Neil Hermon, fund manager of the Henderson Smaller Companies Investment Trust (LSE:HSL), explains how he finds growth winners and names three shares that he has recently been buying.
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Kyle Caldwell, head of collectives, interactive investor: Hello. Joining me today is Neil Hermon, fund manager of the Henderson Smaller Companies Investment Trust, which invests in UK companies. Neil, thank you for your time today.
Neil Hermon: No problem at all, Kyle. Good to speak to you.
Kyle Caldwell: So, Neil, you look to find growth at a reasonable price. How do you go about this, in practice? What sort of qualities do you look for in a business?
Neil Hermon: So, we are growth investors who do believe investment-making is about growth, it’s about the future. However, valuation is important to us, so we’re going to [unintelligible 00:00:43] both at the right price, [both? 00:00:45] at a reasonable price. In terms of how we find our investments, a lot of filtering processes we go through. So, for example, we’ll do screening for certain financial characteristics of companies. We’ll use our experience; so, I’ve done this job for far too long – 28 years, it’s been – and the team itself has got about 40 years’ experience. And all we do is meet a lot of companies, as well. We see over 300 companies a year, as a team; one-to-one in their offices, our offices, or Zoom, as it currently is.
And what we look for in the companies; we talk about the 4 Ms, and these are the characteristics we want the companies to display. So, those are model – a strong business model. Can they franchise, competitor advantage. Management is important in smaller companies that are led by one or two key individuals. And we get to assess such management teams over a period of time. Thirdly, money – balance sheet and cash flow – and lastly, Momentum - earnings momentum. And those are the things we look for in the companies we invest in.
Kyle Caldwell: The trust also pays a dividend and, on that front, has provided consistent dividend growth since 2003. Do you invest in a certain number of dividend-paying companies in order to try and achieve a rising level of income each year?
Neil Hermon: So, we don’t target income, per se, or we don’t target companies that pay a dividend. What we essentially do is focus on total return. So, you know, capital and income as a combination. And if you look at our returns over the longer-term, most of our returns come from capital rather than income. However, we do like profitable cash-derivative, dividend-paying companies. We don’t really invest in blue sky or unprofitable businesses. And if you think about what we’re investing in, being a GARP-type investor, typically those companies will be growing their dividends at a good rate because their profits are growing quickly. And therefore, that essentially come out as a very strongly-growing dividend.
So, I think when I started in the trust, we were paying – back in 2002 – it was about 0.5p annual dividend per share. It’s now 23.5p, which is 25% compound growth over the last 18 years. So, that demonstrates the fact that it's working, in the sense that all we’re looking for is those profitable cash companies who will increase their dividends over time.
Kyle Caldwell: At the time of this recording in early April, we’re a year on from the UK stock market recovering from the heavy sell-off in the first quarter of last year. Have you been switching the portfolio, of late, to the potential winners of a post-pandemic recovery, and perhaps away from those companies that perform well during lockdown?
Neil Hermon: I think the one thing about the way we approach investments – we are very long-term, so our average holding period is around five years. So, the portfolio is very much built around long-term winners. And, therefore, it isn’t seeing rapid change of names in the portfolio overall. We like that consistency of long-term returns.
However, we are aware of changing macroeconomic and market conditions, and I think the market dislocations like we saw last year – when markets fell rapidly in March – do provide opportunities to pick up some undervalued opportunities. And I think, certainly last year, a number of companies were overly-impacted as the market took a too-pessimistic perspective of their ability to recover from the Covid crisis. So, we used that opportunity in the second and the third quarter of 2020 to pick up some of those undervalued names that we felt would recover strongly in the post-Covid world. And you know, we essentially tilted the portfolio. To be honest, I think you look at it today; the market is running very strongly since the vaccine news in November last year, and that undervaluation opportunity has somewhat passed. And for us, we’re looking much more back towards those long-term-growth structural winners.
Kyle Caldwell: Could you name a couple of companies that you’ve added in that period, in that third and fourth quarter of last year? And also, perhaps name a couple of companies that, they’ve looked long-term structural winners, that you’re now finding more attractive?
Neil Hermon: Yes, of course. So, I mean, a couple of things that we added last year – so, one would be Mitchells & Butlers (LSE:MAB), the pub company. Its brands include All Bar One, Browns, O’Neill’s, Miller & Carter. It’s a well-known brand. It’s about 650 pubs across the UK, 80% of them freehold. It got severely impacted by market conditions and, clearly, the fact that we were closed – they closed their operations last year - was clearly quite damaging for them, and the share prices fell very sharply. However, it’s recently raised money. Its balance sheet is in good order. And you know, from our perspective, I think ultimately, we are social creatures. We’re all keen to get back to the pub. We have a roadmap – as obviously evidenced by Boris – they obviously open again outside, and the month after that, clearly, obviously, be opening.
So, I’d say we think trade will recover quite sharply. A number of factors around that. I think you’ve got that kind of pent-up demand. Consumers have saved a lot of money during the Covid crisis. [Unintelligible 00:05:58] estimate £250 billion household savings. Competition has decreased because a number of things, unfortunately, won’t open again; so, competitors in terms of pubs and restaurants. And I think that pent-up demand – and also likely it’s the case in summer –means that trade will recover very sharply. So, we think that’s well-set for a recovery.
Another name would be Gym Group (LSE:GYM). Similar story here, really. Low-cost leisure operator, gym operator. Again, closed for a lot of last year because of the Covid crisis. It’s raised money; balance sheet is strong. And again, I think when we go back to trading – they’re obviously open again – demand will bounce back very sharply. We’ve seen significant competition decrease from some of their peer group, and they’ll have an opportunity to grow their sites going forward. So, again, I think another story which will bounce-back sharply in ‘22 and beyond.
And just lastly, a structural winner for us, Impax Asset Management (LSE:IPX). So, it's an ESG investor. As we know, ESG is a really big theme currently. It’s clearly a kind of structural change in the market overall. A lot of investors are clearly allocating money towards ESG-type portfolios. Impax has got a long-term reputation in the market. They’ve got a very strong performance record, and they’ve got the credibility. So, they’re seeing various inflows, currently. Its AUM has grown from 5 billion, at the end of 2016, to 16 billion at the ’19. And now, up to 28 billion. So, growing very quickly and rapidly. Although the shares don’t look particularly cheap at this point in time, we think that the earnings growth will be very, very sharp in future years. So, we’re optimistic about the prospects of Impax over the longer-term.
Kyle Caldwell: Neil, thank you very much for your time today.
Neil Hermon: Thank you, Kyle. Thanks for your time, too.
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