Companies with sustainable earnings growth will do better than those dependent on cyclical factors. We look for companies that are attractive in terms of their higher earnings growth rates and returns on equity but have lower valuations versus the rest of the market.
The richest source of undervalued, under-researched stocks can be found in the small and mid-cap growth space. With small/mid cap value stocks trading towards the top end of their historic valuation range, it has masked the undervaluation of growth stocks in this arena, which are still attractive. This is not an homogeneous universe. Small/mid cap growth stocks are trading at half their price five years ago, whereas small/mid cap value is higher than it was at the peak, in 2000.
Investors should be wary of avoiding cyclical sectors: they need to look at niches in those sectors. For example, a stock that I believe is a potential outperformer is Nordic Semiconductor, which supplies chips for the cordless computer mice that Logitech makes – in five to 10 years all computer mice and keyboards could be cordless. This is a play on the consumer and specifically on technology. That does not mean a consumer boom is in the offing but people will spend in certain areas, creating growth opportunities such as this.
An interesting theme, given the moderate economic growth, is M&A activity. Large corporations have record levels of cash and are likely to use that to acquire companies with sustainable growth. There has been evidence of this in Proctor & Gamble’s acquisition of Gillette for 29-times earnings. This trend is likely to continue.
Since our fund started 18 months ago, five of our dominant franchises have been taken over: Glenmorangie, Falck, ISS, Recoletos and Radiometer. This confirms our stance that the valuation of these high quality companies is too low.
James Hordern, manager of the Melchior European Opportunities Fund
