Downing Strategic Micro-Cap Investment Trust (DSM) targets UK micro-cap companies which are trading significantly below their long-term value. The trust’s managers look to build a strategic equity stakes (between 3% and 25%), and engage with boards seeking change. If need be, the managers will take a more confrontational approach. All this takes time, and Downing invests on a five- to seven-year time frame.
DSM has a concentrated portfolio, meaning the NAV may be exposed to short-term disappointments. Some ‘lemons’ within the portfolio did sour early, which has meant that the NAV performance since IPO has been disappointing. Yet the team are confident that there are no more lemons and that, over the medium term, we should start to see the fruits of their investing labour be rewarded.
Although COVID-19 has put back expectations of some catalysts to drive the NAV, the other impact of the pandemic has been the discount widening dramatically (now standing at 24%). Taking into account the discount to the market that the underlying portfolio trades at, we estimate the ‘double discount’ is c. 54%. This suggests we are in ‘deep value’ territory.
Whilst the portfolio is concentrated, the balance sheet should give comfort to investors. Currently DSM has cash of 24%, and an investment in one company structured as a loan amounting to 18% of NAV. This cash gives the managers significant flexibility and should reduce DSM’s inherent volatility. We understand that, on a three-year view, the managers have confidence in all of the portfolio companies performing better in terms of underlying earnings and, in the absence of M&A, for this to be the main driver of returns.
Applying private-equity style due diligence to companies with a market cap of below £150m means that DSM offers a very different investment thesis to most funds and trusts. Indeed, there may be no true comparator.
The managers have been making small adjustments to DSM’s portfolio – exiting two investments, and making two new investments (which have yet to be publicised). That said, the portfolio is dominated by a small number of companies, on whose fortunes DSM’s prospects largely rest.
NAV performance YTD has been reasonably good on a relative basis, with almost all holdings proving operationally resilient. The real damage has been the de-rating in DSM’s share price from a modest 2.1% discount at the end of February to a 24% discount at the time of writing.
In our view, there are potential catalysts on the horizon which could lead to the discount narrowing. The team are now in year three of their investment time frame for a large part of their portfolio, and any corporate activity for investee companies might contribute strongly to NAV progress and validate the investment proposition. Alternatively, if the loan owed to DSM were to be fully or partially repaid , this could act as a catalyst for the discount to narrow if a more sustained buyback programme from the board (see Discount) was anticipated.
In terms of value opportunities, DSM is hard to beat on a double discount we estimate to be c. 54%. Certainly, there may be bumps on the horizon, but this could be an interesting entry point seemingly at a moment of maximum pessimism for the trust.
|Estimated 54% look-through discount, reflecting lowly rated underlying companies and a 24% 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 cash of 24% on the balance sheet
||Highly concentrated portfolio means that any pitfalls experienced by any investments could meaningfully impact NAV
|Clear catalysts identifiable for a re-rating
||Illiquidity of underlying investments means managers have limited room to adjust portfolio (should they want to)