With less than two months left, 2019 has so far been a really strong stock market year. The Stockholm stock exchange’s broad OMXSPI index is up around 25 percent since the start of the year, and among the gems that have sparkled especially brightly are the market’s many small companies. How does Catella Småbolagsfond go about picking its stocks, what does a well-composed portfolio look like and, not least, which sectors and companies are particularly hot right now and for 2020? Forest products, selected health care and technology, and really good corporate management and reliable owners – this is a brief summary of the wish list of Martin Nilsson and Henrik Holmer, the managers of Catella Småbolagsfond.
One difficulty with small caps is the fact that their shares can often be difficult to trade, and this is difficult to get around. Liquidity is often less good, and the entrances and exits can get very crowded if something suddenly happens. The fund managers naturally have to consider this when compiling the portfolio – not everything can be made up of really small companies, and some holdings in larger and more liquid companies are also needed.
Catella Småbolagsfond has internal limits for how liquid the portfolio must be at any time, and the size of the individual positions is determined partly by the fund managers’ belief in each case and partly by the liquidity of the shares.
“This is one of the first points when we look at a new case. Liquidity: can we build a position of reasonable size?" says Martin Nilsson.
At the same time, as a small cap fund manager, you obviously do not want to miss out on the growth opportunities that can often be found in small companies. In order to put together a working mix, Henrik Holmer says that the fund has slightly more positions of smaller size, but may also apply higher return requirements in these cases than otherwise. Small stocks should have a theoretical potential to increase their value maybe three, four or five times over time.
In order for the fund to invest in a company, it must not exceed 1 percent of the Stockholm stock exchange’s total market value, which currently corresponds to around SEK 55 billion. If this is the ceiling, on the other hand, there is a lot of leeway downward,” says Holmer.
“We also go down in size, we can definitely have down to companies of half a billion kronor,” he says.
The fund’s benchmark index is Carnegie’s small cap index, which is adjusted twice a year. Just as companies can grow out of the index in terms of size, they can of course also shrink back into it if their share price falls. An example of this is specialty drug company Sobi.
“It was like a rocket that shot from being a small cap to a large cap and disappeared from our universe. Then it had a tough time and fell back into the index,” says Nilsson.
As for the distribution of holdings, Holmer says this is “quite large”, with the fund currently holding around 90 companies and SEK 7.5 billion in managed assets. The fund’s six largest holdings currently account for about 24 percent of assets, while many other holdings are significantly smaller. To manage the risks of the really small companies, such as in healthcare and medical technology where there are many exciting companies with big hopes for the future, the managers apply a kind of “portfolio of portfolios” thinking, with a large number of small companies included but with small positions. This is done to allow for the fact that some of the companies will naturally fail.
Among those that have shown fresh signs of success, Martin Nilsson names Bioarctic, which recently issued some very positive news. From being a small holding with low liquidity it suddenly exploded.
“In two to three days it rose almost 70 percent and then suddenly weighed much more than the fund. We see even more upside in this company; it is able to grow organically and will hopefully be bigger in the future,” says Nilsson.
In general, the fund is cautious in its investment process when it comes to buying companies on hope. But a relatively large proportion of the small-caps universe is actually in biotechnology – and very popular as Sweden has proven good at developing new companies in this sector.
A large part of the managers’ job is to follow the daily flows of the stock exchanges as it can be especially important with small companies to keep track of when they move. This can mean a rare chance, for example, of getting into a stock you have long been interested in.
“When you want to buy certain small companies, it might not be possible, and so you have to take the opportunity when it comes. This makes blocks very important: sellers and buyers make up a block and trade. This is a much more important part of the small-caps universe than among big companies,” says Nilsson.
In addition to biotechnology, many outsiders believe that new technology makes up a big part of the small company shares in the market. But that’s not really the case. Technology accounts for about 4 percent of the index, while many people believe the sector is much larger than that.
“We have a number of technology companies, such as Mycronic, which has been a holding for a long time, with fantastic returns and it is a fantastic company overall,” says Nilsson about the company known for its manufacturing of highly advanced mask writers used in the semiconductor industry and the display industry.
Mycronic recently changed its CEO from Lena Olving, who retired, to Anders Lindqvist. This share has also periodically been one of the most frequently shorted on the Stockholm exchange since a number of US hedge funds have speculated on a downturn for this Swedish company. So far, however, the hedge funds’ strategy has often been very costly, says Nilsson.
“They have been completely wrong, which has cost them huge amounts of money. And not only have they been wrong, it has also cost to borrow the shares. One of the first hedge funds that went in and shorted at SEK 50 closed its position at SEK 115, which gave them a huge negative return,” says Nilsson.
The mistake the short sellers have made, believes Nilsson, is probably expecting the company to be a classic boom and bust, where it builds up an order backlog and delivers, before watching the sales evaporate.
“This means that they do not really understand the business model, with the company spreading orders over very long periods, which also reduces the volatility,” says Nilsson, who also highlights a lesser known part of Mycronic, the Assembly Solutions division, which has been built up over a period of several years and has shown a negative return. However, profitability in the division is now on the rise and Mycronic’s target is for Assembly Solutions to achieve an operating margin in excess of 10 percent. “It is heading that way,” says Nilsson.
Forest products have been another very successful part of the small caps fund for some time. This sector includes the fund’s single largest holding, SCA, and Holmen is also a relatively large holding. Forest products have made up around 10 percent of the fund, according to the managers, and contributing to the successes have been the recent major upward valuations of forest assets. Both SCA and Holmen have upwardly valued their forest assets level with their current market values. In the case of Holmen, you also get a packaging business in Iggesund and 21 hydropower plants “for free”, plus the company now has a buyback programme for 10 percent of its outstanding shares. Since August, Holmen has risen almost 50 percent.
If we look instead at SCA, it has indicated a value for its forest assets of SEK 63-67 billion, while the company’s current market capitalisation is around the same level.
More recently, the fund, like other parts of Catella Fonder, has increased its focus on sustainability. Here too, the forest holdings are a good example since woodland binds large quantities of carbon and thus acts as a counterbalance to emissions from elsewhere. But the fund also works with sustainability in several other ways, says Holmer.
“To begin with, we have exclusions: we simply do not invest in certain companies in controversial sectors or in products that we do not consider sustainable,” he says.
In addition to weapons, tobacco, alcohol and gambling companies, some of the industries deselected in this way are those that are active in fossil fuels.
“Another element is that we include companies with business models that are driven by sustainability, which provide potential in the longer term and reduce risks. Then we have an aspect of sustainability known as ESG scoring: there are independent firms that give companies a rating based on how good they are with sustainability. Smaller companies often have a lower score simply because they are small and lack resources. Here we can actually help and act as a sounding board – if we see that a small company has a poor score, it is often because of a lack of particular documentation so it is fairly simple to improve the rating,” says Holmer.
As one of his favourite companies, Holmer highlights a relatively unknown medical technology company called Xvivo Perfusion, which develops systems and solutions that are sold for organ transplants – mainly for lungs, but also for hearts. The fact is that a very large proportion of all donated organs will never be used because they are not delivered in time or are judged to be of low quality. In the US, for example, only one fifth of all donated organs are used and the rest are discarded.
Xvivo has a solution that allows more organs to be used through storage, improvement and extended life of the organs. The company is a market leader in this field and has strong growth.
“Since it was listed in 2013, Xvivo has grown by an average of 22 percent per year. In the latest quarter it grew by 33 percent, it makes money and a majority of sales are recurring revenues with high gross margins,” says Holmer.
According to Holmer, the share has been one of the fund’s better positions during the year. It is now traded at around 25 times earnings, “But given how quickly it is growing into its valuation, we believe it is justified in this case,” adds Holmer.
Some of the fund’s other favourite shares are Fortnox, Bygghemma and Nordic Waterproofing.
Fortnox supplies business admin systems, primarily to small companies and entrepreneurs. The share has skyrocketed and is up over 160 percent this year. The question, of course, is whether it is time to leave the party?
“We are staying put. This is a company with a high multiple but that is also growing – profits are growing 60-70 percent. What I think people underestimate with Fortnox is the fact that it is a platform company, which adds services in insurance, finance and payments. I saw yesterday on LinkedIn that it has recruited its 300,000th customer, and these are mainly small and medium-sized companies where they make accounting easier. That is the core. And a management that is building on new products and services,” says Nilsson.
As for Bygghemma, the share has climbed around 50 percent since the start of the year, but the company is still a little misunderstood, believes Holmer.
“There are many investors who do not want to take on anything that includes the word “bygg” (construction), and nor do they want retail exposure. I can understand that, but there are completely different driving forces in this company,” he says, and continues:
“Bygghemma is the leading retailer of building and home furnishing products for consumers in the Nordic countries. Its sales are online and it has many strong brands. The most important part of the case is Bygghemma’s dominant position, which gives it economies of scale and means it can always guarantee lower prices than its competitors.”
One advantage is that the building and home furnishings market is being driven by the ongoing transition from physical commerce to online, and the industry is far behind many others – the segment has an online share of only 8 percent, compared with 19 percent for white goods and 27 percent for home electronics.
One relatively large holding in the fund is Nordic Waterproofing, which manufactures roofing membranes. Although it may sound a bit boring, this is a company that is growing by 16 percent, with 12 percent organic growth. A buyer pays a P/E multiple of just over 10 for a dividend yield of 5 percent. The fund has held this share ever since its listing since the fund managers value the company’s management, with the CEO being one of the major shareholders. Nordic Waterproofing also has a very strong market position.
When it comes to the big question, deciding what to invest in, the two fund managers say that there are a number of basic issues to consider. The company must be active in an industry with underlying growth. And it must have a strong market position – either through organic growth or through acquisitions. There are a number of further factors to look at.
“We evaluate to a great extent the company management and the main stakeholders – who owns the company, who are in the management, do they have the same interests as us? Have they created value over time?" says Nilsson, and adds that they are happy to back a shareholder with documented talent.
“If you look at the holdings we have had in the past, some names come up frequently. One example is Latour, where we have had quite a few holdings over time: Troax, Sweco, Alimak – this is one example of a very good controlling shareholder,” he says.
So, what do the managers say about the third-quarter reporting season, which is largely over now? Better than expected, is their opinion.
“For us, the season has been very good. It just about came in for most of the holdings and that’s not always the case at all. Lots of strong reports, as always with some disappointments, but in general I think the reporting season has been better than expected,” says Nilsson.
The fund managers are also still convinced that small companies will continue to outperform large companies – generally speaking.
“If you look at the valuations, small companies are now traded level with large companies and medium-sized companies, in terms of p/e twelve months forward they are at 15-16. But if you look at expected profit growth for small companies, it is more than twice that of large and medium-sized companies,” says Holmer.