Harry Nimmo’s six tips for stock-picking success

Star fund manager Harry Nimmo, who will retire at the end of this year after a 40-year stint as a fund manager, talks toKyle Caldwell, collectives editor at interactive investor, about his rules for finding winners in the UK smaller companies space. He also reveals three longstanding holdings he continues to back, gives his views on the prospect of a recession, and reveals the investment lessons he’s learned during his career.

Kyle Caldwell, collectives editor at interactive investor: Hello and welcome to our latest Insider Interview. Today, I’m joined by Harry Nimmo, fund manager of the abrdn UK Smaller Companies Growth (LSE:AUSC) Investment Trust. Harry, thanks for your time today.

Harry Nimmo, fund manager of the abrdn UK Smaller Companies Growth Investment Trust: Well, thanks for having me.

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Kyle Caldwell: So, Harry, it's just been announced that you will be retiring at the end of this year after a 40-year stint as a fund manager. Could you summarise the key investment lessons you've learned over that period?

Harry Nimmo: Well, the first one is the importance of momentum. The idea behind that is that businesses are either getting better or getting worse. There's a dynamic of change going on, and the important thing in investing is to get on board with those companies that are getting better. [Those with] strong momentum that are exceeding expectations. A second important factor is that you have to have a strong and stable investment process. This gives real consistency and visibility, and it means the importance of the manager is less, the process is more. So, we have a screening process that is back-tested. We call it the matrix, and this helps us be consistent, and it also helps to cut down the legwork. We only concentrate on and research companies that score really well on our matrix as potential buys, and likewise, if we see any poorly scoring stocks in our portfolio, we ask ourselves, why do we own these stocks, and these are candidates for sale.

Another important thing I've learned is that smaller companies that are successful in the UK can quite often translate their success internationally and this gives them a far larger market to go for. Another thing is that founder-run businesses are often very important. Five out of our top 10 stocks are founder-run, and these are special people in business terms. They can both start businesses [and] grow them into businesses that make tens of millions of pounds of profit, employing maybe 1,000 people or more. So, these are some of the lessons I've learned.

Kyle Caldwell: You've been managing abrdn UK Smaller Companies Growth trust for nearly 20 years. How has the portfolio evolved over that time?

Harry Nimmo: A lot has changed in the last 20 years. The first thing is that, really in the 1990s, traditional manufacturing used to dominate the small-cap world. Paper and packaging, textiles, engineering, chemicals and the like, that's all changed. They've all gone overseas and that sort of sector barely exists anymore. We've seen the rise of the internet, online technology, and many sectors have changed completely, and it's been led by smaller companies.

We've seen it in retailing with the likes of ASOS (LSE:ASC). We've seen it in airlines with automatic booking, Jet2 (LSE:JET2) and the likes. Hargreaves Lansdown, all the platform companies. We've seen it in price comparison sites. We've seen it in healthcare with Abcam (LSE:ABC). New companies come in and take market from the old, traditional businesses. Online gaming was another one. The likes of Paddy Power, which is now with Flutter Entertainment (LSE:FLTR).

So, a major change, if anything, that has run its course. This is also what we see. We see stocks and companies that are growth companies. Many smaller companies, they reach a plateau, and part of it is about judging when that plateau has been reached. Thirteen of the current FTSE 100 largest companies have been in our smaller companies portfolio. But once you get big, it's much more difficult to go to the next level and become even bigger. Businesses naturally mature. These are some of the things that we've learned as the portfolio has evolved over the last 20 years.

Kyle Caldwell: You have six rules for investing in UK smaller companies. Could you run through each of them?

Harry Nimmo: OK, this will be very brief. The first thing is quality. Invest in quality. That keeps you out of trouble in recessions. Our main factor for quality is called Altman Z-scores. It's a composite measure of balance sheet and cash-flow strength that we track constantly and build into our matrix. All our companies, or nearly all of them, have high matrix scores.

What Altman was trying to do was spot companies that were going to go bust, or were more likely to go bust, so that he could avoid them. We try and do that, too. So that's one part of quality. There's also the human part of quality. Low staff turnover and low management turnover is very important to us. That’s the human part of quality within a business. So quality, that's one. Growth is another. We prefer to be in growing businesses rather than contracting businesses. This helps you through a recession, for instance. Growth companies can grow when the economy is contracting, and that really helps you out in the difficult times that you get in a recession.

The third point is momentum. I've already talked about momentum. This is the idea of the dynamic of change, where businesses are getting better, we always want to get on board with the improving companies, the improving situations. And we put it all together in a matrix, as I said, and we use it to pick stocks so that we can cut down on the number of stocks we research. There are, after all, 1,000 listed smaller companies in the UK. There's only 50 in our portfolio. We don't need to know about all the 1,000 companies. It's only the shortlist, the 100 or so, that could make it into our portfolio that we need to research very thoroughly, so we concentrate our efforts.

The next one is that we run our winners and cut our losers. We run substantial amounts of smaller companies. We don't want to be trading constantly. We want to get on board with great companies and run them for many years, and our average holding period is actually very high, it's probably running at four or five years now, and that’s important in our process. And finally, we are value aware, but we don’t let valuations drive our investment process. A company that’s cheap is quite often cheap for a reason. There’s a profit warning around the corner. There’s a dividend cut in the post. That’s why stocks are cheap. Sometimes you get what you pay for in smaller companies.

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Kyle Caldwell: You've just mentioned that one of your rules is running your winners. Could you give a couple of examples of companies in the portfolio today that you've held for a long time?

Harry Nimmo: Well, there's three I could name. Three out of our top five, including the first and second stock in the portfolio. The first one is Telecom Plus (LSE:TEP). They own the multi-utility vendor called Utility Warehouse. You can buy your gas, electricity, fixed mobile telephony [and] broadband all on one monthly bill from them. It's a strong business model and they have a supply agreement with Npower for their gas, so they're not at risk from any price issue and supply issue with gas. And they have benefited dramatically recently from the demise of nearly all the alternative energy suppliers which have not got supply arrangements on their gas. So that's one. We've been a holder of that company for probably 15 years.

The second one is Kainos Group (LSE:KNOS), [which is] run by Brendan Mooney. He comes from Belfast. It's an Ulster-based company. It specialises in digitalisation. This is turning paper-based processes into online processes, things like doing your tax return, your parking permit, all those kinds of things that are now done on a computer, online. Kainos does all the work to set up these processes. It's also becoming international. It used to be entirely UK, but it’s now big in Europe and in America as well.

The third firm is Hilton Food Group (LSE:HFG). It specialises in beef products, but also in fish and particularly salmon. It develops relationships with major grocery chains around the world. Tesco is its partner in the UK, for instance, but it’s also active in most North European markets and in Australia and New Zealand. So, it’s taken a UK business and made it international and that's where a smaller company can really be successful. So those are three of our longest-running investments.

Kyle Caldwell: You've been managing the trust for nearly 20 years, and over that period the trust has comfortably outperformed the average rival trust, and the wider index. But over the past year, it has been a more challenging period of performance. Could you explain why UK smaller companies are currently in a bear market and what the potential catalyst will be for a change in fortunes for the better?

Harry Nimmo: Rising inflation and interest rates has caused markets to take fright, and there's been a flight to lower-risk assets, and in particular large companies [in the] FTSE 100. I think it's also the case that the FTSE 100 contrasts with smaller companies. Larger companies have a high proportion of oil and gas stocks, mining stocks, pharmaceutical companies, utilities, banks, actual beneficiaries of rising commodity prices, rising oil and gas prices and rising inflation. And that has been the reason why that part of the market has done better.

Smaller companies are generally more cyclical, possibly more risky, [and] have done worse. So that's the backdrop. Now, what has changed? There's a lot of talk of recession, a lot of talk of interest rates, inflation causing recession. Now, when recession occurs and I think there's a very good chance of that next year, it is the higher-quality smaller companies that will do better. Thus far, it's been all about value. When an actual recession starts to feed through, then quality will be much more of a factor. So, I think when the actual recession really starts, that's when there will be another rotation, possibly out of straight value, into more quality-oriented businesses, which is our place.

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Kyle Caldwell: And are periods such as these, when smaller companies are very volatile, is it the price that investors have to pay for the fact that over the long term, smaller companies tend to outperform large companies?

Harry Nimmo: On that one, I'd always ask investors to understand that smaller companies are riskier. There is a price to be paid for the better returns. The returns over the longer term have been better. Professors Dimson and Marsh of the London Business School are the ones who really did the important long-term studies on that. Now, I have to caveat this [and say] that past performance doesn’t necessarily predict future performance, but that is a rule so, our thinking is that, with investors who are long-term oriented - that’s important - and who can handle the risk, a proportion of their assets in smaller companies can be most beneficial to longer-term returns, and that's certainly shown by the historic numbers.

Kyle Caldwell: And finally, do you have skin in the game?

Harry Nimmo: I do indeed. The abrdn UK Smaller Companies Growth Trust is probably my largest single investment in my equities portfolio.

Kyle Caldwell: Harry, thank you very much for your time today.

Harry Nimmo: Thank you.

Kyle Caldwell: That's all we have time for today. You can check out the rest of our Insider Interview video series on our YouTubechannel, where you can like and subscribe. Hopefully, see you next time.