How to Find Small-Cap Opportunities: Part 1

This is the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with Alex Wright of Fidelity Worldwide Investment's UK Smaller Companies fund and Fidelity Special Values Investment Trust. Alex explains what is meant by a small cap and how he goes about finding buying opportunities among the stock market's smaller companies. He also explains his criteria for selling them. They look at a host of small caps that include Micro Focus (LSE: MCRO.L  ) Optos (LSE: OPTS.L  ) Paragon, Fyffes, DCC, United Drug, and Speedy Hire.

You can read the second part of the transcript here. You can listen to or download the full podcast here.

EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with Alex Wright.

David Kuo: This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and my guest today is a man who likes small things. He is Alex Wright of Fidelity Worldwide Investment. He runs the UK Smaller Companies fund, but is also in charge of the Fidelity Special Values Investment Trust. So welcome to Money Talk, Alex.

Alex Wright: Thank you.

David: Thank you so much for coming to talk to us today, because on the day that we're recording this podcast, it's also the big parade out in the City of London.

Alex: Yeah, no -- it's certainly very interesting out there. We got a chance to see a bit of that on our way here to the studios, which was nice.

David: So what would you prefer doing? Watching the pageant, or being in here with me?

Alex: I guess totally honestly, probably watching the pageant!

David: The same here, but the things we have to do. Now, I'm assuming that, just because you're taking over the Fidelity Special Values Investment Trust, that you're not going to abandon your love of small and medium-sized companies -- is that correct?

Alex: Yeah, that's certainly correct, so I'm going to continue to run the U.K. Smaller Companies fund, which I've been doing for four-and-a-half years, and that's very much still part of my remit, and going forwards, obviously the investment trust comes on top. That is going to look at the whole market in the U.K., but with a sort of small- and mid-cap bias, and obviously the smaller companies funds continue to be focused in that area of small and mid-cap companies.

David: OK, now, one thing that perplexes private investors, and also people like myself who've been in the market for a long time, is the definition of a small-cap company. What is your definition, or your take, on a small-cap company?

Alex: So in fact probably, in terms of companies in the wider scheme of things out there, small cap extends to really quite large companies. So the IMA sector definition, which is what the Smaller Companies fund follows, is actually companies below about one-and-a-half billion pounds of market capitalization.

David: That's not small, is it?

Alex: So that's actually quite a large company, but that definition is there because it's the bottom 10% of the U.K. market by market cap is defined as a smaller company, and today that's about one-and-a-half billion pounds. I think it's because, at the large cap end, some companies are really very large, and make up a big percentage of the U.K. market, even though there's not actually that many of those companies in number.

David: OK, so some people say that smaller companies are inherently riskier than large companies. Why would you like smaller companies, if they are inherently riskier?

Alex: I think, in terms of volatility, you can see increased volatility in smaller companies that you can in large companies. A lot of that is around sort of the rule of small versus big numbers, so if you're a small company, things that can change can have a much bigger effect on the company than maybe they do in a very large company, where things tend to be steadier. So on an individual basis, the volatility of each individual company can be somewhat higher in smaller companies, and that's why people see them as more risky and potentially more volatile. Actually though, when you look at the market as a whole, over the last three years the small cap sector's actually been less volatile than the large cap sector, and a lot of that is to do with the kind of companies you actually see in the large cap indexes today, so over the last three years, quite a bit of that index has been in banks and materials companies, and those have actually been incredibly volatile over the most recent period. So while I think there are some characteristics that have, in the past, made smaller companies more volatile, that hasn't actually been the case recently, and especially if you have a diversified portfolio of small-cap companies, I think a lot of that volatility on the stock-specific level can be counteractive.

David: OK, that's an interesting point, because how much of small-cap exposure should you have in your portfolio to make it in any way meaningful? Because obviously the large caps are the ones that are going to be mostly what you will be holding in your portfolio, wouldn't it?

Alex: So I think that's a tough question, because obviously it depends on each investor's particular circumstances, and obviously I'm not the sort of advisor looking at asset allocation, but I do think smaller companies have the chance of outperforming large caps over the long term, and therefore, certainly from my personal investing, I do think a meaningful part of your portfolio should be in small companies, because I do think over the long term, be it five or ten years plus, you're going to see better performance from this part of the market, because there's that many more opportunities to choose from here. So I think yeah, a meaningful part of your portfolio is a good place to start, and certainly when you think about sort of special values, which I'm also running, that can go across the cap spectrum, I'm going to have about 60% of that portfolio in sort of mid and small-cap area.

David: OK, so let's take a look at one of the companies that you quite like, I presume -- it's called Micro Focus. Tell me about Micro Focus and why you like it.

Alex: So Micro Focus is a company that I really like, and has been a very good performer for the Smaller Companies fund. At its heart, it's actually a very high-quality business, although not a particularly high-growth business. So this is a software company, and it does COBOL programming, so COBOL is actually a really old programming language -- it's the programming language of mainframe computing, which has been around since the 1970s, and then it's at the heart of a number of different companies, and runs a lot of the big transactions that you see in big business. Because it isn't really an area that's growing, there's also very little competition in this area, and that's the thing that really attracts me to the business. So in the sort of SME part of the market, sort of mid-cap corporates and small-cap corporates, Micro Focus have close to a monopoly position, because all of the old suppliers have really pulled out, and there's only them and IBM really left in the market, and IBM tend to focus on much larger companies, leaving a large part of the market available for Micro Focus to aim at.

David: I remember going back well over a decade now, some of my friends did work at Micro Focus, and at the time it was perceived as a primarily growth company, but then growth fell off a cliff. So are you saying that Micro Focus now is primarily a yield play, rather than a growth play?

Alex: I think it's ... so certainly, I bought it because I saw a very attractive sort of total shareholder return, so it wasn't just about the yield that the company was producing, which admittedly was strong, and continues to be strong today, so this is a company with a dividend yield of over 4%, but also there had been some short term problems with the company, which is what you see in a lot of my investments. So I tend to try and buy after a period of underperformance and potential problems, but where I think there's something that can be fixed within a business. So Micro Focus was trying to go after growth in what isn't really a growth industry, and so it hired in new sales teams, was going after bigger contracts, going more head-to-head with IBM, and not surprisingly that turned out to not be a particularly good policy, because IBM have a much better sales team, and they've also got more resources than Micro Focus, so they really failed at actually powering growth in the business by bringing in that sales team, and that was very bad for the profits of the business short term, because they invested for growth, which didn't then come through. So I thought there was a sort of short term turnaround in what was quite a high-quality business, and it was undervalued because of those near term issues, and it was more that sort of change that I was looking to play, rather than thinking, oh, this is a good yielding business that was good as part of the investment, but not the only thing I was looking for.

David: So in fact, you're not planning to hold this for the long term, or are you planning to hold it for the long term?

Alex: So I don't tend to hold stocks for the long term. I tend to have around a 12- to 18-months holding period, so my kind of investment rationale tends to be around recovery-type investments, so looking for change within companies, often where things have gone wrong, but certainly where they've sort of been overlooked, and people tend to view companies negatively. Using our research at Fidelity, we try to find companies where we think there's going to be positive change going forward, and then if I hold the companies through that period of change, that's why I'm hoping for the larger stock price appreciation. Once that change has come through, even if the investment still looks OK, I would still look to reinvest in more change candidates, because I think that's the way to generate the larger stock price returns.

David: This is probably quite a nice time to talk about another company that you did like at one time, and presumably you're not that keen on any more -- it's called Optos. When I was talking to one of the analysts on our Share Advisor newsletter service, I said, Alex is coming in to talk about Optos, and he went, "Grill him about Optos -- I want to find out as much as possible about Optos," and then the bombshell was dropped, and I found out that you had in fact reduced your holding in Optos. So what happened at Optos that made you change your mind?

Alex: So when I buy a company, I'm looking for positive change, and then looking to sell out sort of after that change. Optos is slightly unusual in that there were a number of different changes happening at the company, so the thing that initially interested me is that, from its IPO, Optos had a very poor period, and the stock price lost a lot of its value. There was a new management team that came in, and basically what they were trying to do is turn around the underlying fortunes of the business. So this is an interesting company, it's a company that takes a picture of the inside of your eye, which is called an optomap, and it's mainly deployed in the U.S., and it mainly had a rental model at the time I purchased it. The problem the company was having was that, while they'd done a great job of selling this machine, they hadn't done a good job of following this up with after care, or trying to prove the medical worth of the technology. So a lot of opticians who were thinking this was a great product, taking it, signing up to a rental contract, weren't using it as much as they'd hoped, and therefore were making a loss on the product. So their installed base was actually falling, and that was the reason for the shares' initial underperformance, from 2007, I think, when it floated, to about 2009. At that point, the management team left, and a new management team came in, and I met them for the first time in late 2010, and that management team was headed by Roy Davies, who previously was at Gyrus, which was an investment other people at Fidelity had made quite a lot of money in, where he turned around that company, so he had a very good pedigree. So I thought some of the things he was saying about trying to change the business really could get quite a lot of traction, so putting in that after-sales support, showing the medical need for the technology, and stabilizing the underlying core. So that looked interesting from one side to me, but then the other really interesting thing that was happening is that there was a new product under development, and this had been under development for a number of years, and it would basically take their existing product, put it into a much smaller machine, and a machine that cost an awful lot less to make than the existing product. So the old product cost $65,000 to produce; this new one only $10,000, so a really big change in the business, and that's why it was quite a large position in the fund previously. What happened, as time went on, the first thing that I was looking for in terms of the stabilization really came through, so the installed base stopped shrinking, and the cash generation from the base business much improved. The new product also continued to be developed, but in part of that development there was considerably more cost going into the business than I had expected. Therefore, while sort of the first change that I was really hoping to come through did come through, the second one, with sort of the new product, did not turn out as I was expecting in terms of the cost versus benefit of that. It meant that, in terms of that product needing to be a success, it was going to have to be an awful lot bigger than maybe I thought it would be originally, to justify the much higher costs that were going into the business to support it. Therefore I do think this is potentially an interesting story still over the medium term, because of that much higher cost base, I think there are worries about short-term profitability in the business, and this is already a business that sort of had outperformed because of the stage one change coming through. Therefore I wanted to cut my position, because of the potential sort of short-term hiccup, even though I do think sort of medium-term, this could still be quite interesting.

David: But as a fund manager, how important is it for you to be in contact with the management of the companies that you are investing in?

Alex: Yeah, so that's really important to me, so I will have met at least 95% of the companies in the fund personally, because I really want to see the management, and hear first-hand what they're trying to do to the business, because if you are investing on the basis of change, you're not going to see that from a spreadsheet or a quantitative screen, because this is something that's going to happen in the future, rather than is sort of happening today. I think what's important as well though, it's not just to meet the management of the companies themselves, because obviously managements of companies are always going to have a bullish outlook from their business, but also to follow that up and talk to the customers, talk to suppliers, competitors, and hear if what they're saying is backing up what management are saying to you, and so you can get a well-rounded picture of the company, and that's something that we use the Fidelity research team for, and is really, really helpful for me.

That was the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with Alex Wright of Fidelity Worldwide Investment's U.K. Smaller Companies fund and Fidelity Special Values Investment Trust. Alex explains what is meant by a small cap and how he goes about finding buying opportunities among the stock market's smaller companies. He also explains his criteria for selling them. They look at a host of small caps that include Micro Focus and Optos.

In the second part of the transcript, they discuss Paragon, Fyffes, DCC, United Drug and Speedy Hire. Just click here to continue reading.

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David does not own shares in any of the companies mentioned. The Motley Fool owns shares of International Business Machines. Motley Fool newsletter services have recommended creating a synthetic long position in International Business Machines. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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