Downing Strategic Micro-Cap

DSM is a highly concentrated micro-cap trust, on a ‘double discount’ of 69%...

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by Downing Strategic Micro-Cap. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

Downing Strategic Micro-Cap

Downing Strategic Micro-Cap (DSM) aims to benefit from market inefficiencies amongst the UK’s smallest listed companies. The team employ a highly concentrated ‘value’ investment strategy based on fundamental analysis. They aim to buy strategic stakes (between 3% and 25%) in companies at prices that suggest a good ‘margin of safety’, but that are mispriced thanks to a problem or issue (real or misunderstood), but which is surmountable.

With three managers currently covering the portfolio of 12 stocks, the team have a depth of knowledge about their investments unlikely seen elsewhere. When necessary they actively work with investments to ensure a strategy dedicated to enhancing shareholder value is enacted.

Performance since IPO in May 2017 has been challenging, with the NAV down 35% and the share price down 52% (to 24 April 2020), underperforming UK smaller company trusts. The team have been clear with investors from the start, that tough decisions will need to be addressed within each company before improvements in share prices will be seen. With a five-to-seven year investment time frame, manager Judith MacKenzie expected a ‘hockey stick’ pattern of returns. By the start of 2020 she was becoming optimistic that DSM’s fortunes would turn. Much of the hard work on the portfolio had been completed, and one or more realisations validating the investment thesis were expected. Current markets have deferred, but not changed, that prospect.

In its annual report, the manager states their investments are well capitalised, and the majority give little cause for worry. The managers believe most holdings will emerge intact from the crisis. With net cash of 16% as at 24/04/2020, DSM’s managers can be opportunistic, but can also support portfolio companies if the need arises.

Kepler View

DSM’s investors have so far had a torrid time. However, the investment thesis for this trust was always going to take longer to show results than might be the case for many other strategies. Whilst DSM’s strategy is clearly higher risk, we also believe that fundamental analysis with a comparable margin of safety is the way to identify significantly undervalued opportunities at the less efficient end of the stock market.

The manager’s value approach and willingness to engage is a clear differentiator. The concentrated portfolio allows the managers to take strategic stakes and act as a positive influence for change. However, with the strategy seemingly on the verge of proving itself, the recent market falls and economic slowdown mean that the champagne remains on ice. With relatively strong balance sheets, it is possible that DSM’s portfolio – already having been priced lowly by the stock market – has a certain amount of in-built protection.

With the discount now having widened to 23% as at 24/04/2020, and the underlying investments having suffered falls, the ‘look through’ discount to the small-cap market is in the order of 69%. DSM has cash on the balance sheet of 16% of NAV, which means – like its well-financed underlying companies – it will potentially come out of the crisis strongly in share-price terms.

bull bear
69% look-through discount, reflecting lowly rated underlying companies and a 23% discount to NAV
Poor performance so far, illiquid nature of underlying companies and small size of the trust all mean that a narrowing of the discount is far from guaranteed over the short term
Highly differentiated strategy, with truly active managers fully engaged with investee companies, and cash of 16% on the balance sheet Highly concentrated portfolio means that any serious COVID-19-related issues on the portfolio could meaningfully impact NAV
Portfolio potentially set to do well in absolute and relative terms in a ‘business as normal’ environment
Illiquidity of underlying investments means managers have little room to adjust portfolio to the new economic reality (should they want to)
William Heathcoat Amory
William Heathcoat Amory is a co-founding partner of Kepler Partners LLP and leads the Kepler investment trust research team. William has 18 years of experience as an investment company analyst. Prior to co-founding Kepler Partners in 2008, he was part of the Extel number 1 rated research team at JPMorgan Cazenove.

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