'Strong Small Caps Will Only Get Stronger Next Year'

Seeing small caps grow is Katen Patel's favourite part of the job. Here's the JPMorgan portfolio manager's take on what's next for smaller companies

Ollie Smith 16 December, 2021 | 8:59AM
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Ollie Smith: Our special report week on the outlook for 2022 is in full swing here at Morningstar.co.uk. We've looked at multi-cap investing, but I want to look specifically at the picture for small caps. So, here to do that with me is Katen Patel, Co-Manager of the JPMorgan Mid Cap Investment Trust, which attempts to spot the small-cap heroes before they get their capes and fly, so to speak.

So, Katen, talking 2022 then, what challenges are small-cap companies going to face?

Katen Patel: Hi, Ollie. Thank you for having me. Well, unfortunately, almost two years on and probably not surprisingly, I still see one of the key challenges for next year being the ongoing impact of the pandemic.

I think most companies have adapted their business models to the new normal. I think the stop/start nature of restrictions and continued uncertainty is unhelpful for investments and planning ahead. But that said, I think many of our companies in the portfolio have remained incredibly resilient and by their very nature, many small-cap companies find themselves in well-protected niche areas of the economy and to some extent, are carrying on relatively unscathed. I think inflation and supply chain issues will also continue to be important factors to watch.

On the latter, actually, anecdotally, from some of the company management meetings we've had recently, it does appear that these are now easing slightly. Inflation clearly needs to be monitored very closely, but evidence in recent months suggest that this is leading to the strong getting stronger. But I think with our focus on quality companies in the portfolio, we are hopeful that our holdings will continue to be resilient.

OS: I realised that was a rather bleak first question to start off on. But on a more positive note, which small caps are you backing and why? Which are the strong ones and how are they going to get stronger?

KP: So, I think two of the more exciting names in the JPMorgan Smaller Companies portfolio, and perhaps are Alpha FX (AFX) and SDI Group (SDI).

So, firstly, Alpha FX is an FX consulting business, which provides foreign exchange services to corporate clients across the globe, and these corporates require these services when undertaking cross-border transactions with their customers or suppliers. And that's clearly a service which is seeing increasing demand as the global economy has become more and more integrated in recent decades. They've got a technology and customer service-led approach in what has historically been a poorly served sector and as a result have grown their client base tenfold and revenue per client fivefold in the last 10 years alone. Clients are also supporting them in setting up across the globe, which should continue to drive revenue growth for many years to come. And since IPO a couple of years ago, their results have consistently beaten market expectations, including two recent upgrades ahead of expectations from the company.

And then, the second company SDI Group is a designer and manufacturer of scientific instruments, has a market cap of about 200 million. They've operated a very successful buy and build strategy for a number of years now, purchasing small sub-five million revenue businesses, operating in structural growth areas of the economy ideally with high barriers to entry. And what they've done is build up a very high quality, diversified group of businesses to which they then provide the corporate structure and investment when required. Just to give you a flavour, products examples include infrared cameras used in art restoration, systems for food and water testing, cameras on some of the most advanced telescopes on the planet, so really diversified resilient group of businesses.

They've demonstrated high margins, high returns on capital and strong organic growth. And that's been supplemented by these small bolt-on acquisitions, which has led the shares to not only quadruple since our initial purchase at about 50p, but I think there's still plenty more to go for here.

OS: Great. And just finally, there are some big British brands in the portfolio aren't there, like Games Workshop (GAW) or Dunelm (DNLM). Can you give an example of where you've invested at the small cap stage and seen positive results?

KP: One of the aspects I enjoy about investing in this part of the market is that you do have many opportunities to find those companies that can see their share price go up multiple times due to the growth prospects they find in front of them. Interesting that you mentioned Games Workshop as a big British brand. It was in fact one of the companies that we identified at the small cap stage as it was reaching a turning point operationally and invested when the shares were below £5. They now sit above £90.

Other examples include JD Sports (JD), which we owned in this fund when it was a small cap company and sold on its entry into the large cap FTSE 100. Also: Future (FUTR), a media company that owns titles such as Decanter and TechRadar, FourFourTwo, where the price has gone up tenfold from our initial investment.

Team 17 (TM17) would be another example. So, this is a video game developer and publisher. Perhaps not a household name, but one of their key video game titles which has been around for a very long time--Worms--has sold over 75 million units globally. We purchased Team 17 when they IPO-ed in 2018 at the price of around 165p. And it benefitted from the consistently strong results the company has produced, and it also operates in a global video game sector that has and continues to see structural growth, which is being supported by demographics, particularly in emerging markets, technology changes and obviously the huge increase in devices that we've seen and the shares are now sitting north of 700p.

OS: Sure. Katen, thanks so much for that. Very interesting journey into the world of small caps. For more reflections on the year to come, look us up on Morningstar.co.uk. Until next time, I've been Ollie Smith.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ollie Smith  is editor of Morningstar UK