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Every week, Kyle Caldwell and guests take a look at how the biggest stories and emerging trends could affect your investments, with practical tips and ideas to help you navigate your way through. Join the conversation, tell us what you want us to talk about or send us a question to OTM@ii.co.uk. Visit www.ii.co.uk for more investment insight and ideas.
As investors, we spend a lot of time thinking about the biggest companies in the world. We often find ourselves obsessing about The US tech giants, and here in The UK, dividend hunters love to think about the HSBC's, the Shell's, and the really big beasts. But the fact is you can make some great returns by going to some of the minnows of the investment world. If we look at small and mid cap shares, they tend to be much less well researched, and in theory they have a longer runway for growth. That does of course depend on you getting it right, you being very patient, and you having enough tolerance risk.
Dave Baxter:So welcome back to The On The Money Show, looking at the issues affecting your savings and investments. We are gonna look at small cap investing through the lens of someone who's very experienced in that space. I'm joined today by Charles Montanaro. He founded Montanaro Asset Management back in 1991 and has a wealth of experience investing in small companies in The UK and beyond. So Charles, thanks very much for joining me today.
Charles Montanaro:Dave, thank you very much for inviting me. It's been an absolute pleasure.
Dave Baxter:So Charles, you, as I mentioned, have a wealth of experience kind of investing in small and mid caps in The UK. Also outside of The UK, you do have some other funds there. I imagine it's an area that DIY investors would kind of love to get to grips with. There's a lot of potential there, but there are also pitfalls, and perhaps there are criteria that you could use to find good small caps and potentially avoid some of the traps. So if you were to kind of imagine, say, a checklist for kind of small and mid cap investing, what would you include on it?
Charles Montanaro:The wealth experience always worries me, Ben. People, you didn't actually call me a veteran, which is what they normally do, which is veteran. Being very old. And all the wealth experience really means I've made many more mistakes than most of the people listening to this. The business was set up in '91, but the philosophy predates that by a few years.
Charles Montanaro:I joined the city in 1980, I worked at Merrill Lynch, and I came across Warren Buffett in 1982. And I read what he wrote, I listened to what he said, and I thought he's a genius. Why don't I simply copy what he does? So the philosophy really goes back to 1982, and I did create a checklist of basically 10 points, and here they are. The first thing we say is what's a classic modern company comprehensible?
Charles Montanaro:Warren Buffett says never invest in a company you don't understand. So my first question is do I really understand what the company does? Is it focused? Is it within my circle of competence? That's the phrase he uses.
Charles Montanaro:I have learned in my career never to invest in a shoe company. In all my career, I've never made money investing in shoes, so I stopped trying. So stick to what you're good at, stick to what you understand, make sure you know how they make money. So the first question is do you understand what they do? Then broadly, buy the best.
Charles Montanaro:Get the market leader. If you're the market leader, you're the leader for a reason. Normally they're offering goods or services people need, but if you are the number one, you're doing something right.
Dave Baxter:So would you simply look for the kind of greatest market share? Is that how you
Charles Montanaro:Normally, look at market share, you work out how they're going to offend that, have they got pricing power, what are they doing better than the competition, what are their USPs, What is the IP? Do they have a product that is outstanding? And is that could that be threatened? Number three, we're looking at quality investment. So I say high quality.
Charles Montanaro:What does that really mean? The next question I ask is, Is this company in control of its own destiny? And that is worth thinking about because if you're a very cyclical company, you are clearly not in control of your destiny. You're dependent on the economic cycle. So we try to find compounding companies that are structurally growing and again focus on whether they've got recurring revenues, whether they can be predictable, which is number four.
Charles Montanaro:Do they have must have products? Do you believe with certainty you can predict what their earnings are going to be? Because earnings ultimately drive your returns. And we only invest in companies that are profitable. That's number five.
Charles Montanaro:Why would you invest in a loss making company? You can come across lots of companies with great stories, but often loss making companies remain loss making and guess what? They often will go bust. Let's not forget small cup is great fun, you can make great returns, but they are riskier than if you're buying HSBC. And talking about risk, risk means lots of things to different people.
Charles Montanaro:For us, it's balance sheet risk. So you don't want to be in a highly gig company that's cyclical and guess what? Be unlucky and find a recession just around the corner because you will lose all your money. We are growth investors. I puzzle sometimes as to why people take a value approach to small cap because you're trying to find the big companies of the future, you're looking for growth stocks, if you're small it's easy to grow than if you're a big company.
Charles Montanaro:I used to have a phrase think of small cap as a gazelle and elephants don't gallop and then I discovered elephants do gallop but still think of nice gazelles. So we're looking for companies that grow and we look for 10% EPS growth per annum. We are looking at the compounders and don't forget really important not to forget valuation. You can find a really good company, but if you buy it at the wrong price, you won't make money. So we're Garth investors, the horrible growth at the reasonable price.
Charles Montanaro:But don't forget what Warren Buffett also says, it's far better to find a wonderful company and pay a reasonable price than a fair company at a cheap price. So we'd rather pay a little bit more to get a better company. And the last two points: go for hidden gems, what we call a hidden gem companies with maybe less than five analysts, because then you're looking at a company that is probably not very well known. There are many global market leaders out there that you won't even have heard of. So look for these gems.
Charles Montanaro:That means you're more likely to have an information edge. And small cap, I've always said in all my career, is all about people. So it's all about management and the great thing that we spend our time doing is spend time with management out of the office, inside visits, really work out are they passionate? Do you believe in what they say? Do they have big insider ownership?
Charles Montanaro:If you take all of those 10 points, you've probably got a decent business.
Dave Baxter:It's interesting, I suppose, applying this to DRI investors because I imagine some of those some of those aren't attainable, they won't be able to meet management, but then perhaps they can do things like, you know, study an area, they can perhaps do a bit of research and start to make themselves a bit more familiar with some of the financial metrics and so on. I guess also I wanted to touch on the kind of risk points. Are there any especially good ways to kind of mitigate the risks? I think one interesting thing I've observed among small cap managers is they really vary by number of holdings. So they either tend to have a lot of holdings as a way of stretching out the risk, or on the other end of things, you get some funds that perhaps take more of a kind of activist approach, they just have a few very, you know, big positions.
Charles Montanaro:I think there's a balance somewhere between the two. When I launched my first fund back in 1993, we raised after three years £10,000,000, and the idea was let's become an activist. I got my £10,000,000. Let's put a million pounds in each of these companies. The biggest company we could invest in was £50,000,000.
Charles Montanaro:Really, really small. And then my first investment I went into, I discovered actually invest activist investing is really tough, politically very tough. It's very hard to get changed by going on the board and trying to do that, almost a semi private equity approach. The other extreme, if you own a 100 companies, you can't possibly know what you're you're investing in. You become basically the market.
Charles Montanaro:So I don't think that achieves a great deal other than the market over time. The small cap effect of 2.8% per annum roughly is the outperformance you've got over seventy years. You should still do better than in large cap, but really the opportunity is to have a small number of holdings We normally have in case of Musket is just under 60 holdings. And I think you'd be paid to have 50 to 60 holdings, you've got the benefit of sector diversification, you've got a spread of exposure, and I think you can get to know these companies really very, very well.
Dave Baxter:Yeah. Well, I guess if you're a DRI investor, maybe you'd have to be more limited because you don't have those resources.
Charles Montanaro:That's probably true, but at least diversify, that's very important.
Dave Baxter:Yeah. So I wanted to kind of delve into your career and some of the kind of interesting lessons you've had, starting, I suppose, on the positive element. You know, it's always interesting to hear about people's big wins and also their kind of big mistakes and so on. What do you judge to have been kind of really successful investments of yours in the small and mid cap space, and what interesting lessons did you take from that experience?
Charles Montanaro:Okay. We all like talking about our winners, multi baggers, so I'm going give you one, and that is Decra Pharmaceuticals. And the reason why it's a good story for us is it gives you an idea of what the marketplace is and was like. So if you can wind the clock back to 1997, Lloyd's chemist actually went private. They had a small veterinary business that they didn't really want to do with them because it didn't really fit in running a chain of chemists.
Charles Montanaro:So in September 2000, they spun it off and Declar Pharmaceuticals was born. Priced at 1.2 a share, it was a market cap of £60,000,000 and that really was our sweet spot at the time because it was too small for the big institutions, Nobody really knew what they did, but for us, it was actually perfect. If you think back to my little ten ten points, we knew what it did. They were the lead in what they did in small market. They were clearly high quality, generated a lot of cash.
Charles Montanaro:So we've all got pets. The great thing about pets is they've got pricing power. If you're going to a vet, you're not going to worry too much about what price you pay for the medicine. You want your dog or your cat or whoever to get better. So it's a very nice business that is run by a guy called Ian Page.
Charles Montanaro:Ian Page is very proudly from Rochdale. He happens to be a Man City fan, which we don't hold against him, but that aside. But he was the van driver when he started life and became the CEO, and he was totally passionate about Decca. So he did very, very well. He grew the business from £60,000,000.
Charles Montanaro:By 2023, he had an approach from private equity house for £4,450,000,000. You actually made, just on those numbers, 36 times your investment. If you added in the dividends, it was 55 times your investment. Now in September 2002, we held 5.3% of the company. We were the fourth largest institution, and if we'd held every single share, we'd have made oh, I hadn't done the sums.
Charles Montanaro:£160,000,000. The problem is you obviously sell over the period of time. Why it was a good story is that we helped him understand the city, and he was very open. When he needed money for acquisitions, we helped him as well. They grew into a huge company, selling in 26 different countries.
Charles Montanaro:So there's your success story. The problem is you don't learn from your successes, you learn from the mistakes. Okay. My biggest mistake, which I think about even today, DTZ. DTZ is a name many of you will know.
Charles Montanaro:They were a London property advisor, see a lot of history. Remember I like companies that are well established, they've got a lot of history, you can track them over different cycles. They started life in 1853 as a property valuer. So basically if you want to take over a company, they would value your assets, they would go to DDZ to give you a valuation. So it was an asset like company themselves, they were basically offering a service.
Charles Montanaro:And a guy called Mark Strukett joined them, it floated in 1987, he joined soon after that and it became worth 500,000,000 on the stock exchange. Did very, very well. But here is where it all went horribly wrong. 2006, they decided to make a big acquisition in The States. 2007, they made a second big acquisition.
Charles Montanaro:And guess what? Because it's very cash generative, they paid cash they borrowed from the bank. Then the GFC comes along. All the property transactions came to a close. They started breaching all their covenants.
Charles Montanaro:By 2011, you've basically lost all your money. So my lesson from that is, well, small cap teaches you humility because I've been around long enough. I've made more mistakes, I said, than probably anybody you've met. But what it teaches you, be very careful about sick old companies and be very careful about gearing. As I said right at the start, you don't want to be in a sick old company at the wrong time of the cycle when you owe the money of money to the banks.
Dave Baxter:Yeah, I imagine it's very easy to get caught up in these kind of growth stories, and therefore, to kind of embrace some of that risk. But would you say then you do want perhaps more of kind of organic growth on the cards in order to Well, I've always said
Charles Montanaro:is you really want a company that when we meet a company, never worry about what they're going to earn in the next three months or six months. What we do want to know is where are you going to be in five years' time, and what will you look like? And if you can't tell us, then that isn't particularly good because it's very hard to value a company when you don't know what it's going to be down the road. Acquisitive companies by nature are riskier because not all deals work less than 50% of deals actually become profitable, so be very careful about the acquisition treadmill.
Dave Baxter:And say you have picked one of these kind of winners you're talking about, perhaps you are taking some profits, but you're still sticking with it. Are there any signs that perhaps it's starting to have a bit less edge? Because I I imagine naturally I mean, you know, you can say I think of companies like Games Workshops seem unstoppable and they're now large caps, but there must be points where you start to think it starts to behave more like an elephant than a gazelle if we're gonna stick with that metaphor.
Charles Montanaro:I think what you learn is you can't be complacent, you've got to keep on top of your investments, and don't assume they'll be good forever. Ian turned around and said to me, the first year after the float, I told him off because he had a profit warning, he missed his numbers. He said, Charles, thank you for doing that because that taught me never ever to go through that experience ever again. And generally, I'd learned that one profit warning normally means three. So look out for profit warnings, but look out for change.
Charles Montanaro:Look we follow management. If management changes, they're leaving, that's not good. If the acquisitions are getting ever bigger, that's increasing risk. That's not good. If they're not as forthcoming, that's be very, very careful.
Charles Montanaro:And you've got to go and meet the companies in situ, look around the plants, see what's what's going on. So the answer is if you do see change, if generally you if you have your 10 bullet points of what you look for, you should also, I I always say, give me three reasons why you're investing in this company. Have an investment thesis. Mhmm. If that thesis changes, then just reevaluate and say, well, actually, is the reason for owning this changed, and should I be doing something else?
Dave Baxter:Yeah. And perhaps it's applying that thinking of kind of would I buy it today if I was starting afresh?
Charles Montanaro:Absolutely right.
Dave Baxter:Yeah. Interesting. And to reflect again, I guess, on your kind of career, I imagine, you know, we're talking about a decent span of time, and I imagine the market must have changed hugely. And being kind of a small cap or makeup investor now versus then must come with, you know, a different set of opportunities, different set of challenges. So I guess kind of briefly, what would the most notable changes be to you?
Dave Baxter:And I suppose, as an investor in the market today, what are the big challenges you're aware of, and equally is there any kind of ray of hope standing out there?
Charles Montanaro:Decent period of time is that another way of saying very, very polite. Okay. Since I started in 1980, that was pre Big Bang, which is October. So the city was a gentleman's club. All deals basically happened at lunchtime.
Charles Montanaro:They started the gin and tonic, we ended with the port, and then you went home. Those were the eighties, they're very, very different. In those days also, people didn't have spreadsheets. You know, it's worth remembering those spreadsheets actually didn't come in till 1987. So it was very much a gentleman's club, very public school.
Charles Montanaro:If you wanted a job, had to know a partner, and that's how you got your job. If you want to invest in a company, you need you relied on the brokers. And basically, ever since Ross Gooby in 1947 created the Cult of the Equity, prior to '47, all pension funds bought bonds, very simple, and then went out to lunch. What then happened post brought brought Gooby is that actually equities gave you higher returns. So by the time I arrived in the city, the typical pension fund had maybe 75% in equities, the rest in gilts.
Charles Montanaro:If they're really adventurous, they might own one or two European names like BMW, Porsche, Danone. So it was very heavily concentrated in The UK, very much in the domestic market. So if you got 60% going into UK equities, and if small cap is about 10% of the market, they were putting 5% into small cap. Happy days. Okay?
Charles Montanaro:But things have moved on. Divine Benefits now, LDI Investing, they've gone back full circle to investing in bonds. They've gone away from equities, they've gone into passives, ETFs are out now here, they've gone global as well, and they've gone into alternatives. So whereas you had a time where, call it 60% was UK equities, now the situation with the MSCI World Index is only four to five percent invested in UK equities. Now what are they gonna be?
Charles Montanaro:They're probably gonna be large cap equities. So if your 10% is small cap, you're looking at less than half percent going to The UK small cap market. And the problem's not being helped by the consolidation that's also happened because you've now got a situation where the wealth managers are getting big, the pension funds are getting bigger and bigger, the insurance companies have got big, even the IFAs have got big. So when I started back in 1980, everybody wanted to own small cap. You've now got a situation where there are not very many buyers left of small cap.
Charles Montanaro:So what that's meant in the last four years, for example, really ever since Brexit, last four years you've seen £5,000,000,000 coming out of UK small cap. And because UK small caps had a tough time, funds are closing down. So whereas when I launched Musket in March, there were 35 UK small cap trusts, you're down to just a handful. So
Dave Baxter:what, I suppose, hope would you offer? I mean, it's interesting to note to expand on that a little bit. You know, we've seen UK equities have kind of returned back to decent health, at least if you look at the FTSE one hundred and those bigger beasts, but the smaller mid cap shares have kind of they've done well, but they've lagged that rally. Is there any kind of reason to hope that things will revert? You know, what where's the optimism?
Charles Montanaro:What I've learned in forty five years is all markets mean revert. So just when you think things can't get worse, generally speaking, things magically change. Sentiment is very fickle. Mhmm. So in March 2003, after TNT bear market, overnight, for no particular reason, the market went up, and people said it's a day cap bounce.
Charles Montanaro:Don't believe it. I think that was the start of the bull market. The GFC March 2009, the same thing happened. And it doesn't take much for the sentiment to change and some buying to come in to see a rapid change of fortune. For example, in the last month, UK All Caps saw the first monthly inflow in five years.
Charles Montanaro:The UK All Share was actually up 23% last year. They actually did very, very well. So people aren't really talking about it. The UK is actually doing quite well. Yeah.
Charles Montanaro:It hasn't happened in The UK yet, but what is interesting is what has happened in the last four or five years ever since COVID, Ukraine, Iran, and so on. What you've now seen in the last four or five years is small gap underperformed by 95%. That's a huge number over about five years. It's in a situation where quality's done really badly because people have bought commodities, they bought banks, they've been oil and gas, and and actually quality has underperformed by about 70%. Again, a very, very big number, Again, over the last five years.
Charles Montanaro:And if you look at growth investors, you've underperformed by 50% compared to value. But what is interesting if you look at lobby charts is you've actually unwound all the previous gains in the previous four, five years. They've almost completely mean reverted. And it won't take much buying for that to change because what has now happened is valuations look really pretty good. And let me give you just a couple of examples.
Charles Montanaro:In 2021, Musket was trading with PE of just under 30 times. That PE today is 13.3. And you mean the Monstera UK Small Companies Trust. That's the cheapest it's been in over twelve years. You normally pay a premium to buy small companies because you get higher growth.
Charles Montanaro:The premium back in 2021 was over a 100%. Now it's down to about 20 odd percent. So people are not paying for the growth that should be coming, and what we're also seeing this year, for the first time in three years is we're looking for double digit earnings growth from the portfolio, something like 13%. So if you're a fan of PEG ratios, you're looking potentially at a PE just over 13, with a growth not far off that, and the growth from small cap is higher than large cap, which again people haven't really looked at, so it may well be the magnificent sevens will just leave them alone for a bit because small cap may be looking more interesting.
Dave Baxter:Yeah, yeah. I guess it'll be interesting, there is a challenge potentially if we're seeing rates remaining higher for a bit longer on the back of Iran, maybe that won't be helpful, but as I mentioned at the start, is a kind of an area where you do need to exercise some some patience. One point I wanted to return to was just the idea of research. As I mentioned, you know, DOI investors don't have as many resources, but what would it make sense for them to be looking at? I mean, suppose there's kind of annual reports you wanna be on top of.
Dave Baxter:Is there anything else that kind of stands out?
Charles Montanaro:I mean, Peter Lynch, The Gillen Fund, somebody if I came up with two people, Peter Lynch and Warren Buffett were the two people I can relate to most. What he basically said is you won't find the multibaggers in a spreadsheet. You've got to invest in what you know. And I was go out to the shops. Go out.
Charles Montanaro:Get out of the office. So I think there's a lot to be said to that. So what I would argue as you and I investing, for example, start with reading. You don't have to read the very clever books with very complicated algebraic forms, which are way over my head. If I had to choose two two people, read Warren Buffett and read read Peter Lynch.
Charles Montanaro:Because they actually what they do is they make they demystify investing. They make it simple for the ordinary folk because, really, investing is all about common sense. We in the city just make it sound much more complicated than it needs to be. So I would read Read the annual report. There's so much online.
Charles Montanaro:You can just order reports and start from the back. Always read the outlook statement, obviously, but they're nearly always gonna be positive. But look at the small print at the back because that's where you find the litigation, the things they don't want you to read about. But you've got plenty of time, there's plenty of good information, and if you are lucky enough to know about AI, AI gives you more information than you can possibly imagine. So try out AI and you can get a lot of information.
Charles Montanaro:Dare I say, you can still go to a library if a library is open where you're living, but actually but what I would also say is do your research, do your homework, and why don't you buy one share and attend the annual general meeting? Because if you go to the AGM, you'll meet management, you'll probably meet the AGM at their place. So you gotta go out there. They might give you a cup of tea. We actually have very good chocolate biscuits, but you can go out.
Charles Montanaro:So there's and management are very accessible. They are very keen to tell you their story.
Dave Baxter:Yeah. So lots of interesting points there. I'm afraid that is all we have time for, but thanks for your time.
Charles Montanaro:Thank you for letting me tell you my story. It's been a pleasure.
Dave Baxter:Thank you for watching and for listening. Of course, as always, we do have plenty of additional fund analysis for you. Just go to ii.co.uk. If you have thoughts on the episodes, if you have topics you would like us to cover, do email us on otm@ii.co.uk. Hope you enjoyed the podcast and see you next time.