Look beyond the recovery trade to find tomorrow’s large caps today

UK smaller companies have been very much in favour over the last few months. Their domestic exposure, coupled with the UK’s strong post-lockdown domestic recovery, have caused prices in the sector to surge.

Both open- and closed-ended UK smaller companies funds have outperformed the FTSE 100 and FTSE 250 over the year so far.

Yet, there is more to UK smaller companies than the COVID-19 recovery story. One of the strongest performing trusts in the sector, JPMorgan UK Smaller Companies (JMI), has seen some of its highest returns this year come from stocks it held before the pandemic – and for which its managers, Georgina Brittain and Katen Patel, say the investment case remains strong even as the pandemic recovery passes its peak. The features that unite these companies include their strong competitive advantages, often operating in distinct niches, with clear opportunities to expand.

Here, we discuss three such companies in depth, which have each seen their share prices more than triple since the team at JMI bought them.

A snapshot of the future

The first is SDI Group (Scientific Digital Imaging plc), a manufacturer of scientific products for use in life sciences, healthcare and astronomy applications. The JPM team first identified the company when it was a small, £50m business and eventually bought shares in the AIM-listed firm in August 2019, after the company had grown and liquidity had improved.

SDI’s slightly generic name belies a nimble management strategy that has enabled it to grow at pace. The company has expanded through the acquisition of other small, niche operators which are strategically complementary to SDI, often holding a dominant position in their fields within the larger imaging and sensor sectors.

These operators include a company supplying infrared cameras for art restoration, another whose imaging helps identify leftover proteins on surgical equipment and a third that creates electrochemical sensors for food testing. The diversity of fields in which its sub-companies operate has proved useful for SDI, meaning that it has been more resilient to market shocks – a global pandemic being an obvious example.

Meanwhile, its pipeline of potential acquisitions remains strong. The companies they acquire are too small to be targets for private equity. SDI takes a ‘hands off’ approach to these companies post-acquisition, with their management teams often remaining in place and SDI providing support to help them grow. This makes it an attractive buyer for potential sellers.

Since the JMI team bought it in August 2019, SDI’s share price has risen from 50p to 200p.

Keeping global trade going

An ever more globalised marketplace means that the need for foreign exchange (FX) support among businesses continues to grow. Yet, the historic providers of such services, namely large banks, typically have outdated infrastructure that can add significant delays to international transactions.

Enter Alpha FX, which provides FX services to a broad range of businesses. The £900m AIM-listed company has invested heavily in its systems and technology, which means it is able to offer foreign exchange transactions more efficiently and at a lower price. As a result, it has been gradually taking market share from incumbent players for several years.

Several factors have contributed to this success. One that JMI’s managers point to is Alpha FX’s approach to hiring, which is data-led and one that they have invested heavily in. This means it has had lower turnover among its personnel which has resulted in strong customer retention due, in part, to consistency in its client servicing. This has been demonstrated in the extreme by its global expansion strategy, which has seen it be the first to open in new markets where their clients have shown demand, such as North America.

Alpha FX operates on the back of a modular, cloud-based system, which means it can upgrade and add new services quickly. One such new service is its app-based solution, Alpha Payment Solutions, which allows for instant transaction settlement. This should provide a strong platform for future growth.

Since the JMI team first bought into the company in October 2018, its share price has risen from 600p to 2200p.

Platforming pharmaceutical development

A third hidden gem of the smaller companies sector is Ergomed, which is benefitting from a trend few consumers are aware of, but that is transforming an entire industry. Increasingly, pharmaceutical companies are opting to outsource aspects of the research process that can be done more effectively by third-party players. This is resulting in reduced research costs, which is driving drug development volumes, forming a virtuous circle for these third parties.

Ergomed is one such outsourcing supplier. Its two key areas of operation are in the ongoing compliance and drug safety monitoring for already approved drugs, and in clinical research monitoring, which essentially involves setting up and collating data from drugs trials.

The compliance and regulatory burden is only growing in the pharmaceutical market and Ergomed, operating globally, is benefitting from the growth of this sector in both the EU and US. Overall, the market is currently growing at around 10% per annum.

Crucially, it is very well managed, with its founder still owning 20% of shares, the company’s interests are firmly aligned with shareholders’, and it has high revenue visibility due to the strong order backlog. Since the JMI team bought shares in February 2020, their price has risen from £4 to c. £14.

Finding the future

All three of these companies, operating in very different and distinct niche markets, demonstrate the rich pickings available for UK smaller company investors. They are each covered by a maximum of only two brokers, demonstrating why skilful stock pickers and internal research capabilities can be crucial to success in this market. According to JMI manager Katen Patel, all three companies continue to under-promise and over-deliver and recent and long-term performance suggests that both attributes have been beneficial for investors in JPMorgan UK Smaller Companies Investment Trust.

Login to read the full article...