Two fundamentally sound smaller companies that still merit a place in our portfolio
Heightened economic and political uncertainty means we will favour quality businesses over ‘story stocks’, says Robert Stephens
Separating the wheat from the chaff is a key part of investing in the stock market. It is even more important when you are buying smaller companies, since a relatively high proportion are of questionable quality. The prevalence of weak balance sheets, a lack of sustainable competitive advantage and excessively ambitious growth strategies means investors must be highly selective, and embrace diversification, when they buy smaller companies.
This is particularly relevant in today’s uncertain economic and political environment. Smaller companies could be hit harder by falling consumer spending, rising interest rates and high inflation than their larger counterparts. As a result this column will persist with
a fundamentals-led approach that prioritises safety over speculation when allocating capital within its Inheritance Tax Portfolio of Aim-quoted stocks. Encouragingly, existing holdings such as Craneware continue to be conservatively financed. The Us-focused hospital software firm’s recent full-year results reported a net-debt-to-equity ratio of just 20pc despite the acquisition of a rival, Sentry, during the year. This suggests it could make further acquisitions without coming unstuck in an era of higher interest rates. The results showed that sales had risen by 119pc and adjusted earnings by 29pc. Recurring revenue increased by 164pc, so the business now has greater visibility on sales, while customer retention remains high.
According to the company’s latest trading update, released earlier this week, progress has continued in the first four months of its current financial year. Although the US healthcare industry’s recovery from the pandemic has been sluggish, the business has been able to manage the rising input costs that have compromised many companies’ profitability in recent months.
It is well placed to contend with many of the economic difficulties, such as rising interest rates and high inflation, that are likely to persist over the coming months. And with a sound competitive position, strengthened and broadened by the acquisition of Sentry, it is well positioned to deliver further sales and profit growth.
Since we first tipped the stock in
March 2017 it has gained 71pc; it has risen by 20pc since its addition to our IHT portfolio in January 2018. It now trades at around 25 times forecast earnings. While this is high relative to many stocks in the current market downturn, Craneware’s solid financial position, clear competitive advantage and long-term growth prospects mean it has further return potential. Hold.
Update: Brooks Macdonald
This wealth management company, part of our IHT portfolio since August 2018, is another fundamentally sound business. Since then the shares have slipped by a modest 4pc but it has paid 14pc of our purchase price in dividends. It has raised its divi every year since 2005 despite the numerous bear markets and corrections along the way. The current bear market has, unsurprisingly, led to a sharp fall in the shares, which have lost 30pc so far this year. If the market falls further, Brooks is likely to fare even worse because of the link between its funds under management – and hence its income – and asset prices.
In its latest quarterly update it said funds under management had fallen by 0.9pc against a backdrop of volatile markets. However, investors had still entrusted £200m of new money to the company. This amounts to around 1.3pc of funds under management and shows that its underlying performance has been relatively positive.
The company continues to have an upbeat long-term outlook. The proportion of people aged over 65 is growing and we are increasingly forced to organise our own pensions instead of relying on defined benefit schemes. And, while short-term share price volatility is likely to be high thanks to ongoing economic uncertainty, the company’s status as a “leveraged” play on the stock market means it is likely to generate high returns in the next bull run.
At 15 times forecast earnings, Brooks remains relatively inexpensive. Its solid fundamentals, sound income prospects and recovery potential earn it a continued place in our IHT portfolio.