Three rules for picking sensible stocks

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With various stock markets and assets, including gold, reaching or close to record highs, investors who’ve failed to get in on the rallies may be concerned that they’ve missed the boat.

However, one area of the market that’s lagged, but is still a source of cheap valuations, is UK smaller companies.

In our latest episode, Kyle asks Artemis fund manager Mark Niznik to run through the three rules he lives by when seeking sensible stocks.

Niznik, who manages the Artemis UK Smaller Companies and Artemis UK Future Leaders Ord (LSE:AFL) investment trust alongside William Tamworth, names UK companies that are leaders in their respective niches.

Niznik is a professional investor happy to eat his own cooking, with his entire pension invested in the funds he manages.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments.

In this episode, we’re going to be covering how to find sensible stocks, which is no mean feat. However, I think it’s particularly pertinent at the moment given that a number of stock markets are at, or close to, record highs, including the UK, the US, and Japan, and that’s at the time of this recording, which is 13 October.

Joining me to discuss the three rules he lives by when picking sensible stocks is Mark Niznik, manager of Artemis UK Smaller Companies fund and Artemis UK Future Leaders investment trust.

Mark, great to have you on the podcast.

Mark Niznik, manager of Artemis UK Smaller Companies fund and Artemis UK Future Leaders: Thanks very much for having me, Kyle.

Kyle Caldwell: So, Mark, your first rule is to favour companies that don’t have any debt. Could you talk us through that?

Mark Niznik: I think the first point to mention is that companies go bust through having too much debt. So, if you don’t have debt, you tend to avoid companies that collapse.

The other thing is that I found that having cash or strong balance sheets give you options for the future. So, you could choose to invest more in your company with the cash that’s on your balance sheet.

You could choose to make acquisitions that would further enhance your earnings into the future or - something that has been a more recent phenomenon - you could choose to buy your shares back if you thought they were cheap in the stock market. So, having cash on your balance sheet gives you options.

Having too much debt can lead to problems if the future or your outlook tightens and your profits dip. That leads into serious problems. So, I like to avoid highly indebted situations and invest in companies with cash.

Kyle Caldwell:Have you learned the hard way by experience? Have you invested in any companies in your career, or certain sectors, where there’s been high leverage and it has come back to bite the company?

Mark Niznik:Absolutely. Most of the lessons I’ve learned have been the hard way over a long career. I would say that while we seek to invest in companies that have very strong balance sheets, there’s always one or two that have some debt. There’s one currently in the portfolio. It’s only a small holding, but it’s a company called Videndum (LSE:VID).

They have too much debt, and that came out of a Hollywood writers’ strike where they sell film equipment into that industry. When all the writers were on strike, they weren’t making the films, and the debt built up to a level that really spooked investors, caused the profits to dip and the shares to collapse.

So, it’s always there [and it makes] sense to try and avoid that situation where you can.

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Kyle Caldwell: Let’s now move on to your second rule, and that’s to look for companies that are growing at a sustainable rate and are leaders in their niche area. So, what sort of qualities or attributes does a company need to possess to be a leader in their respective field?

Mark Niznik:So, the idea behind investing in companies that are leaders in their little niches is that over the decades, I’ve found that to help companies with better buying power or pricing power.

Pricing power is important when you have inflation that’s kind of kicking back into the system. So, we’ve now got a government with slightly inflationary policies. If you think about the Budget last year where National Insurance was increased in quite a material way for companies, companies need pricing power to improve the prices to offset that cost push from the National Insurance or whatever the new cost pressure is. If you’ve got a market leader, they tend to be able to do that more than not.

If I could say an example. So, with the Budget last year, that was particularly painful for companies that had low operating margins and lots of UK staff. For instance, in our portfolio, we own Wetherspoon (J D) (LSE:JDW), the pub company. They have 40,000 staff, roughly. When you add on the National Insurance increase and the National Living Wage increase from last year, it was about an extra £60 million of costs that they had to cover off, just to keep the profits the same.

Now, while Weatherspoon isn’t a market leader, I would say they are absolutely a market leader in the value end of the pub market, and they were able to push their prices up such that in the year just gone, they managed to make £81 million of pre-tax profit, which was 10% above last year after absorbing some of those cost increases.

So, that’s what I mean by having better pricing power for niche market leaders.

Kyle Caldwell: And pricing power hands companies the ability to be in control of their own destiny?

Mark Niznik:Correct.

Kyle Caldwell: In terms of what companies need to have pricing power, is it a strong brand or a loyal customer base? Are they the two main things?

Mark Niznik:It could be many things. It could be a strong brand. So, for example, we invest in Greggs (LSE:GRG), the on-the-go food company. That has an incredibly strong brand, so it could be brand. It could be intellectual property, so it could be some kind of technology that gives you an edge over others in the market.

It could be just the pure market size relative to others in the market that gives you better buying power, so you can buy better than your competitors. You can invest more than your competitors. It could be a number of things, actually, but we’re always on the lookout for what is that niche ability to give that company better buying power than others.

Kyle Caldwell: Your third rule is to pick companies that are making money today rather than focus on companies that are promising future growth. Could you talk us through that?

Mark Niznik: Yeah. Certainly, in the world of smaller companies, it’s very easy to get carried away with a really sexy growth story. So, the company might not be making much money, or any money, but they promise very good growth into the future. And that’s really easy to get excited about. The problem with that is the expectations that are then on that company to deliver are very, very high, such that if they fail to deliver or if there’s a wobble, the shares can fall dramatically.

We prefer not to invest in companies with very hyped future expectations. We prefer to focus on companies that are producing good profits and especially great cash generation. Because it is still the case that profits can be easily manipulated to suit the company. Cash in the bank is much more difficult to manipulate.

So, we like companies that are growing their cash each year into the future at a modest, predictable rate. It is cash that pays the bills, that pays the debts, that ultimately pays dividends, and that’s what we focus on when others may be focusing on profit growth and earnings growth.

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Kyle Caldwell: And how do you strike a balance between a company paying out a certain level of dividend but not overprioritising the dividends? When companies do overprioritise the dividend, that can stunt the long-term growth of a business.

Mark Niznik: Yeah. We tend to focus on the cash flows before the dividend payments. So, it’s important for us, at least for my colleague Will Tamworth and I, to look at companies that are paying out a great cash generation. And then, again, going back to the question of too much debt and cash, that cash generation gives you options.

You can either pay it out as dividend if you want, you can reinvest it in more capex (capital expenditure) to grow the company, you can use that to buy your shares back, and you can use it to make acquisitions. We would always look at companies that pay out too much of their cash flow by dividend a little less favourably. It depends on the company, but we prefer companies to reinvest for the future growth of the business.

Kyle Caldwell: Once those three rules are applied, seen in a recent investor note, you pointed out that you’re seeing plenty of opportunities at the moment in the area of the market you invest in, which is UK smaller companies.

Before I ask you about some of the opportunities you’re seeing, I first wanted to find out your observations on why the UK stock market as a whole is so unloved.

We’ve seen the top end of the market, the FTSE 100, surpass 9,000 points around the middle of July. Yet we’re not seeing a lot of investors return to the UK market. Indeed, if you look at the fund flow statistics over the past decade, in the vast majority of months, UK funds have been experiencing outflows. So, what needs to happen for that tide to turn?

I did have it put to me by some fund managers that they needed to see a sustained period of strong performance for the UK stock market. We’ve already seen the FTSE 100 have a very strong six to nine months, and yet we’re not seeing buyers return.

Mark Niznik: I think it comes down to confidence in the domestic UK economy. If you look at what Will and I do in small-cap land, about 60% of the revenues of those smaller companies are derived from the UK market. In large caps, that’s only 20%.

So, in small-cap land we’re much more directly attuned to the domestic UK economy. And as you said, over the last decade, the UK stock market and the economy has been on the kind of investor ‘naughty step’.

We’ve had Brexit, we’ve had the threat of a Corbyn government, we’ve had the Kwarteng/Truss budget. We’ve had a lot of negativity in investors’ mind thrown at that market, and that’s caused significant worry. We think that’s about to change.

I suppose Will and I would frame it as kind of an each-way bet, an investment in small caps at the moment. On the one hand, if we’re right, as employment doesn’t collapse, then consumer confidence should grow. As consumer confidence grows - the consumer is about 60% of the UK economy - that should help grow the UK economy.

At a time when US investors are kind of questioning the growth in the US, the valuations there are much higher than the UK. So, it wouldn’t take much for a small shift from one out of the US into the UK to make a significant difference to UK market as a whole and to UK small caps, especially. So, that’s on the one hand.

On the other hand, if we’re wrong and the UK economy continues the kind of mediocre, bumbling along we’ve had for the last decade, then a return in UK small caps will be more of the same, I would suggest. We’ll continue to get outflows, and the returns from small caps will be a diet of takeovers and share buybacks.

Now, I say it’s an each-way bet because in that environment, that’s kind of what it’s been for the last decade. Our fund has managed to return over a 100% in that decade. That’s an 8% a year return when the return in large caps has been 7%. So, that’s not a brilliant outcome, but it’s not bad. So, it’s kind of not too bad on that bet as opposed to the first expectation of very good growth.

Kyle Caldwell: Within UK smaller companies, are there any particular sectors or types of businesses that you would point out are offering outstanding value?

Mark Niznik: Yeah. Well, Will and I are stock pickers, so we’re not kind of top-down macro people. But because of that worry over the domestic UK economy, a lot of domestic cyclical companies have been put on such good value ratings.

So, we’ve been able to invest in market-leading companies such as Dunelm Group (LSE:DNLM), the market leader in home furnishings; DFS Furniture (LSE:DFS), the market leader in sofas; Hollywood Bowl Group (LSE:BOWL), the market leader in tenpin bowling; Jet2 Ordinary Shares (LSE:JET2) in holidays; Moonpig Group Ordinary Shares (LSE:MOON) in online greeting cards, and Victorian Plumbing Group (LSE:VIC) in online plumbing.

All these companies are market leaders in their little niches, and they’re on very low valuations because of the negativity surrounding the domestic side of the UK economy.

So, we’ve invested in those, and we hope as that negativity subsides, the share prices of those kind of companies should improve.

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Kyle Caldwell: As you’ve mentioned, the UK stock market is trading on a much cheaper valuation than across the pond. When you compare the UK smaller companies with its own history, how do the valuations compare today?

Mark Niznik: I would say the UK small-cap market is pretty reasonably priced. It’s not the absolute lowest that it’s ever been, that would be wrong for me to say. It’s certainly a lot cheaper than many of the other Western stock markets that you could invest in. So, on a relative basis, absolutely, it looks good value.

Will and I are very excited about the prospects here because there’s so much negativity around investing in the UK at the moment.

Kyle Caldwell: It’s an area of the market [where] I know you’re putting your money where your mouth is. As I understand it, you invest your whole pension in the funds that you manage, although you do caution that this isn’t for everyone. Could you talk us through that?

Mark Niznik: Absolutely. So, when Will and I meet new companies, we always like to see the directors of those companies owning a decent amount of those companies because it aligns our interests as shareholders in the company with the directors’ interests in the company. We’re financially aligned.

So, the same way, if I’m sitting here with you, Kyle, and saying, ‘Yeah, Will and I are really excited about the prospects for UK smaller companies. We think it aligns interests.’ But I would say the real reason is that we think we’re going to make a lot of money by investing my pension and Will’s pension in this area.

Will and I have bought just over £2.5 million worth of shares in the Artemis UK Future Leaders Investment Trust in recent months because those shares are on a 15% discount to the underlying value of the trust asset, and that company is about 90% the same as our larger unit trust.

So, to me, if we’re excited about the future for UK small caps, we can buy this company on a 15% discount. That’s why we’ve invested out our money.

Kyle Caldwell: That’s all we have time for today. My thanks to Mark, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app, and if you get a chance, please do leave us a review or a rating in your podcast app too. We love to hear from you, and you can get in touch by emailing OTM@ii.co.uk.

In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website, which is ii.co.uk. I’ll hopefully see you again next week.