If 2017 was a year in which the rising tide raised all boats, investment success in 2018 will require much more sectoral scrutiny and stock picking skill.
The volatility in financial markets we have already experienced this year looks set to continue and in this environment we believe that investors who simply track the index, whether passively or actively, are likely to be disappointed.
We believe that the most promising sectors and stocks for the months ahead are those that are less susceptible to external forces. For example the resources sector, where commodity pricing is all important, is vulnerable to macroeconomic movements. Even leading consumer brands are likely to find the going tough in the face of a squeeze on household incomes during a period of higher inflation and potentially rising interest rates.
From our perspective, businesses in industries with clear structural growth potential look much more exciting in 2018. If you can also find companies with a management team that demonstrates the ability to execute on strategies to exploit that potential, we feel that’s a compelling proposition.
Value behind the IT frontline
In our view one good starting place to go hunting for such companies is the technology sector. That does not have to mean the headline grabbing but potentially risky pioneers of cutting edge technologies. Instead, more mature enterprises with a proven business model and an established record of cash generative growth could offer a more attractive option.
Alternative Investment Market listed Nasstar is a good example. It provides cloud computing hosting services to small and medium-sized enterprises in a wide range of different sectors. This is a huge market with SMEs looking to access the benefits of the cloud for their businesses but lacking the expertise to develop solutions in-house or the scale to get the customer service they need from the giant IT companies also operating in this space.
When companies such as this are well managed, we have seen them grow rapidly in their particular sweet spot and get noticed. For instance, we were investors in SQS Software, a business specialising in quality assurance and systems testing, until its takeover at the end of last year. While these businesses aren’t necessarily on the frontline of disruptive trends in technology, their growth prospects can be alluring and valuations reflect that: the offer made by SQS’s acquirer represented a 57% premium to its pre-bid share price.
Growth from healthcare services
The healthcare industry provides similar opportunities. Again, we believe there is value to be found away from the headline makers in areas such as early stage biotech, for example amongst healthcare service companies.
Take Ergomed, a contract research organisation (CRO) that has delivered exceptional growth by skillfully exploiting the trend amongst large pharmaceutical companies to outsource many of their activities. It works alongside these companies to develop their drugs and therapies, managing clinical trials and analysing crucial patient data, but is not exposed to the risks of the trial or product failing.
As with technology, we see value in businesses such as Ergomed, when well managed, provide critical outsourced services to a large and growing end market.
Franchisers prove their worth
Franchising businesses are another niche segment of the market that we believe look very attractive in 2018. The big attraction of franchising is that it offers a means to scale a business rapidly without significant capital investment. A key skill for the management team is recruiting and managing the right franchisees to grow the business and drive greater value.
One company excelling on this front currently is Alternative Investment Market listed Filta Group, in which we have been invested since its IPO in 2016. Filta’s franchisees use specialist equipment to clean the deep-fat fryers of restaurants and other commercial kitchens. They now service more than 5,000 customers a week, prolonging the life of kitchen machinery, reducing restaurant’s environmental footprint, and resolving a health and safety headache.
We feel the recurring revenues that a company such as Filta Group generates provide reassuring stability for investors in the business, while the franchising model offers a scalable model with long term growth potential.
It’s a similar story at Franchise Brands, which owns a string of attractive franchise operators’ brands such as the car repair service ChipsAway and the business-to-business drain clearance company Metro Rod. The Franchise Brands group provides central services to each of its brands, enabling each individual business and its franchisees to focus on growth in their respective markets.
Like many of the opportunities we see in healthcare and IT, these companies aren’t necessarily glamorous, and they may not be well known outside their respective fields. However, from an investor’s perspective, they could be seen to provide fundamental attractions in a potentially more challenging year for markets – the ability to grow irrespective of macro economic trends or themes, dependable and diversified revenues, and, above all, strong management teams. In our opinion it is these virtues that sensible investors will seek out in 2018.
This article was originally published by FE Trustnet, 19th March 2018.
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