My 10-point checklist for picking smaller company shares

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Smaller company shares can make for exciting investments but they carry plenty of risk. The latest episode of the podcast looks at the checks DIY investors can apply when trying to sort the winners from failures. Charles Montanaro, an experienced smaller company investor, looks at some of the methods that work - and some of the lessons he’s learned from a long career.

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Dave Baxter, senior fund content specialist at interactive investor: As investors, we spend a lot of time thinking about the biggest companies in the world. We often find ourselves obsessing about the US tech giants, and here in the UK, dividend hunters love to think about the HSBC’s, the Shell’s, and the really big beasts.

But the fact is you can make some great returns by going to some of the minnows of the investment world. If we look at small and mid-cap shares, they tend to be much less well researched, and in theory they have a longer runway for growth. That does, of course, depend on you getting it right, you being very patient, and you having enough risk tolerance.

So, welcome back to The On The Money Show, looking at the issues affecting your savings and investments. We are going to look at small-cap investing through the lens of someone who’s very experienced in that space.

I’m joined today by Charles Montanaro. He founded Montanaro Asset Management back in 1991 and has a wealth of experience investing in small companies in the UK and beyond. So, Charles, thanks very much for joining me today.

Charles Montanaro, founder of Montanaro Asset Management: Dave, thank you very much for inviting me. It’s been an absolute pleasure.

Dave Baxter: So, Charles, you, as I mentioned, have a wealth of experience investing in small and mid-caps in the UK. Also, outside the UK, you have some other funds there. I imagine it’s an area that DIY investors would love to get to grips with. 

There’s a lot of potential there, but there are also pitfalls, and perhaps there are criteria that you could use to find good small caps and potentially avoid some of the traps. 

So, if you were to imagine, say, a checklist for small and mid-cap investing, what would you include on it?

Charles Montanaro: The wealth experience always worries me a bit. You didn’t actually call me a veteran, which is what they normally do.

All the wealth experience really means I’ve made many more mistakes than most of the people listening to this. 

The business was set up in 1991, but the philosophy predates that by a few years. I joined the City in 1980, I worked at Merrill Lynch, and I came across Warren Buffett in 1982. I read what he wrote, I listened to what he said, and I thought he’s a genius, why don’t I simply copy what he does? So, the philosophy really goes back to 1982, and I did create a checklist of basically 10 points, and here they are. 

The first thing we say is what’s a classic Montanaro company?

Warren Buffett says never invest in a company you don’t understand. So, my first question is do I really understand what the company does? Is it focused? Is it within my circle of competence? That’s the phrase he uses.

I have learned in my career never to invest in a shoe company. In all my career, I’ve never made money investing in shoes, so I stopped trying. So, stick to what you’re good at, stick to what you understand, make sure you know how they make money. 

So, the first question is do you understand what they do? Then, broadly, buy the best.

Get the market leader. If you’re the market leader, you’re the leader for a reason. Normally, they’re offering goods or services people need, but if you are the number one, you’re doing something right.

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Dave Baxter: So, would you simply look for the greatest market share? 

Charles Montanaro: Normally, you look at market share, you work out how they’re going to spend that, have they got pricing power, what are they doing better than the competition, what are their USPs, what is the IP? Do they have a product that is outstanding, and could that be threatened?

Number three, we’re looking at quality investment. So, I say high quality. What does that really mean? 

The next question I ask is, is this company in control of its own destiny? And that is worth thinking about because if you’re a very cyclical company, you are clearly not in control of your destiny. You’re dependent on the economic cycle. So, we try to find compounding companies that are structurally growing and, again, focus on whether they’ve got recurring revenues, whether they can be predictable, which is number four.

Do they have must-have products? Do you believe with certainty you can predict what their earnings are going to be? Because earnings ultimately drive your returns. And we only invest in companies that are profitable. That’s number five.

Why would you invest in a loss-making company? You can come across lots of companies with great stories, but often loss-making companies remain loss making, and guess what? They often will go bust. Let’s not forget small cap is great fun, you can make great returns, but they are riskier than if you’re buying HSBC. 

And talking about risk, risk means lots of things to different people. For us, it’s balance sheet risk. You don’t want to be in a highly geared company that’s cyclical, and guess what, be unlucky and find a recession just around the corner because you will lose all your money.

We are growth investors. I puzzle sometimes as to why people take a value approach to small cap because you’re trying to find the big companies of the future, you’re looking for growth stocks, and if you’re small it’s easier to grow than if you’re a big company.

I used to have a phrase ‘think of small cap as a gazelle and elephants don’t gallop’ and then I discovered that elephants do gallop but still think of nice gazelles. So, we’re looking for companies that grow and we look for 10% earnings per share (EPS) growth per annum. 

We are looking at the compounders and, don’t forget, it’s really important not to forget valuation. You can find a really good company, but if you buy it at the wrong price, you won’t make money. So, we’re GARP investors, the horrible ‘growth at a reasonable price’.

But don’t forget what Warren Buffett also says, ‘it’s far better to find a wonderful company and pay a reasonable price than a fair company at a cheap price’. So, we’d rather pay a little bit more to get a better company. 

And the last two points: go for hidden gems. What we call a hidden gem are companies with maybe less than five analysts, because then you’re looking at a company that is probably not very well known. There are many global market leaders out there that you won’t even have heard of. So, look for these gems. That means you’re more likely to have an information edge. 

And small cap, I’ve always said in all my career, is all about people. So, it’s all about management and the great thing that we spend our time doing is spending time with management, out of the office, inside visits. Really work out are they passionate? Do you believe in what they say? Do they have big insider ownership?

If you take all those 10 points, you’ve probably got a decent business.

Dave Baxter: It’s interesting applying this to DIY investors because I imagine some of those aren’t attainable, they won’t be able to meet management, but then perhaps they can do things like study an area, they can perhaps do a bit of research and start to make themselves a bit more familiar with some of the financial metrics and so on.

Also, I wanted to touch on the risk points. Are there any especially good ways to mitigate the risks? One interesting thing I’ve observed among small-cap managers is they really vary by number of holdings. So, they either tend to have a lot of holdings as a way of stretching out the risk, or on the other end of things, you get some funds that perhaps take more of an activist approach, and they just have a few very big positions.

Charles Montanaro: I think there’s a balance somewhere between the two. When I launched my first fund back in 1993, we raised after three years £10 million, and the idea was to become an activist. I got my £10 million, let’s put £1 million in each of these companies. The biggest company we could invest in was £50 million. Really, really small.

And then my first investment I went into, I discovered that, actually, activist investing is really tough, it’s politically very tough. It’s very hard to get change by going on the board and trying to do that, almost a semi-private equity approach.

The other extreme, if you own 100 companies, you can’t possibly know what you’re investing in. You become, basically, the market. So, I don’t think that achieves a great deal other than the market, over time, the small cap effect of 2.8% per annum roughly is the outperformance you’ve got over 70 years. 

You should still do better than in large cap, but really the opportunity to have a small number of holdings, we normally have in the case of Montanaro UK Smaller Companies Ord (LSE:MTU) just under 60 holdings. And I think you’d be paid to have 50 to 60 holdings, you’ve got the benefit of sector diversification, you’ve got a spread of exposure, and I think you can get to know these companies really very well.

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Dave Baxter: Yeah. Well, I guess if you’re a DIY investor, maybe you’d have to be more limited because you don’t have those resources.

Charles Montanaro: That’s probably true, but at least diversify, that’s very important.

Dave Baxter: Yeah. So, I wanted to delve into your career and some of the interesting lessons you’ve had, starting on the positive element. It’s always interesting to hear about people’s big wins and also their big mistakes, and so on. 

What do you judge to have been really successful investments of yours in the small and mid-cap space, and what interesting lessons did you take from that experience?

Charles Montanaro: OK. We all like talking about our winners, multi-baggers, so I’m going to give you one, and that is Dechra Pharmaceuticals. The reason why it’s a good story for us is that it gives you an idea of what the marketplace is and was like. 

So, if you can wind the clock back to 1997, Lloyds Chemist actually went private. They had a small veterinary business that they didn’t really want to deal with them because it didn’t really fit in with running a chain of chemists.

So, in September 2000, they spun it off and Dechra Pharmaceuticals was born. Priced at £1.20 a share, it was a market cap of £60 million and that, really, was our sweet spot at the time because it was too small for the big institutions, nobody really knew what they did, but for us, it was actually perfect.

If you think back to my little 10-point checklist, we knew what it did. They were the lead in what they did in a small market. They were clearly high quality, generated a lot of cash.

So, we’ve all got pets. The great thing about pets is they’ve got pricing power. If you’re going to a vet, you’re not going to worry too much about what price you pay for the medicine. You want your dog or your cat or whoever to get better. So, it’s a very nice business that is run by a guy called Ian Page.

Ian Page is very proudly from Rochdale. He happens to be a Man City fan, which we don’t hold against him, but that aside, he was the van driver when he started life and became the CEO, and he was totally passionate about Dechra. So, he did very, very well. He grew the business from £60 million. By 2023, he had an approach from a private equity house for £4.45 billion. You actually made, just on those numbers, 36 times your investment. If you added in the dividends, it was 55 times your investment. 

Now in September 2002, we held 5.3% of the company. We were the fourth-largest institution, and if we’d held every single share, we’d have made oh, I hadn’t done the sums, £160 million. The problem is you obviously sell over the period of time.

Why it was a good story is that we helped him understand the City, and he was very open. When he needed money for acquisitions, we helped him as well. They grew into a huge company, selling in 26 different countries. So, there’s your success story. 

The problem is you don’t learn from your successes, you learn from the mistakes. So, my biggest mistake, which I think about even today, DTZ. 

DTZ is a name many of you will know. They were a London property adviser, with a lot of history. Remember I like companies that are well established, and they’ve got a lot of history, you can track them over different cycles. They started life in 1853 as a property valuer. So, basically, if you want to take over a company, they would value your assets, [you] would go to DTZ to give you a valuation. So, it was an asset-like company, they were basically offering a service.

A guy called Mark Struckett joined them, they floated in 1987 - he joined soon after that - and it became worth £500 million on the stock exchange, and did very, very well. But here is where it all went horribly wrong. In 2006, they decided to make a big acquisition in the States. In 2007, they made a second big acquisition. And guess what? Because it’s very cash generative, they paid cash, they borrowed from the bank. Then the global financial crisis (GFC) comes along. All the property transactions came to a close. They started breaching all their covenants. By 2011, you’ve basically lost all your money.

Small cap teaches you humility because I’ve been around long enough. I’ve made more mistakes, I said, than probably anybody you’ve met. But what it teaches you is to be very careful about sick old companies and be very careful about gearing. As I said right at the start, you don’t want to be in a sick old company at the wrong time of the cycle when you owe lots of money to the banks.

Dave Baxter: Yeah, I imagine it’s very easy to get caught up in these growth stories, and therefore, to embrace some of that risk. But would you say then that you do want perhaps more kind of organic growth on the cards?

Charles Montanaro: Well, when we meet a company, we never worry about what they’re going to earn in the next three months or six months. What we do want to know is where are you going to be in five years’ time, and what will you look like? And if you can’t tell us, then that isn’t particularly good because it’s very hard to value a company when you don’t know what it’s going to be down the road.

Acquisitive companies by nature are riskier because not all deals work, less than 50% of deals actually become profitable, so be very careful about the acquisition treadmill.

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Dave Baxter: Say you have picked one of these winners you’re talking about, perhaps you are taking some profits, but you’re still sticking with it. Are there any signs that perhaps it’s starting to have a bit less edge?

Because I think of companies like Games Workshop Group (LSE:GAW) that seem unstoppable and they’re now large caps, but there must be points where you start to think it starts to behave more like an elephant than a gazelle if we’re going to stick with that metaphor.

Charles Montanaro: I think what you learn is that you can’t be complacent, you’ve got to keep on top of your investments, and don’t assume they’ll be good forever.

Ian turned around and said to me, the first year after the float, I told him off because he had a profit warning, he missed his numbers. He said, Charles, thank you for doing that because that taught me never ever to go through that experience ever again. And generally, I’d learned that one profit warning normally means three. So, look out for profit warnings, but look out for change.

We follow management. If management changes, they’re leaving, that’s not good. If the acquisitions are getting ever bigger, that’s increasing risk. That’s not good. If they’re not as forthcoming, be very, very careful. And you’ve got to go and meet the companies in situ, look around the plants, see what’s going on.

So, generally if you have your 10 bullet points of what you look for, I always say, give me three reasons why you’re investing in this company. Have an investment thesis. If that thesis changes, then just re-evaluate and say, well, actually, has the reason for owning this changed, and should I be doing something else?

Dave Baxter: Yeah, and perhaps it’s applying that thinking of would I buy it today if I was starting afresh?

Charles Montanaro: Absolutely right.

Dave Baxter: Yeah, interesting. And to reflect again on your career, I imagine we’re talking about a decent span of time, and I imagine the market must have changed hugely. Being a small cap or mid-cap investor now versus then must come with a different set of opportunities, a different set of challenges. 

So, briefly, what would the most notable changes be to you? And as an investor in the market today, what are the big challenges you’re aware of, and equally is there any ray of hope standing out there?

Charles Montanaro: Decent period of time? Is that another way of saying ‘veteran’ but being very, very polite? 

OK, since I started in 1980, that was pre-Big Bang, which is October 1986. So, the City was a gentleman’s club. All deals basically happened at lunchtime. They started with gin and tonic, and they ended with the port, and then you went home. Those were the 1980s, they were very, very different. 

In those days also, people didn’t have spreadsheets. It’s worth remembering those spreadsheets actually didn’t come in till 1987. So, it was very much a gentleman’s club, very public school.

If you wanted a job, you had to know a partner, and that’s how you got your job. If you wanted to invest in a company, you relied on the brokers. And basically, ever since Ross Goobey in 1947 created the ‘Cult of the Equity’, prior to 1947, all pension funds bought bonds, very simple, and then went out to lunch. What then happened post-Gooby is that actually equities gave you higher returns. 

So, by the time I arrived in the City, the typical pension fund had maybe 75% in equities, the rest in gilts. If they were really adventurous, they might own one or two European names like Bayerische Motoren Werke AG (XETRA:BMW), Porsche Automobil Holding SE PRF PERPETUAL EUR 1 (XETRA:PAH3), Danone SA (EURONEXT:BN). So, it was very heavily concentrated in the UK, very much in the domestic market. So, if you got 50%-60% going into UK equities, and if small cap is about 10% of the market, they were putting 5% into small cap. Happy days. 

But things have moved on. Defined benefits now, LDI (liability-driven investing) investing, they’ve gone back full circle to investing in bonds. They’ve gone away from equities, they’ve gone into passives, exchange-traded funds (ETFs) are out now here, they’ve gone global as well, and they’ve gone into alternatives.

So, whereas you had a time where, call it 50%-60%, was UK equities, now the situation with the MSCI World Index is only 4% to 5% invested in UK equities. Now what are they going to be? They’re probably going to be large-cap equities. 

So, if your 10% is small cap, you’re looking at less than 0.5% going to the UK small cap market. And the problem’s not being helped by the consolidation that’s also happened because you’ve now got a situation where the wealth managers are getting big, the pension funds are getting bigger and bigger, the insurance companies have got big, even the IFAs have got big. 

So, when I started back in 1980, everybody wanted to own small cap. You’ve now got a situation where there are not very many buyers left of small cap. What that’s meant in the last four years, for example, really ever since Brexit, you’ve seen £5 billion coming out of UK small cap. And because UK small caps had a tough time, funds are closing down. So, whereas when I launched Montanaro UK Smaller Companies Ord (LSE:MTU) in March 1995, there were 35 UK small-cap trusts, you’re down to just a handful.

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Dave Baxter: What hope would you offer? It’s interesting to expand on that a little bit. We’ve seen that UK equities have returned to decent health, at least if you look at the FTSE 100 and those bigger beasts, but the smaller mid-cap shares have done well, but they’ve lagged that rally. Is there any reason to hope that things will revert? Where’s the optimism?

Charles Montanaro: What I’ve learned in 45 years is all markets mean revert. So, just when you think things can’t get worse, generally speaking, things magically change. Sentiment is very fickle. So, in March 2003, after TNT bear market, overnight, for no particular reason, the market went up, and people said it’s a dead cat bounce, don’t believe it. 

I think that was the start of the bull market. The global financial crisis in March 2009, the same thing happened. It doesn’t take much for the sentiment to change and some buying to come in to see a rapid change of fortune. 

For example, in the last month, UK All Cap saw the first monthly inflow in five years. The UK All Share was actually up 23% last year. They actually did very, very well. So, people aren’t really talking about it, but the UK is actually doing quite well.

It hasn’t happened in the UK yet, but what is interesting is what has happened in the last four or five years ever since Covid, Ukraine, Iran, and so on. What you’ve now seen in the last four or five years is small gap underperformed by 95%. That’s a huge number over about five years. It’s in a situation where quality’s done really badly because people have bought commodities, they bought banks, they’ve been in oil and gas, and actually quality has underperformed by about 70%. Again, a very, very big number, Again, over the last five years.

If you look at growth investors, you’ve underperformed by 50% compared to value. But what is interesting if you look at lovely charts is you’ve actually unwound all the previous gains in the previous four, five years. They’ve almost completely mean reverted. And it won’t take much buying for that to change because what has now happened is valuations look really pretty good. Let me give you just a couple of examples.

In 2021, Montanaro UK Smaller Companies Investment Trust was trading with a price/earnings (PE) of just under 30 times. That PE today is 13.3. That’s the cheapest it’s been in over 12 years. You normally pay a premium to buy small companies because you get higher growth.

The premium back in 2021 was over a 100%. Now it’s down to about 20 odd per cent. So, people are not paying for the growth that should be coming, and what we’re also seeing this year, for the first time in three years, is we’re looking for double-digit earnings growth from the portfolio, something like 13%. 

So, if you’re a fan of PEG ratios, you’re looking potentially at a PE of just over 13, with a growth not far off that, and the growth from small cap is higher than large cap, which, again, people haven’t really looked at. So it may well be the Magnificent Seven, just leave them alone for a bit because small cap may be looking more interesting.

Dave Baxter: Yeah. It’ll be interesting, there is a challenge potentially if we’re seeing rates remaining higher for a bit longer on the back of Iran, maybe that won’t be helpful, but as I mentioned at the start, it is an area where you do need to exercise some patience. 

One point I wanted to return to was the idea of research. As I mentioned, DIY investors don’t have as many resources, but what would it make sense for them to be looking at? There’s annual reports you want to be on top of. Is there anything else that stands out?

Charles Montanaro: If I came up with two people, Peter Lynch and Warren Buffett were the two people I can relate to most. What he basically said is you won’t find the multi-baggers in a spreadsheet. You’ve got to invest in what you know. In other words, go out to the shops, get out of the office. So, I think there’s a lot to be said to that. 

What I would argue as you and I investing, for example, is start with reading. You don’t have to read the very clever books with very complicated algebraic formulas, which are way over my head. If I had to choose two people, read Warren Buffett and read Peter Lynch. Because what they do is they demystify investing. They make it simple for the ordinary folk because, really, investing is all about common sense. We in the City just make it sound much more complicated than it needs to be.

So, I would read and read the annual report. There’s so much online. You can just order reports and start from the back. Always read the outlook statement, obviously, but they’re nearly always going to be positive. But look at the small print at the back because that’s where you find the litigation, the things they don’t want you to read about. 

But you’ve got plenty of time, there’s plenty of good information, and if you are lucky enough to know about artificial intelligence (AI), AI gives you more information than you can possibly imagine. So, try out AI and you can get a lot of information.

Dare I say it, you can still go to a library if a library is open where you’re living, but, actually, what I would also say is do your research, do your homework, and why don’t you buy one share and attend the annual general meeting? Because if you go to the AGM, you’ll meet management, you’ll probably meet the AGM at their place. So, you’ve got to go out there. They might give you a cup of tea. We actually have very good chocolate biscuits, but you can go out. Management are very accessible. They are very keen to tell you their story.

Dave Baxter: Yeah. So, lots of interesting points there. I’m afraid that is all we have time for, but thanks for your time.

Charles Montanaro: Thank you for letting me tell you my story. It’s been a pleasure.

Dave Baxter: Thank you for watching and for listening. Of course, as always, we do have plenty of additional fund analysis for you. Just go to ii.co.uk. If you have thoughts on the episodes, if you have topics you would like us to cover, do email us at: OTM@ii.co.uk. I hope you enjoyed the podcast and see you next time.