The stampede into index and exchange traded funds has set up favourable conditions for active stockpicking. Momentum buying of huge multinationals might be a low risk approach in a stagnant world without competition, where brand and business scale are allowed to create huge entry barriers. However, we live in a world with increasing disruption that challenges incumbents. The forces are not just technology, big data and new business models, but changing consumer tastes, as millennials shun old brands and favour experiences over goods.
Disruption is challenging the argument that the biggest companies just keep on growing, or are even safer. Essentially, the indices are backward looking, capturing past strengths that historically drove the dominance of today’s big businesses. Now, change is accelerating and investors should have less respect for today’s index giants. Continued disruption by new entrants applying innovative business models is chipping away at many big businesses. The pace seems to be catching older businesses and the stockmarket by surprise. But nimble investors can avoid declining sectors.
High street retailers and traditional banks are two of the areas under threat from new mobile online services. Many of the new businesses need little capital to expand and are readily scalable, tackling cosy sectors with fat margins but poor customer value. Fevertree Drinks, for example has created a powerful brand and a £3bn company in just a few years within a sector dominated by giants.
The bargains are hiding further down the FTSE 100, in the Mid 250, and in some larger AIM stocks. Not only has the Mid 250 beaten the FTSE 100 over the last 5 years, but it is also ahead since records began more than 30 years ago. There are more dynamic and mispriced businesses out of the spotlight. The problem for some of the biggest institutional investors is that even stocks at £2bn capitalisation can be hard to buy in the secondary market. In this area, smaller investors have an edge. Mispricing of shares – particularly in smaller and medium sized companies – is likely to create greater opportunity for performance and reward for investors who have the skill to evaluate company prospects.
Many of these businesses have greater control over their own destiny and pricing, less subject to the vagaries of global competition and technology. Investors have noted, for example, that the veterinary sector appears to have more positive characteristics than big pharma – growing, but without the same levels of regulation and price control. The companies that can exploit these pockets of growth tend to be smaller or medium-sized.
Investors should focus on businesses that are either best in class and dominant in their sector, or entrants that have identified a niche that they will, in time, own. There are great risks in picking young companies at the pioneering stage, but much of the reward can be achieved later, with less risk, when it is clear that the business model is accelerating.
Consistently high returns on capital points to management that have proven to be effective at deploying capital and over time compounding superior returns. Characteristics include barriers to entry, recurring revenue, low capital needs, and often some type of rare asset. Companies that are champions in their field or with high sustainable returns on invested capital and strong cash flow generation, can deliver long term shareholder value. Equally, investors must be alert to any loss of pricing power, often indicated by a lack of like-for-like organic growth in customer numbers.
If investors focus on the stockmarket area where they have an edge, and conduct fundamental research, they can outperform. In a turbulent world it is important to focus on tomorrow’s winners.
Disclosure: At the time of writing, SVM Asset Management holds positions in Fevertree Drinks.
This article is for informational purposes only, and to the extent that it is passed on, care must be taken to ensure that it is in a form which accurately presents the information presented here. The information and author’s opinions presented in this article have been obtained from sources believed by SVM to be reliable, however, SVM makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material.
This article does not represent financial advice and is not an offer to invest in any of the funds or companies mentioned. SVM UK Growth Fund is a sub-fund of SVM Funds ICVC, an open-ended investment company. SVM Asset Management Ltd is the investment manager of the ICVC.
Past performance is not necessarily a guide to future performance. Stockmarkets and currency movements may cause the value of an investment and the income from it to fall as well as rise and investors may not get back the amount originally invested.
By Margaret Lawson, Manager, SVM UK Growth Fund
Issued by SVM Asset Management Limited which is authorised and regulated by the Financial Conduct Authority.