The impressive trajectory of the FTSE 100 index (UKX) has coincided with a rapid depreciation of sterling in the wake of the Brexit vote. Large-cap UK companies derive around three-quarters their revenue from abroad, so this has been positive for blue chips.
Smaller-cap indices, meanwhile, are typically linked more closely to the UK economy. However, firms on the FTSE 250 (MCX) still derive around half their revenue from overseas. As a result, many small company fund managers are rotating out of businesses with UK earnings and looking further afield.
Mike Prentis, manager of the BlackRock Smaller Companies trust (BRSC), says he's positive on the world economy, but cautious on the outlook for the post-Brexit UK economy. Neil Hermon of the Henderson Smaller Companies trust (HSL), a Money Observer Rated Fund, thinks similarly.
Both trusts are remarkably similar - the managers have had tenures of 15 years and were appointed to their respective mandates within two months of each other. Both are also serial outperformers, currently trading on a discount of around 15 per cent with gearing of 9 per cent.
Both managers like ‘quality’ companies that can deliver long-term growth with a focus on good valuations.
Keywords (KWS) provides services to big video gaming companies – think Microsoft, Sony, Electronic Arts. Its list of customers is many times larger than it was at IPO in July 2013 when it was heavily dependent on Microsoft.
A profits warning followed just two months after flotation, at 123p, after Microsoft postponed the launch of its Xbox One console in many regions. Shares, which closed at 164p the previous day, fell 35 per cent to a low of 106p in the following months.
After that, Keywords ‘went off everybody's radar for a long time and was very dull,’ says Prentis. ‘Then they started to get their act together and increased their customer base to become more global and started to acquire [similar] businesses.’
Keywords is the biggest provider of translation and localisation services to video games companies. Prentis says most of the big players in the industry are looking to outsource that work.
Having met management at IPO and decided not to invest, he started with a small holding of 25 basis points and at 30 June Keyword accounted for 0.9 per cent of the portfolio.
Broker Panmure Gordon says it has ‘long-term confidence’ in the business, but downgraded its rating from 'buy' to 'hold' on valuation grounds.
Tensions between the US and North Korea and worries over the latter's nuclear capabilities have worried investors in recent months and sparked a rush to safe haven assets.
There's scope for plenty of winners in these types of conflicts, though, defence companies being the obvious beneficiaries. Hermon has recent snapped up a stake in Ultra Electronics (ULE), a naval warfare, cyber security and aerospace specialist.
Defence spending has been under pressure for many, particularly in the US, where Ultra makes around two-third of its sales. After a strong run up to £19, shares have traded volatile sideways since late 2010.
Now, though, ‘we're seeing a sea-change in military budgets globally’, Hermon explains. President Trump is trying to raise US defence spending, which will clearly boost Ultra. Despite this, shares de-rated by 25 per cent between March's record high 2,245p and September's 12-month low 1,715p.
It now trades on 12 times estimates for next year's earnings, which ‘looks quite attractive’ to Hermon. 'We think Ultra's set for a period of reasonable growth after what's been a tricky period.'
Broker Investec agrees, noting that the valuation is towards the bottom of its historic range. ‘This is undeservedly low,’ according to analyst Rami Myerson. A target price of 2,300p implies potential upside of 26 per cent.
Other ‘international’ stocks Prentis likes include veterinary services providers Dechra Pharmaceuticals (DPH) and CVS Group (CVSG). When the former floated 10 years ago, it was ‘essentially a UK business’. Now, though, more than 70 per cent of its business is done in the US and Continental Europe.
CVS is more of a late bloomer in the overseas market, recently branching out into the Netherlands. It's growing like-for-like sales by about 6 per cent and has seen earnings growth of 30 per cent in its recent full year.
UK not written off entirely
While Prentis is sceptical on UK-focused retailers and leisure companies, both managers are finding investments that rely on parts of the UK economy. Prentis likes the pub companies, with holdings in Fuller Smith & Turner (FSTA) and Young & Co's Brewery (YNGA).
Both see the housebuilding sector as having tailwinds. Prentis has recently found opportunities in companies that build affordable social housing, ‘which is a priority for whichever party happens to be in power’. These include Morgan Sindall (MGNS) and MJ Gleeson (GLE).
Hermon reckons housebuilders are attractive valuation-wise, with high yields, low price/earnings multiples and good price/book ratios. ‘The housing market is still quite strong [and] is being helped by Help to Buy… and structurally we're undersupplied in the UK so we need to build more housing’.
Bellway (BWY) is currently Hermon's second biggest holding. ‘Bellway is a growth story, it's growing into a space that has been vacated by the bigger builders who've capped production.’
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