‘a little bit of a competitor to Hargreaves Lansdown, but B2B’. He says it has ‘a very good management team and is highly cash-generative, it has strong balance sheets and a strong business model, and it has returned more than 70 per cent since floating this year’.
Another example of a company he bought at IPO is Team 17, a games software developer. Hermon says: ‘This space is growing rapidly, and the UK has a strong industry. Team 17 is also growing fast and the management team has a substantial stake in the firm. We hope it will over-deliver. It’s up by more than 30 per cent since IPO.’
Hermon studiously avoids certain sectors. He says: ‘We don’t like blue-sky biotech start-ups. We like firms to be profitable, cash-generating and dividend-paying. We don’t do early stage firms. We don’t go for biotech, as we don’t have a doctor on the team. We don’t do mining – as Mark Twain said, “the definition of a mining company is a hole in the ground with a liar at the top of it”. The commodity space is a bit jam tomorrow; we generally avoid it.’
Hermon has seen a lot of mergers and acquisitions activity recently. ‘Foreign firms are buying UK companies. A couple of our portfolio companies have been acquired: Fenner was acquired by Michelin and, more recently, ZPG was acquired by US private equity company Silver Lake. That drives turnover in the portfolio, and we think that theme will continue as foreign corporates take advantage of weak sterling and a feeble UK stock market.’
Reflecting on the risks ahead, Hermon says: ‘Brexit is months away, and we still haven’t got a deal and negotiations are stuttering. That is hitting consumer confidence in the UK. The UK equity market is unloved by both domestic and international investors.’
He mentions the old adage that stock markets hate uncertainty and adds: ‘We are now at peak uncertainty. We would love to have clarity. There is a range of scenarios as to how this pans out, from the simply disastrous to not bad.’
Ultimately, though, Hermon believes the UK market could do well once the outcome is clearer. ‘You can’t argue that Brexit is not having an impact. But our job is to look through it and identify who’s going to come out of it stronger. Don’t ignore the opportunity. At some point, when there is clarity, some of these stocks will look pretty cheap.’ Trade wars and interest rates are other concerns. ‘We’re moving from a low-inflation, low-interest rate, low-growth environment to a much more dynamic one.’ However, he adds: ‘ Our job is to find companies that can navigate through those risks and deliver good returns. As an equity investor, when there are no risks, then you should worry.’
Hermon in six
1 My best investment was… NMC Health, a healthcare business. We bought it in 2012 at £1.90 a share and it’s now worth about £35. It fitted our ‘four Ms’ perfectly, and it had a combination of fast organic growth and diversification. But it got too big for us. It reached the FTSE 100 in September 2017, so we exited the position.
2 My worst investment and lesson learnt is… I never had a firm go bust. But I have had things go wrong. Conviviality, a convenience store business we invested in, did well initially but then issued a shocking profit warning this year. The share price fell by 60 per cent in one day. We sold out immediately. It was painful and we lost money, but a few weeks later, it turned out that the firm had huge unpaid VAT bills and it went bust, so at least we sold out immediately. The lesson: it’s impossible not to get things wrong, but when things do go awry, reappraise your investment and take action if required.
3 My alternative career would have been… professional footballer, or cricketer, but I wasn’t good enough. I’ve been in my current career for more than 25 years. Training as an accountant was only a way to get into this job. I always loved stock market investing, so I never wanted an alternative career.
4 In my spare time I like to… play cricket. I have four boys, so I end up taxiing them around and watch them play football. I enjoy family life.