Knott finds the gems in small caps

FUND manager Simon Knott, rated as one of the best stock-pickers in the UK, has snapped up large stakes in a handful of minnow companies in recent weeks.

Knott says the powerful rally in the smaller end of the stock market, where he invests, has made it harder to find 'undervalued' shares. But he has discovered what he believes are a couple of gems.

'We've had a bull market in UK smaller stocks since the week before the Iraq war began in March,' he says. 'Anything including the kitchen sink has risen in price and now many have become overvalued.'

Knott runs the Discretionary unit trust and Rights & Issues investment trust. Discretionary has turned £1,000 into £1,553 in three years, making it the best performing fund in the smaller companies according to fund analyst Trustnet. The average fund lost 14.8% and the FTSE All-Share fell 24%.

The fund manager rating system of investment broker Bestinvest credits Knott as top performer from any fund sector over five, seven or ten years.

Knott aims to seek out companies that generate decent cash, but their potential has not been spotted by the wider market.

Last week he snapped up 3% of DRS Data & Research. The company, which is valued at £24m, produces machines capable of counting multiple choice exam papers. It has also won the contract for the 'e-counting' of next year‘s London mayoral elections. The shares have more than doubled to 70p in the last year.

Knott built a 25% stake in Litho Supplies between September and November. The £10m company, highlighted by This Is Money's small caps specialist Pat Lay in September, sells equipment and services to the printing, graphic arts and corporate markets. Knott says the amount of money the company is generating is not reflected in the share price.

A longer-term holding has been Alternative Investment Market-listed fabric dyes and baby products firm Mayborn Group. Knott has been particularly impressed with the sales performance of the Sangenic Nappy Wrapper, a patented nappy disposal system. He bought the shares in March. They have since rocketed from 64p to 207p. He says that the shares are now more fairly valued but he intends to hold on.

The largest share holdings in the Discretionary fund include Enterprise Inns, because of rising beer prices and the company's tight grip on its leasehold pubs, and industrial group Dyson. The company‘s shares have hit fresh heights ahead of results on Thursday (4 December). Investors hope innovative new products will drive profits higher.

Knott also holds HBOS bank in his top five. He backed the bank believing the merger between Halifax and Bank of Scotland would reduce costs. He has retained his shares but may sell when he's found a 'new home for the money'.

The £33m Discretionary fund carries a low initial charge of 3% and a cheap annual fee of 1%.

James Calder of Bestinvest has the Discretionary fund on his 'buy' list due to Knott's impressive track record. However, he points out that Knott underperformed the wider market in 1998 and 1999 because growth stocks rallied, leaving behind the 'deep value' stocks that Knott prefers. Calder recommends also investing in a growth fund to balance the risk.

The Rights & Issues investment trust, which has risen 26% against a 24% fall in the FTSE All-Share in the past three years, is a split-capital investment trust. Calder sees no reason to back it when you can invest in the unit trust, which also holds some money in the Rights & Issues trust.