Two UK small-caps we are excited about

abrdn Global Smaller Companies manager Kirsty Desson sits down with ii's Sam Benstead to discuss the prospects of smaller firms, which she says tend to be higher growth compared with larger peers.

Desson reveals the shares she is excited about currently, include US small-cap MSA Safety Inc (NYSE:MSA), and gives her view on investing in the UK, where she owns CVS Group (LSE:CVSG) and Intermediate Capital Group (LSE:ICP).

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Sam Benstead, deputy collectives editor, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Kirsty Desson, manager of the abrdn Global Small Companies fund. Kirsty, thank you very much for coming into the studio.

Kirsty Desson, manager of abrdn Global Small Companies fund:Thank you for having me.

Sam Benstead: So, smaller companies, why should we invest in smaller companies and how do you define them?

Kirsty Desson: Great question. So, the way in which the universe is defined, we use the MSCI All Countries World Index, which is the broadest benchmark for small-cap stocks, and takes the bottom 15% of each regional index and pools these together to constitute the overall benchmark.

Now, what's really important to remember is that even though it's the bottom 15% of each regional index, it's actually together two-thirds of the world's companies. So, it's a vast and diverse universe from which to pick stocks. And that's one of the great attractions of investing in the small-cap market.

The other points to remember are that generally the small-cap stocks are less well covered than large-cap stocks. And for investors like us that have a well-proven process, that means that there's a lot of inefficiencies for us to exploit in the market.

The other point to remember about the small-cap universe is that generally you're capturing stocks at an earlier stage of their development and therefore you tend to see higher growth coming through. And all these three aspects together mean that small-caps have actually outperformed large-caps over the long term.

Sam Benstead: These great returns from smaller companies, do they come with greater risk as well?

Kirsty Desson: So, we get asked that question a lot. And if you take volatility as a proxy for risk, then yes, across all geographies, small-caps are more volatile than large-caps. However, if you adjust for risk, the returns on small-cap are still higher than you see in large-caps.

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Sam Benstead: And how would you pick smaller companies then? Which are the types of stocks that get you really excited?

Kirsty Desson: So broadly, we have a philosophy of investing in quality companies that have sustainable growth and scope to actually beat analyst expectations over time. So, how do we find those stocks? Well, there's 6,000 stocks in the universe, so the only way we feel that you can consistently and objectively screen the entire universe is to have some form of quant tool.

So, we use a quant tool initially to hone down the universe and focus our efforts on those stocks that display those quality growth and momentum characteristics. Then from that, we take the shortlist, and we do a deep dive into those fundamentals, looking at things like balance sheets, what the competitive advantage is, how sustainable that is, the management team margins and, of course, ESG (environmental, social and governance). And then from that, we make a decision around whether the stock is eligible for the portfolio or not.

Sam Benstead: And how many positions do you hold then? How many stocks have made the grade? And can you give me some examples of some positions that you're excited about?

Kirsty Desson: So, we say we hold anywhere between 40 and 60 stocks, but typically it tends to be around 44 to 55 names. A great example of a stock that we've bought recently that scored well in the matrix is a US company called MSA Safety Inc (NYSE:MSA). So even though it's a small-cap stock, it's one of the world leaders in providing safety equipment for the likes of firefighters, and also industrial equipment and gas detection systems.

And what we like about this name is that, one, it's got a market leadership position. It's got very strong technology behind it and a high degree of trust, which is essential in these sorts of services. But we're also seeing quite steady growth for the name. So, this tends to be quite economically resilient.

Demand is often driven by regulation and particularly so in emerging markets, which is where the company is seeing growth coming through. So, we're seeing rising penetration of safety equipment outside developed markets and that's providing this nice, steady upward trend in growth for the company.

Sam Benstead: And are you finding opportunities in the UK? It is perceived as perhaps a lower-growth market than maybe the US, but are there exciting companies, smaller companies there as well?

Kirsty Desson: The UK market has a great range of small-cap, innovative companies. It's been a particularly challenging period for UK companies, as I'm sure you know, and the UK continues to have concerns around particularly employment and inflation, which means it's operating at a slightly different level of activity versus the rest of the world.

Having said that, the market does look exceptionally cheap and we're even seeing some terrific quality-growth companies offering quite attractive yields at the moment. So, when we start to see a bit more stabilisation in the UK market and investors beginning to reward quality companies, then we feel it might be the right time to step out into the water a bit more and pick up some of these great bargains that are out there.

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Sam Benstead: How much of the portfolio is invested in the UK, and can you give me some examples of companies you like here?

Kirsty Desson: We're currently around neutral in the UK, which is unusual because historically we've generated a lot of alpha from UK stocks and therefore we've had higher weights there. The two stocks that we do have in the UK market at the moment are Intermediate Capital Group (LSE:ICP), where we've been adding money recently, and also CVS Group (LSE:CVSG), the veterinary group.

We really like CVS from a bottom-up point of view. It looks particularly attractive at the moment. Unfortunately, it's been hit by an investigation by the Competition and Markets Authority (CMA), which, for various reasons, we think is overblown. Post the investigation, we've seen an excellent trading update from the company. They continue to roll out their strategy and there's a lot of room for growth for this name. So, we continue to believe in the CVS story.

Sam Benstead: And are you paying a premium for these smaller companies? Normally, high-growth shares come with a high price tag as well.

Kirsty Desson: At the moment, no. Which is one of the reasons why we think now is a great entry point for small-cap. In fact, since around 2018, we've seen the discount on small-cap versus large-cap grow. And currently it's as wide as it's been since pre-GFC (global financial crisis). And if you drill into that, what you'll find is that small-cap growth stocks are trading at even a discount to their 10-year P/Es (price to earnings). So, valuations for the asset class are very attractive right now.

Sam Benstead:Is income a part of your investment process? Do you look for high dividend yields and are there any smaller companies that are very good for income seekers?

Kirsty Desson: So income is not a core part of our investment philosophy. However, it can be used as an interesting valuation tool because obviously quality companies which throw off a lot of cash and return cash to shareholders are currently yielding quite high metrics. So, while it's not a core part of our investment philosophy, where we do see high yields, [that’s] obviously an indication of companies that are perhaps undervalued.

Sam Benstead: And we spoke before about smaller companies being cheaper at the moment. But are there any companies that you're very willing to pay a premium for, some very exciting smaller companies, and what sectors and countries do they operate in?

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Kirsty Desson: Generally, what you'll see is a portfolio is at a higher P/E versus the benchmark. And that's because, overall, we are willing to pay up for quality and for higher growth. Across the portfolio, we do see certain themes emerging where there's structural long-term growth in those names. For instance, in EV-related companies or alternative energy stocks.

I think one stock that looks particularly interesting right now and has performed extremely well since early last year is a French company called Gaztransport et technigaz SA (EURONEXT:GTT). They make membranes that allows liquefied natural gas (LNG) to be transported around the world. We think that there is a long-term growth story in LNGs given that it's a cleaner fossil fuel than other fuels.

At the moment, it has obviously benefited from a shift away from, say, Russian gas to alternative sources of fuel. So we've seen a nice pick-up in activity because of that. GTT is the world leader in this technology. It has around 80% global market share. It's very hard for competitors to replicate what they do.

And we're also seeing the company moving into areas such as hydrogen transportation, which provides yet another leg for growth for the business. So, names like GTT we continue to add to the portfolio and we're very happy to pay up for those sorts of names.

Sam Benstead: Kirsty, thanks so much for coming into the studio.

Kirsty Desson: Thank you.

Sam Benstead: And that's all we've got time for. You can check out more Insider Interviews on our YouTube channel where you can like, comment, and subscribe. See you next time.