Small caps firms embracing self-improvement to up their earnings

17th July 2014

Henry Lowson, manager of the AXA Framlington UK Smaller Companies fund looks at how smaller companies are building value through acquisitions and expanding their global footprint…

Smaller companies with good management teams, that have a history of successful execution of a stated strategy, are in my view often more attractive than investing in ‘fashionable’ IPOs which often have no track record and may have inflated valuations.

Small caps advancing on the acquisition trail

Merger and acquisition (M&A) activity has been noticeably absent over the last few years, but macroeconomic conditions have improved, cash on balance sheets has grown, and confidence – the major missing element – is starting to return. While smaller companies are usually beneficiaries of M&A activity, given its contribution to long-term out-performance, some are also on the acquisition trail themselves.

An example is Regenersis, a provider of after-sale services and product repair, which recently announced the acquisition of Blancco, a global leader in data erasure software. The market for data erasure, required when smart phones or laptops are disposed of or changed, is growing by over 20% per annum and will be driven higher as tougher EU data regulations come into place in 2015.  Acquiring Blancco provides Regenersis with a competitive advantage in terms of its technological leadership and the shares have more than trebled since the fund made an initial investment.

Self-help sustains earnings

Earnings downgrades still outweigh earnings upgrades and more recently this has been driven by the strength of sterling: foreign earnings are converted into sterling at a lower rate. This headwind is important as almost 50% of FTSE Small Cap Ex-IC revenues come from outside the UK.

In this period of downgrades, self-help and the ability of new management to reinvigorate a business is key. A prime example is Restore, one of the leading providers of document management and office relocation services. CEO Charles Skinner has restructured the business since he joined in 2009, taking it from just £12.8m to over £50m of sales through a series of bolt-on deals expanding its addressable market. With a market capitalisation of over £100m, Restore is beginning to appear on investors’ radars and profits are forecast to grow by over 15% this year according to consensus earnings expectations.

Inspect the IPOs

Companies are queuing up to list on public markets, with valuations reflective of the current elevated appetite for risk. As confidence and economic growth shows signs of improvement, it is easy for investors to get carried away, but we believe it’s a case of ‘buyer beware’ with IPOs. Pricing power and barriers to entry are important attributes to look for in investments but it is also crucial that management remains incentivised in the business after listing.

UK smaller companies remain an under-researched area of the market, but they can offer an attractive mix of overseas and domestic earnings and appear to be in strong financial shape to evolve and prosper in what is a dynamic economic and geopolitical environment. A number of companies are now reporting strengthening order books and management are thinking how they might best deploy their balance sheets.

 

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