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.
After a difficult 2020, the new year brings with it renewed optimism within the UK investment trust world. The light at the end of the COVID-19 tunnel has started to emerge with the vaccine being distributed at a rapid rate, while uncertainty surrounding Brexit has been resolved. In this article, we look at what could be one of the beneficiaries of the improved sentiment towards the UK; Downing Strategic Micro-Cap (DSM), and discuss why now could be an interesting entry point into this heavily discounted trust…
A portfolio for the future of the UK
Launched in 2017, the trust was formed against a challenging backdrop, with Brexit uncertainty clouding sentiment towards UK smaller companies, and later with the impact of COVID-19. This has been reflected in the significant discount to NAV that the trust trades at, which currently sits at 20.2%. However, from a balance sheet perspective, DSM now sits in a very strong position. With 16.4% of the portfolio in cash, and a further 17.0% invested in a loan (paying rolled-up interest at a rate of 10% per annum), the managers have plenty of flexibility to take advantage of opportunities, either deploying cash from current balances, or should the loan be repaid.
The team at DSM expect the underlying earnings from the portfolio to continue to improve and for this operational improvement to be the main driver of returns over the short to medium term, reflecting some of the changes that management have implemented in these businesses over the last couple of years. However, the market is yet to fully recognise this and they believe there is significant potential within the portfolio for valuations to improve over the long term. Currently the trust is trading at discount to NAV of more than 20%, but many of the underlying companies are also trading at significant discounts to their publicly traded industry peers.
When compared to other equity funds, the microcap nature of the holdings (discussed in greater detail here), the portfolio is highly differentiated particularly when compared to Smaller Company equity funds and, as such, could be seen as a diversifier for investors. At a sectoral level, the largest allocations are towards electrical equipment (22.7%), support services (11.4%) and financial services (9.8%). In comparison, in the FTSE AIM Index, the largest sector allocations are towards technology (14.5%), health care (11.7%) and retail (11.2%). That said, the portfolio is relatively concentrated with fewer than 20 holdings currently, which potentially means it could be more risky. This is because the individual performance of portfolio constituents will affect the NAV more than would be the case with a more diversified portfolio.
The manager, Judith Mackenzie and her team, believe that there are a number of market inefficiencies and opportunities which can be exploited at this moment in time, particularly when targeting companies with market caps of less than £150m. Venture Life, the integrated consumer healthcare business, is an example used by the DSM team. They believe the company has a strong management team behind it, who have previously demonstrated their ability to build consumer healthcare businesses - as was seen with Sinclair Pharma which went from inception in 2003 to a business with £76m in revenue and £17.1m of EBITDA by 2015. Sinclair Pharma’s product portfolio was subsequently sold in two transactions with an aggregate value of £300m. Currently the company has a well invested manufacturing base with a largely fixed cost, but has latent or excess capacity that the management team aim to fill by an increased portfolio of products. If it is achieved, this in turn provides investors with significant operational leverage as capacity is filled. In recent times, the business has been growing quickly and in Downing’s view, has now reached an inflection point in terms of profitability as seen in the results for the second half of 2020, where the company reported c. 80% revenue growth translated into greater than 1000% earnings growth (as measured by EBIT).
Another example within the portfolio is DigitalBox. The company is a ‘pure play’ digital advertising media company with a pedigree in emerging publishing technologies and titles. The strategy of the company is to acquire, transform and grow digital media properties. The team at DSM believe that the financials and business model of the company are attractive and that the company has the ability to generate gross margins of c. 80% and EBITDA margins of close to 30%. Alongside this, DigitalBox has an attractive cash conversion of close to 75%. Looking forward the team at DSM expect the company to continue expanding through adding additional titles and gaining critical mass, which will allow them to benefit from synergies and cross-selling. Downing have investor rights within this investment including the right to be an observer at board meetings.
Through investing in these types of company, Judith and her team aim to generate total returns of 15% per annum (over a five year investment horizon). As we discuss in more depth here, the team employ a ‘private-equity style’ investment process, searching for fundamentally mispriced companies, typically due to a problem or issue which can be overshadowing the share price. The team look to solve these issues through engaging with directors and the board, taking strategic stakes in the companies (between 3% and 25% of equity). A key aspect of this process is the high level of due diligence, which is particularly important in the current uncertain conditions.
Thanks to a challenging first few years, DSM trades at a material discount to NAV and other smaller and micro-cap trusts. Taking into account the discount to NAV and the discounts that the underlying companies within the portfolio trade at relative to their peers, we calculate that the trust is trading at a ‘double discount’ of close to 43.3%. As such, and though not without risk, DSM offers a potential “deep value” investment opportunity with the potential for a dramatic turnaround in performance should sentiment towards the wider UK market and economy continue to improve.
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