How to engineer profits from small-cap stocks

By Keiron Root

By Keiron Root

9 August 2000

Gervais Williams has been a fund manager specialising in smaller company portfolios since 1985, when he decided the time was right to switch from his original career.

"I used to be an engineer," he says. "I trained as a civil and marine engineer and ended up working on the marine side. The job was OK but it was heavily dependent on the workload from oil-related business, particularly from the Middle East, and it was obvious that it was going to contract." The oil price collapsed not long after he had joined Throgmorton (now part of Framlington) as a trainee fund manager.

"I started off looking at small caps and I have been in the sector ever since," he says. "I have never had any desire to move into other sectors or deal with larger companies."

Mr Williams, now with Gartmore, is responsible for several smaller company portfolios, including the Gartmore Irish Growth Investment Trust, and the group's UK & Irish Smaller Companies unit trust.

The inclusion of Irish companies in the latter portfolio sets it apart from its peer group, but Mr Williams says it is a logical approach for a UK smaller companies fund. "It is unusual in that it includes Irish stocks as well but many UK investors are used to investing in UK and Irish companies, because the London and Dublin exchanges were as one until a few years ago. We continue to include Irish stocks because they enable us to participate in the rapid growth of the Irish economy."

The fund's largest holding is Dublin-listed Iona Technologies, a "middleware" supplier, supplying software that lets mainframe and client/server networks interact. "It has 4 per cent of the portfolio which is a very large holding for this fund - we would not normally let it get that high - but it is a grossly misvalued stock. The company provides products and services to organisations building large-scale internet commerce applications and they have announced record first quarter results."

Mr Williams adds: "We are looking for companies that are growing rapidly, through expansion of business or increasing market share or research and development, or by acquisition or any combination of these. As fund managers, we are trying to manage the level of risk in the portfolio, because the volatility of small-cap portfolios is likely to be much higher than for large-cap funds.

"If you are running a small cap portfolio, you have more than 2000 quoted companies, including AIM stocks, to choose from, so the opportunity to hug the index is much less than if we were running a large-cap fund. So you are always more likely to hold a portfolio of bottom-up stock picks, because of the nature of the sector."

Mr Williams believes the greater volatility in the market can bring opportunities as well as difficulties. "The average holding period for our investments has been shortening over recent months - it is 18 months to two years - because the volatility is such that the opportunity for fund managers to profit from price moves is occurring with much greater frequency."

He illustrates the point by talking about the typical ups and downs of a technology flotation. "Imagine a typical company that comes to market and doubles on day one, then halves in the next fortnight and then doubles again three weeks later. Given that the opportunity presented to the investors by this volatility is in the 'mispricing' of their holdings, this creates the opportunity for greater gains.

"We are not trading the portfolio but we do have the opportunity to increase the returns from the portfolio without adding to the risks. With regard to the sector split of the portfolio, you will not be surprised to learn that we have a sector bias towards technology, both software and hardware, biotech and media stocks. But the position which is a bit unusual is that we have quite a lot in resources stocks - oil and gas and mining."

The fund's major holdings include technology companies such as Iona, Cedar Group, Interx IQE, and Inter-Alliance and biotech operations Cambridge Antibody Technologies and Oxford Glycoscience, the mining stalwarts RJB Mining and Lonmin.

The emphasis on resources stocks is not simply a case of Mr Williams reverting to his old career, but a reflection of the good value to be found in these sectors. "The oil price has risen, which has been good for the oil and gas sector, but base metal prices, particularly for platinum and palladium, have been strong too, which has been good for a major holdings, Lonmin.

"Within the oil and gas sector, there are exploration and production stocks still undervalued by the market. The strong oil price has had a lot to do with the sector becoming more attractive but a lot of these stocks have strong prospects in their own right and some of the exploration and production stocks haven't recovered quite as quickly as some of the big oil stocks."

Emphasising areas other than TMT (telecoms, media and technology) also has an effect on the risk profile of the portfolio. "The risk characteristics are very different for resources stocks compared to, say, technology or biotech stocks. There is no denying that some of these companies are quite high-risk investments, but the risks are not correlated in the same way between different sectors and what you ideally want is a portfolio where the risk profile differs across all holdings."

Conversely, there are some market sectors out of favour. "We have a big underweight position most notably in manufacturing stocks. For example, we have very little in motor component manufacturers because of the strong pound and its attendant problems."

Fund manager: Gervais Williams

Age: 41

Fund: Gartmore UK & Irish Smaller Companies Fund

Size of fund: £116.60m

Fund launched: 30 December 1994

Manager of fund: Since Launch

Fund yield: 0.35%

Initial charge: 5.25%

Annual charge: 1.25%

Current bid/offer spread: 6.5%

Minimum investment: £1,000 (subsequently £250)

Minimum monthly savings: £50 per month

Micropal star rating (maximum *****) ****

Fund performance (to 24 July 2000; offer-to-offer, with net income reinvested)

One Year 78.41%

Two Years 73.07%

Three Years 130.85%

Five Years 324.14%

Since launch 500.59%

Source Standard & Poor's Micropal