Fund Managers’ Favourites: Small-Cap Picks

Alanna Petroff: We're always hearing in the news about big market moving stocks on the FTSE 100, but that means that many quality smaller companies are not on the radar for many investors, but that's now going to change.

I'm joined now by Dave Taylor, he is from Chelverton Asset Management, and he runs the Chelverton UK Equity Income Fund. We're going to be talking about some quality, small-cap companies.

Dave, thank you for joining me.

David Taylor: My pleasure.

Petroff: So, let's go over your investment strategy.

Taylor: What we're trying to achieve is there's a whole host of lovely little UK companies out there that generate a lot of cash and pay a very good and growing dividend.

Petroff: Okay, so now you have about 70 stocks in your fund, right now.

Taylor: We do, yeah.

Petroff: But we're going to go through three of our top picks.

Taylor: Right. These three top picks at the moment all have a number of things in common. They're very well managed. For those of you interested in P/Es, which we're not really, they are all on single figure multiples. They're all on yields of at least 4%, and very, very importantly they all throw off absolutely tons of cash.

Petroff: That's always a nice thing. Okay, so let's go and review the very first company that you have that's Hilton Food Group (HFG).

Taylor: Hilton Food Group is a stock that we've owned since it floated, and what it does, it supplies processed meat to supermarkets. Now in the UK, it's one and only customer--because you really can only have one customer in any territory--is Tesco. So, what it does is it takes meat in from the abattoirs, it doesn't own any abattoirs, and it processes it. So, it turns it into mince, it will cut steaks, all higher value-added products that particularly in the barbeque season where you will get sort of meat products with sauces on and things like that. So, they also work with Tesco in Ireland, very importantly though they always operate in any territory they are with, with the number one food retailer in that territory. And they're in Holland with Albert Heijn. They are with the top food retailer in Sweden, and just recently they've moved into Denmark with Coop.

Petroff: So, since you invested when the company listed in 2007, the stock is up by 64%.

Taylor: We think it will continue to do very well. It's growing its earnings and its dividend 10% last year, 10% this year, and 10% next year.

Petroff: That's a nice thing to hear.

Taylor: Fantastic. Tuck it in the bottom drawer, and then just have a look in a few years, and you would have done very well.

Petroff: Okay, now let's talk about John Menzies (MNZS), that's your second pick.

Taylor: Yeah, John Menzies is a very interesting business, because it comprises essentially of two separate companies. The first company is a newspaper and magazine distribution business. Now that has been in decline for the last few years for obvious reasons, whilst it has been in decline in the industry, the number of players in the UK has moved from three down to two. So, they have been able to mitigate actually some of that downturn. However, it is fair to say that going forward that this isn't a growth story, what it is, it's about taking costs out.

The second part of the business there, is the more interesting bit, that is also very cash generative and that's the aviation services business. This is now more than 50% of the profits, and they have a ground handling business with lots of airlines and lots of airports around the world, including EasyJet, Cathay Pacific, British Airways. They are the second largest ground handling business in the world.

What's fantastic for us as investors in something like Menzies is the stock market for as long as I can remember has been very, very poor at valuing stocks it can't pigeonhole. How on earth can you pigeonhole a stock that has newspaper distribution here and an airline services business here?!

Petroff: It is a strange sounding company.

Taylor: Absolutely right. So we say don't even try. Just look at the cash flow.

Petroff: Okay, and VP (VP.) is your last choice.

Taylor: VP Group is an equipment hire business. Once again, very well managed, a very strong balance sheet, almost no debt, and that's actually very important. Now what we mean by – I'll come back to that in a bit -- but what we mean by equipment hire is they essentially have bits of kit for the construction industry. They provide testing equipment for oil rigs, so nearly 20% of their business is involved in oil and gas. That's diversification. They have specialist equipment for the rail industry, for example. So they have been ticking along in the last while, whilst the recession has been going along, and it's tough because they are in – nearly 40% of their business is in basic construction and housing, which is not really doing very well at the moment. But what they have done is they kept their equipment base up-to-date, they have kept investing in new equipment.

So what will happen is, we're expecting the construction market to start picking up probably at the back-end of 2013 into 2014. It's a very easy way for the government to put money into the economy, to target it regionally, and to get the feel good factor going again. We think that's going to happen. We think this is just in the normal course of cycles anyway. What will happen then is VP will be in a fantastic situation where it's got lots of new modern kit, that it will be able to rent out ahead of its competitors. So, what we sometimes look for in recessions is those businesses that with will come out of the recession in a much stronger competitive position than they went in. VP is definitely one of those, because they've got the balance sheet strength to keep investing in kit, where a lot of their competitors have really got the stuff that's years old, and quite frankly out-of-date there.

Petroff: So let's go over very briefly the key risks for each of these three companies.

Taylor: Absolutely, right. Key risk with VP unquestionably is that the GDP growth doesn't pick up. The contracting sector doesn't pick up for a longer period of time than we think.

Petroff: Okay.

Taylor: So 2014, 2015. What that means is you won't get the icing on the cake. It will still tick along and generate cash, you get your 4% yield.

I think, Menzies, the risk there is actually the newspapers and magazines. That the trend towards digitization continues to happen, but rather more quickly, and to a greater extent, nwe think. So that business is actually in decline. So they have been able to mitigate it with cost cutting to-date, but if that really picked up that will be difficult.

And I think Hilton Food, the real risk there is twofold. First of all, growing in new territories. They probably need to find a couple of new territories. They have been very, very successful, and they are now looking to Eastern Europe. That's one. And then the second risk: it has to be a risk, but I can't really see it being a problem to be quite honest with you is, any company that has a small number of very large customers are obviously very susceptible to anything happening in any of their customers. But we've just seen the recent problems with Tesco, but Hilton is absolutely fine.

Petroff: Okay, thanks very much for joining me.

Taylor: My pleasure.

Petroff: From Morningstart.co.uk, I'm Alanna Petroff, and that was Dave Taylor from Chelverton Asset Management. Thanks for joining us.