Four stocks that are recession winners

Neil Hermon, fund manager of Henderson Smaller Companies (LSE:HSL) investment trust, has a fifth of the portfolio in consumer discretionary companies. With a UK recession all but confirmed for 2023, Hermon names the economically sensitive companies he thinks are best placed to weather the storm of a likely decline in consumer spending. He also names reasons to be optimistic in 2023, and explains why he is confident that smaller company shares will outperform Britain’s biggest businesses over the long term.

Henderson Smaller Companies Investment Trust is a member of the interactive investor Super 60 investment ideas list.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today I am joined by Neil Hermon, fund manager of the Henderson Smaller Companies Investment Trust. Neil, thanks for coming in today.

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Neil Hermon, fund manager of the Henderson Smaller Companies: Thanks for having me, Kyle.

Kyle Caldwell: In 2022, UK smaller companies have notably underperformed UK larger companies. What needs to happen for that to change in 2023?

Neil Hermon: I think there's several reasons why markets have been so difficult in 2022, starting off with the zero-tolerance policy towards Covid in China, which has impacted on the economic growth there. We've had the war in Ukraine, clearly not helpful for the geopolitical situation and, risk-taking, but it has also led to a significant rise in raw material prices around metals, oil and food. And the big impact there has been around energy prices, as Vladimir Putin has weaponised the gas that they've been importing to Europe. That's exacerbated the cost-of-living crisis for the UK consumer, or the Western consumer.

We're seeing rising prices of anything energy-related, but also things like food, etc. We've also had a very different policy from the central banks. At the end of 2021, you had a pretty dovish perspective in terms of inflation, transitory, low interest rates, and quantitative easing throughout 2022, as inflation, and perception of it, becomes more embedded.

Central banks have been more hawkish, so we've seen a significant rise in interest rates throughout the course of this year as they try to essentially compress or depress the economy, for demand destruction, to affect the economic growth.

We've also seen within the market a trend from away from growth towards value and the impact of long-term interest rates rising means that the future cash flows of companies gets depressed. Obviously, that [affects] growth companies more.

And then more recently in the UK perspective, we've had some sort of political shenanigans, which have clearly been somewhat traumatic over the last couple of months. So, lots of reasons why markets performed badly. Mid and small-cap has underperformed large-cap, they tend to be more sensitive to the economic slings and arrows. And therefore, in a market where the economy is in a more difficult place small and mid-cap tends to underperform. You get that flight to liquidity and the safety of large-cap.

Saying that, can you talk about what’s going to happen from here? I think there are some reasons to be positive about, certainly, our space of the market, mostly about the micro, the companies we invest in. So, the operation points out that our companies remain very robust. Although things have become more difficult, earnings growth has still been very robust. So, the portfolio is growing its earnings by around 19% this year and forecast 10% next year.

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In some ways, we've already had that underperformance. So, markets move ahead of the reality, mid and small-cap down 20% this year reflects what they think about the future. So, we've already had that underperformance already in place and that provides an opportunity going forward.

Valuations are very low because of significant compress throughout the course of this year. If you look at any strategy piece, the UK market is very, very cheap and that's also the case with our own portfolio.

Balance sheets very good order, lowly levered, over half our portfolio’s got net cash. There's no financial risk there. We're seeing director buying. We're seeing dividends go up. We're seeing buybacks, companies think their own stock is quite cheap. So, there are a number of reasons why we are quite positive about the micro-fundamentals of our portfolio.

What are the catalysts for things to get better? Probably three things I'd pick out, an end to the zero-tolerance policy towards Covid in China, and there are some signs, maybe, that's kind of at the edges getting a little easier. A resolution in Ukraine, unfortunately, no sign of that coming anywhere soon. But clearly, obviously, that would certainly help in terms of inflation and the gas price.

And most importantly, really, it's around the market perceiving a peak in interest rates and inflation. It's the uncertainty which causes the problem rather than the certainty. So, throughout the course of 2022, the news on both things just got worse and worse and worse, and interestingly enough last week when the US CPI numbers came out, and they were actually below expectations for the first time in about eight/nine months, the markets, performed very well. So that's what we really need for a better environment for 2023.

Kyle Caldwell: You've just given some reasons for optimism and named some catalysts, but the big elephant in the room is that the UK looks like it's going to enter a recession. Have you prepared the portfolio for that scenario and how will the portfolio cope with this challenging economic backdrop?

Neil Hermon: So, we haven't really changed the portfolio. We are a relatively low turnover portfolio anyway. We do believe in investing for the longer term within the companies and finding quality businesses that will deliver long-term returns. So turnover is low, average holding period of stocks in our portfolio is around five years. And it's very difficult trying to avoid economic movements within the context of small-cap. We don't have many defensive-type sectors. We can't invest in tobacco or staples per se. So, most of our stocks are reasonably economically sensitive. So, we haven't changed our philosophy process. We haven't changed the sort of things we look at, at all. We do have structural growth drivers in our portfolio. Being a growth fund manager, we're overweight in areas like software and media and electronics, which generally are going to grow over the longer term. So, we are cognisant of the fact that the economy is going to be in a way more difficult place next year. But I think our companies are well placed to deal with that.

Kyle Caldwell: The portfolio has around 20% in consumer discretionary companies. Could you name a couple of examples of firms that you think will be able to weather the storm of a predicted decline in consumer spending during a recession?

Neil Hermon: I think yes, it's a fair point. I think as exactly as you said about 20% of the portfolio is in consumer discretionary. It's very hard not to have anything in small-cap given it's quite a high portion of the overall index.

So, some of the companies, I think, will survive well given a more different environment next year. So, for example, Hollywood Bowl (LSE:BOWL), a leading provider of bowling alleys in the UK, it's in the name really. Why do we like it? Very good management team. Got a very strong balance sheet, got net cash. It's quite a resilient part of the market, low-ticket item, affordable treat for the family and they've got some good opportunity for growth in the context of they're rolling out their Puttstars concept, kind of crazy golf and also they're expanding in Canada as well. So, we think that's well placed to withstand.

A second example will be Young & Co's Brewery (LSE:YNGA), so Young's is a pub chain, particularly focused around London, the South East/the South West. High-quality estate, freehold estate, quasi-family run, so very conservatively managed, balance sheet in an incredibly good place, lovely pubs, places you and I would love to go and have a pint or somewhere to eat. And a very high social demographic customer ‘AB’, 30 to 54. Lowly levered, going to have an opportunity to buy some new pubs as they go through the course of year, as things become more difficult. Trading well below its own asset value, so I think that will survive and succeed into the future.

Third example, Team17 Group (LSE:TM17), it's a developer of computer games, that's a growth area in the market. We've been investors since IPO, it's delivered consistently throughout that period of time through developing new games, not triple-A but more the A and AA games and they've had a good recent success with some new games in the last few months, plus also made some very good acquisitions of strategically important things like buying in their own IP. So again, I think good set well for 2023.

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And just to throw one maverick example into the equation, which wouldn't be a logical place to put your money in a consumer downturn is DFS Furniture (LSE:DFS). It's a leading retailer of sofas in the UK. Now, you think clearly in the context of a difficult consumer environment, big-ticket items like sofas, wouldn't be on the priority of consumers, and it probably won't be, and we acknowledge the fact that it's going to be a much more difficult year, next year. However, a good management team, very strong balance sheet. And what's been proved in previous recessions is that, DFS is a winner. They've taken market share in every previous session as some of the weaker competition goes to the wall. So, although we know the next 12 months for DFS is going to be tough, as we come out of this, as inevitability we will do, because economies are cyclical. It will have a higher market share and a higher ability to earn more money going forward. So very cheap valuation today, difficult for next 12 months, but I think in the longer term is a winner.

Kyle Caldwell: The trust pays a dividend and on that front, dividend growth has been consistent since 2003. Could you name a couple of examples of income-paying smaller companies that you own?

Neil Hermon: Yes, so exactly as you said, we've got a good long-term track record of dividend growth on the trust, it's 19 years unbroken. This next year would get us into the ‘dividend hero’ status. And that's really a function of the fact we're investing in high-quality growth companies. We do like our companies to pay dividends, we think it's a good discipline to have. So, we like, profitable, cash-orientated dividend paying companies.

Over 80% of our portfolio pays a dividend. So, we think it's an important characteristic. And the growth and dividends has been a function of the fact these companies are growing their earnings, therefore growing the dividends. So, a couple of examples of stocks that are high dividend payers would be OSB Group (LSE:OSB), the buy-to-let lender, and Victrex (LSE:VCT), a speciality chemicals business.

Kyle Caldwell: You've spoken about 2022. It's been a difficult year to be a smaller company investor. Are you confident that over the long term, say, on a five to 10-year view, that UK smaller companies will outperform UK larger companies?

Neil Hermon: Yes, I think the context here is that smaller companies are less liquid, more volatile than large companies and tend to be more prone to the swings of economic cycles. So, in a time when things become more difficult, there's a propensity to underperform. However, if you take a very long-term perspective, so a 65-year view, which is the LBS review of the small-cap impact, smaller companies have outperformed by an average of 3% per year against large-caps. And that basically equates to using compounding up, an eight-fold return. So, the long-term returns of small-caps is incredibly, incredibly strong and much better than large-caps. I don't think the reasons for that are broken at all. So, it's basically about the law of large and small numbers, growing from a smaller base, more innovative industries, the ability for management team to have more of an impact, a source of new ideas and technology. All those remain valid. So, we don't see a reason why small companies won't continue to deliver great long-term returns for investors. This year has been difficult, but that doesn't really damage the long-term ability for small companies to do that.

Kyle Caldwell: And finally, a question we ask all fund managers we interview. Do you have skin in the game?

Neil Hermon: Very much so. So as part of the bonus structure at Janus Henderson, some of our bonus is deferred and that deferral goes into essentially, Henderson Smaller Companies. So I've got a significant amount of deferred in that perspective. I've also bought equity during my tenure at Henderson Smaller Companies and never sold a share. So that's a pretty large part of my financial wealth. I think that's really important. I think it's important to have alignment. And essentially, if you can't back yourself, who can you back? So, yeah, I am very much aligned with other shareholders.

Kyle Caldwell: Good to hear and thanks for your time today, Neil.

Neil Hermon: Thank you.

Kyle Caldwell: That's all we have time for, for today. For the rest of our Insider Interviews, you can check out our YouTube channel where you can like and subscribe. Hopefully, see you next time.