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.
Imagine browsing through a property website and stumbling upon a four-bedroom house for sale in a fancy part of London at the bargain price of £100,000.
The odds are you’d want to buy it but also be fairly skeptical of what you were really getting. Before signing a contract or making any bank transfers, you’d do some due diligence, ensuring the property was sound and that you weren’t just buying into a decrepit studio flat with a 3-month leasehold.
Assuming that everything was as advertised, it would be hard not to purchase the property. Whether you lived there or sold it on, you’d have found something priced a fraction of its true value, making it something of a no-brainer to buy.
Sadly for us, opportunities such as this rarely seem to pop up in life. As any weekday afternoon’s TV schedule will prove, lots of people are interested in property, and a successful property ‘empire’ is practically a fetish for Brits in particular, which means very rarely are such opportunities missed by bargain hungry property investors.
But according to the team at Downing Strategic Micro-Cap (DSM), a very different state of affairs exists for those interested in the UK’s smallest companies.
The investment trust, which was launched in 2017, invests in smaller UK stocks that typically have a market capitalization below £150m. It is also unusually concentrated as it typically only holds between 12 to 18 companies.
Aside from being trust managers Judith MacKenzie’s and Nick Hawthorn’s area of expertise, the focus on companies at the smallest end of the market is something that helps the DSM team find cut price opportunities. Unlike the capital’s property market, many London-listed small caps receive little attention from investors.
The result, according to the team at DSM, is that while the risks associated with the smallest companies should not be ignored there is arguably much more opportunity to find stocks in this part of the market trading well below their actual value than further up the market cap scale.
The Volex value play
A good example is Volex, DSM’s largest holding, where the majority was purchased at 75p. The trust managers have realized value in the stock by selling down some of their position but believe there is still plenty of upside to be gained from it. While they may yet be disappointed, the results from the investment so far are also a strong example of how DSM’s value-based approach can pay off when things pan out.
A similar story may be playing out with another of the DSM’s major holdings, Real Good Food, which was one of the trust’s first acquisitions back in 2017.
It’s also been a slightly different investment to Volex. Firstly, DSM took on both equity and debt in the company. Perhaps more importantly, its stake in the business was such that it could take a directorship role in the company and use that to try and enact the change it wanted to see.
Having a say in the business
Part of that involved encouraging the company to sell of some off its subsidiaries and return cash to lenders and shareholders. The result has been a return on the trust’s initial investment of 15%, and while things may not necessarily pan out, the potential is there for more gains to come.
Although it still has exposure to Real Good Food, DSM’s investment in the company thus far shows another benefit of going down the market cap scale. Aside from being able to find good value, the smaller size of these businesses mean DSM can take larger stakes in them and have more say in how they’re run.
That might mean, as in the case of Real Good Food, acting more like a private equity firm and engaging with management to realise existing assets. Alternatively, it could be persuading firms to make internal changes to their business efforts or personnel.
This may take a while…
Whether DSM takes a more active approach to its investments or leaves management to the managers of the company itself, one of the challenges facing the trust and its shareholders is the time it can take for both turnarounds to be implemented and investors to cotton on to a small cap success story. The investment in Real Good Food, for instance, took several years to materialize and is still ongoing.
Part of the reason for this is that turnarounds, whether it be selling off assets or restructuring a business, can be slow to take place. Any benefits they may confer can take years to materialize as a result.
The other problem is due to the lack of information available about small caps. Although this works in DSM’s favour by creating more opportunities to find good value companies, it also means the rest of the market can take a long time to figure out that a company is worth investing in. As this is the ultimate driver of share price growth, there can be a longer lag in time between a company proving itself and its share price increasing than there typically is further up the market cap scale.
A hockey stick portfolio?
This may be part of the reason DSM has tended to underperform its benchmark, the Numis Smaller Companies Index since launching. But it’s also something the trust managers have been telling shareholders to expect from the start.
MacKenzie and her team have said repeatedly that investors should expect to see returns over a 5 – 7 year period. They’ve also predicted a hockey stick-like performance over time, in which a period of underperformance is followed by strong returns.
There is no guarantee that their predictions will be proved correct, but heading into 2022 there are some positive signs. The majority of the trust’s underlying holdings have seen insiders buying shares and DSM’s own management team has been investing in the trust itself, suggesting those who know most about the portfolio are confident enough to put their own money to work.
For those who share the managers enthusiasm for the UK’s smallest companies, and their view that the sector contains bargains for those with the patience to wait for them to reach fruition, this could be an interesting time to consider the trust.
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