Interactive Investor

Star manager Harry Nimmo's tips for stock-picking success

7th June 2018 16:48

Kyle Caldwell from interactive investor

Small-cap investor Harry Nimmo lifts the lid on his investment philosophy, revealing to Kyle Caldwell his six-step process to finding 'tomorrow's giants'.

Over three decades ago an academic paper revealed a simple yet highly effective way to improve investors' odds of stockmarket success: avoid the big names and instead identify tomorrow's giants.

The study, carried out by Rolf Banz in 1981 at the University of Chicago, first documented what is known today as the 'small firm effect' or 'small-cap premium', whereby over the long term smaller-sized shares deliver much higher returns than their larger rivals.

Banz's study looked at the US stockmarket, but other studies over the years have drawn the same conclusions for other markets, including the UK. Research carried out in 2015 by the London Business School, for example, found that over 10-year periods since 1955, smaller firms outperformed larger companies five times out of six.

On the surface, though, fund investors don't seem convinced that small is beautiful. Over the past decade fund flows into the Investment Association's (IA's) UK smaller companies sector have been lukewarm, with money exiting the sector during periods when volatility has picked up.

The UK referendum on leaving the European Union in 2016 was a case a point, with outflows from the sector. Some investors have not returned: since July 2016, net outflows stand at £107 million, part of a trend that has seen UK equities in general being given the cold shoulder.

But according to Harry Nimmo, the small cap veteran who since the turn of the millennium has delivered annualised returns of 11%, investors should not make the mistake of thinking it is retail investors who are behind the curve.

Past performance is not a guide to future performance

"Joe public", the private investors who pick their own funds or shares, have been the big beneficiaries of the small-cap premium, as they have been attuned to the trend that smaller companies outperform larger ones.

It is asset allocators for institutions who tend to shy away from smaller companies, most commonly citing illiquidity as an issue by saying they cannot get in and out.

But I don’t see why they would need to sell, given that returns from small caps (versus large caps) have been much better over long time periods. This is not new news – it was identified a couple of decades ago.

Fickle institutions

Nimmo adds that asset allocators for institutions tend to be more fickle than retail investors in attempting to make "big macroeconomic calls".

"UK equities are not flavour of the month right now, due to the obsession about macro events. But, as we all know, even the most intelligent of economists get things wrong, which is why I think investors will be better served by focusing on picking companies and finding the future winners by looking at the finer details at a micro level, rather than worrying about macro factors such as the impact Brexit will have on the UK economy."

He adds that suspicion towards smaller businesses "has also been driven by investors regarding UK smaller companies as being heavily geared towards the fortunes of the UK economy - but various businesses I own operate on a global scale."

Indeed, since the Brexit vote Nimmo has tilted his two portfolios in favour of companies with international earnings, which now account for just over 50%.

Nimmo focuses his sights on ‘quality’, one of the six principles that have helped shape his stock-picking success over the course of his career.

"Quality equals lower risk, and over the years it has been the lower-risk smaller-cap names that have delivered the highest returns."

Both the Standard Life Investments UK Smaller Companies fund and the Standard Life UK Smaller Co. Ord  investment trust, the two portfolios that Nimmo spearheads, are littered with various examples of small caps that fit the quality label, including retailer Ted Baker, Britain’s largest sausage-maker Cranswick, and CVS Group, which provides veterinary services.
 

Past performance is not a guide to future performance

Nimmo adds that such quality stocks are 'no higher-risk than the big blue chips'. He adds:

"I've never had a company go bust in my open-ended fund, and dividend cuts have been few and far between, whereas I can think of a number of large cap names that have blown themselves up."

His second rule is to ensure growth is sustainable by assessing whether a company has the tools in its armoury - durable competitive advantages such as intellectual property - to fend off future challengers. Nimmo's third rule is to 'concentrate your efforts'.

He adds that most fund management teams are 'too big' and look at too many stocks. Instead, Nimmo has a share-screening process that ranks companies in terms of earnings consistency, profit growth, valuation and price momentum.

Principle number four is 'run your winners', and Nimmo reels off a number of names that he has held for several years, including Domino's Pizza and Abcam, a medical services company. Management longevity is rule number five; he prefers to invest in businesses that are run by their founders, such as Fevertree Drinks and NMC Health.

Last but not least, he says it is important for small-cap investors to not become 'obsessed with valuation'.

 "It should be more of a sense check, if you like, rather than driving your whole decision-making."

Trading activity of late has been quiet, as he has been content with the current names held. He has, however, been adding to Motorpoint Group, the used car dealer, and XP Power Ltd, which makes power adapters for machinery.

Over the years, stocks listed on the Alternative Investment Market (AIM) have become a bigger feature across Nimmo's portfolios.

Earlier this year the board of SLS increased the portfolio's upper limit for AIM stocks to 50%, up from 40%. The market has matured, he says, noting that "nowadays AIM has a much more diverse range of businesses". 

He adds:

"There are lots of profitable businesses, whereas in the past this was not as common. Dividends have also become more of a feature." However, he warns that investors need to be cautious: "Let's be clear, over the long run the AIM market return has been very poor and indeed it has been a very dangerous market that has been prone to fads."

But the changing face of AIM is a welcome one, particularly given that since August 2013 AIM shares have been eligible for inclusion in tax-free ISAs.

They also tick the inheritance tax (IHT) exemption box, recruiting an army of new investors via IHT investment planning services operated by various wealth managers and fund managers.

According to Investor's Champion, which has a service that screens for stocks qualifying for IHT relief, around a third of all the money invested in AIM is from investors driven by IHT planning considerations.

Tax break in danger?

However, Nimmo has concerns that under a future government, possibly led by Jeremy Corbyn, the tax break's days may be numbered.

"You would hope it would be retained as the tax incentives help new businesses grow, which is good for the UK economy. But if Corbyn is ever elected, it could be taken away." 

Such a move would naturally unsettle AIM, and likely by extension UK smaller companies generally.

The performance of the UK economy, which grew at a mere 0.1% in the first quarter, is another headwind. Nimmo seems unconcerned, though.

He points out that his best years compared to peers and the index were 2001/02 and 2007/08. "Given our preference for high quality businesses, we lose money less quickly than our competitors, as the market tends to reward the most resilient names," he adds.

With a two-decade track record Nimmo has seen plenty of changes, but most striking of all has been the growth in passive investing, which is making big strides in eating active managers' lunch.

He does not feel threatened, however, and nor should he be. The small-cap arena is one of the main areas where stock-pickers can add value over the long term – something that Nimmo has certainly achieved in spades.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

This article was originally published in our sister magazine Money Observer, which ceased publication in August 2020.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.