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Small wonders

For those brave enough to invest part of their savings in the UK stockmarket, 2011 could be summed up as a roller-coaster ride and the start of 2012 has not been without investment shocks either – witness Tesco’s first profit warning in more than 20 years.

But despite the talk of euro-zone and sovereign debt crises, share prices of certain UK smaller companies are just shy of their all-time highs, reflective of peak margins and robust order books.

There are several reasons why UK small company margins are the recipients of this much-needed fillip.

Smaller companies have traditionally been associated with the manufacture of niche products, which, when combined with high barriers to entry in their industries, keep operating margins sustainably high.

Examples include AZ Electronic Materials, a provider of advanced speciality chemicals for use in integrated circuits and devices, which holds the number one or two position in most of its markets.

Victrex, dominates the market for PEEK polymers. This high-performance patented material is used in healthcare and aerospace applications and clients have access to an unrivalled technical sales force when ordering it. This ensures delivery of the exact product specification to the end user.

Renishaw, a manufacturer of high-specification probes, also has enviable margins due to its proprietary technology. Order books continue to grow, which, with the resultant operational gearing through cost efficiencies, has led to rising margins.

The clear message is that superior product specification and sales service delivers pricing power and high margins. China, in particular, is looking to spend more money on technology as its labour force becomes more expensive and does not have the technical know-how to replicate these high-spec products.

Many smaller companies have adapted to the current low-growth environment and improved margins by increasing the degree of after-sales service they provide.

Following in the footsteps of aerospace giant Rolls Royce, smaller engineering companies have increased the service element substantially over the years. Fenner, for example, has practically doubled margins over the past 10 years as a result of moving away from the pure manufacturing of conveyor belts used in the coal industry, to offering a full service element for customers, including repairs, maintenance and conveyor belt scanning.

On the whole, companies have emerged from the last recession leaner and fitter than they have been for many years as a result of shrinking their cost bases.

In the UK, rising unemployment, together with a weakening of collective bargaining power, has translated into a much more flexible labour market.

A company’s ability to outsource its labour force can further enhance margins and advances in technology have also led to increases in productivity, bolstering margins.

We are not totally convinced margins will continue to rise. In fund management, mean reversion is a powerful force and it is our belief that margins will return to more normalised levels.

The rally in the oil price since the start of the year has already had a knock-on effect on other input prices. Polymer costs, for example, rose by 22 per cent in January alone, impacting rigid plastic packaging firm RPC’s margins. That said, niche value-added products, lower industry costs and an increased service offering will go part of the way to ensuring that small company margins will stay relatively high for some time to come.

Jonathan Brown is co-manager of the Invesco Perpetual UK smaller companies fund


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