Kepler Trust Intelligence
Updated 29 Sep 2021
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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.

Some of the most interesting opportunities available in stock markets can be found amongst the smallest listed companies. Even Google started somewhere, and among these companies are likely to be some of the bigger companies of the future, operating in niches and technologies that are primed for growth.

Meanwhile, from an investment perspective, their newness, nicheness and nimbleness often means that valuing them is a challenge and the market is often guilty of dramatically undervaluing them, given their significant potential.

However, because these companies are so small, it can also be hard for private investors to take advantage of the opportunity presented by this mispricing. Both from an informational standpoint – these companies only produce the minimum disclosures necessary and often have few comparators – and from the point of liquidity, where limited knowledge of these companies creates a small market for their shares.

Small companies, big opportunities

Downing Strategic Micro-Cap (DSM) offers investors a route to the opportunities in the smallest listed companies, participation in which is often illiquid making the investment trust structure an excellent means to get the best from them. The trust focuses on just 12 companies that its management team, led by Judith MacKenzie and Nick Hawthorn, believe have the greatest potential for a pricing uptick.

This concentration enables the managers to take meaningful positions in these companies, from around 3% upwards, which in turn means that they have the clout to engage with management and help companies implement the changes needed to grow, if required.

Proof in the pudding

The newest investee company within the portfolio is Tactus Group Holdings. The company, headquartered in Warrington, supplies consumer technology, including own and third-party hardware such as basic laptops, sophisticated gaming computers and accessories to go alongside these.

Tactus is an unusual investment for DSM as it is not yet listed. However, the managers have the ability to invest up to 10% of the trust in unquoted companies, providing these are of exceptional quality. The managers believe that Tactus’ combination of a proven ability to create successful brands, alongside its track record of sensible acquisitive activity, put it in the exceptional category, and so they invested in May 2021.

Tactus had previously won a significant mandate from the Department for Education as its personal computing requirements ramped up in the early stages of the pandemic, demonstrating the strength of its basic laptops business. DSM’s investment helped finance the acquisition of a successful D2C gaming computer manufacturer, CCL Systems, the acquisition helping to expand Tactus’ market share in this space.

The strength of Tactus was demonstrated in August when FTSE 250-listed technology investor Chrysalis Investments participated in a £40m funding round, partly facilitated by DSM exiting half of its investment. This partial exit coupled with a revaluation of the remaining equity prompted a £1.07m valuation uplift for DSM. Crucially, investors would need to pay a 15% premium to access Tactus through an investment in Chrysalis – while DSM offers exposure to the company at a c. 13% discount.

A fluid path to growth?

Another of DSM’s newer investments, Flowtech Fluidpower, tick a number of the managers’ criteria for value creation – there is a clear self-help opportunity, alongside scope to de-leverage and improve structurally, with the subsequent growth of end-markets expected to follow from that process.

Flowtech is a cyclical distributor of hydraulic and pneumatic fluid-power parts and as a result was heavily affected by COVID lockdowns, as industries that use these components slowed production in the face of widespread economic uncertainty.

DSM used this opportunity to introduce the company to the portfolio at an especially attractive price. Shortly afterwards, a change in the board and a re-focused strategy have driven improvements to both costs and working capital efficiency. The firm has also invested in an e-commerce platform, which will allow the business to scale more efficiently as demand continues to return post-COVID.

Alongside these internal improvements, there are several structural drivers supporting higher revenues over the medium term and the business ought to continue taking market share across the UK. DSM’s managers continue to think that Flowtech is relatively underappreciated in the market and that there are several catalysts to see significant growth in the future.

Sifting through the smallest opportunities

Each of these companies is benefitting from a galaxy of interconnecting factors, including clear operating specialisms, skilled management teams and strong growth strategies. Yet, to identify these factors within small companies like this requires the skills to filter through the information available on the market – and a focus on meetings with company management. This is where the talents and track records of the DSM management team come into their own and is reflected in the improving prospects for their portfolio companies.

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