Downing Strategic Micro-Cap (DSM) aims to benefit from stock market valuation inefficiencies that exist amongst the UK’s smallest listed companies. This is an area of the market that offers the potential for significant value-add from a manager. DSM’s management team aim to identify catalysts for value to be crystalised, but if required they will engage with senior managements or boards in order to effect change that will be this catalyst.
DSM is by definition a ‘value’ investment strategy based on fundamental analysis and has a highly concentrated, high-conviction portfolio. However, the investment thesis envisages a longer time frame than most, at five to seven years. Investee companies will typically have a market capitalisation of below £150m at the point of investment, but are often much smaller. This size of company is significantly smaller than many institutional investors will contemplate, and as such DSM offers exposure to companies unlikely to be found in other funds or portfolios.
Performance since launch has not been as hoped, yet the managers believe there are clear signs that DSM’s shareholders have reason to be optimistic. Certainly, as we discuss in Portfolio, the prospects for each underlying company appear good and clearly aligned with the wider economic recovery in the UK. The performances of Volex and Real Good Food illustrate respectively the upside potential from the investment process and how the structured approach to investing can still deliver returns whilst exposing the trust to less equity risk.
The portfolio is concentrated but DSM’s strong balance sheet could provide comfort to investors. As we discuss in the Gearing section, DSM has cash of c. 17%. This gives the managers significant flexibility and should reduce DSM’s inherent volatility.
DSM is very different from other equity funds. The managers are highly active, with very low levels of turnover in the portfolio and a degree of focus on investee businesses which is only usually seen in direct private equity trusts. However, in our view portfolio construction offsets some of the higher-risk characteristics that the concentrated portfolio has relative to traditional equity funds.
The team are now in year three of their investment time frame for a large part of their Portfolio, and this is intended to be the value-accretion phase. Part of DSM’s investment thesis is that at the small-cap end of the market, equity is not efficiently priced. Volex and Real Good Food provide illustrations of the team’s process at work, and also the UK economic recovery should prompt operational or M&A catalysts in the portfolio companies to further validate DSM’s investment proposition.
Downing estimates that the portfolio companies as a whole trade on a 40+% discount to their base case intrinsic value. Their assumptions are based on a conservative assessment of each businesses’ prospects over the long term. When combined with the trust’s current discount to NAV, we believe that value investors should find DSM an interesting prospective investment. DSM is a classic value play, and so if current momentum continues this discount might be expected to narrow. In our view, in terms of value opportunities, DSM is hard to beat. It seems Judith MacKenzie and the DSM team share this confidence, with their own recent purchases of shares in the trust echoed by the management teams of the underlying companies buying their own companies’ shares.
|Portfolio companies look to be in a strong position to capitalise on the UK economic recovery||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 cash of 17% on the balance sheet giving the managers flexibility||Highly concentrated portfolio means that any pitfalls experienced by any investments could meaningfully impact NAV|
|Estimated 40+% look-through discount, reflecting the discount to the manager's base case intrinsic value, and a 14% discount to NAV||Illiquidity of underlying investments means managers may have limited room to adjust portfolio|