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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.

The past decade has not been kind to value investors. A long period of access to cheap capital, combined with euphoric beliefs about the potential growth of specific companies, often made a more even-handed approach to markets look like something that belonged in the past.

What a difference a few months can make. Since the last quarter of 2021, we’ve seen a sea change in markets, with shares in many highly valued companies plummeting, as the prospect of inflation, war in Ukraine, and lingering pandemic-induced problems all combined to make these sorts of businesses much less attractive than they were 12 months ago.

Value-driven investors have not been totally immune from these problems, but they have tended to fare much better than their growth-oriented counterparts. That reflects something of a flight to safety, as investors looked for reliable firms that they believe are more likely to endure a tough macroeconomic environment.

Deep value investors have had a slightly different experience. Just as they weren’t lifted by much of the market mania of the past few years, nor were they particularly badly impacted by the fallout of the past few months.

Downing Strategic MicroCap (DSM) is arguably a good example of this. The trust invests in companies at the smaller end of the UK small cap market, with a concentrated portfolio containing 12 to 18 companies. These businesses have tended to be shunned by investors over the past few years, but also haven’t seen any material new investment in 2022.

The result is that DSM’s net asset value (NAV) has remained relatively stable so far this year, dropping by approximately 5.3% as of 13 July 2022, compared to a 27.2% fall in FTSE AIM-All Share Index.

Despite performing well on a relative basis, the trust has seen its discount widen substantially to 20% over the same period. The trust’s board announced plans this year to redeem up to 50% of shareholders’ investments in March 2024 at their NAV.

Arguably this represents a value play in and of itself, assuming relative outperformance continues and the appeal of redemption remains, then the market seems more likely to recognise the trust’s potential, leading to a tightening of that wide discount.

The fact it hasn’t been given this recognition thus far may reflect the dynamics of the portfolio itself. DSM managers Judith McKenzie and Nick Hawthorn look for value opportunities in the small cap space, often with the intention of taking an active role in influencing how the introduction of strategic initiatives can unlock shareholder value in holdings.

Investing in this way does not lend itself towards any sort of momentum trades – DSM investors aren’t going to be riding a wave of hype-driven returns for their holdings. The idea is to get in long before other market participants realise the ‘true’ value of the investments made. This is why Judith has always said investors should be prepared to invest for the long-run, with a three to seven year time horizon for each investment. It is worth noting that the trust is now just over five years old, so theoretically has a portfolio of ‘maturing’ investments.

Flowtech provides a good example of this. The company, a master distributor of fluid power products for many industries, had a tough time during Covid, when many of its customers were forced to close shop.

But earnings are on track to recover and the firm looks capable of maintaining a strong free cash flow yield moving forward. Partly that will come from growth but the firm is also taking steps to cut costs and improve operational efficiency, which should ultimately mean better returns for shareholders.

DSM took a stake in Flowtech back in mid-2020, when the start of the pandemic caused its share price to fall dramatically. Judith and Nick believed the company would see a bounce back – which has since happened – and that there would be growth further down the line. We are yet to see that growth but it’s still early days and there are certainly signs that it’s in the works.

It’s a similar story with Digitalbox. Despite a recent de-rating, the digital media company has managed to deliver strong returns for DSM since the trust took a stake in it.

There have been some very positive signs here, most notably with the acquisition of student media site The Tab. In a relatively short period of time – Digitalbox only completed the deal in October 2020 – the company has managed to turn The Tab into a profitable business, with good opportunities for growth.

The company made another acquisition in May, with the conditional purchase of TVGuide.co.uk. The site has over a million monthly visitors and the Digitalbox team believe they’ll be able to achieve another quick turnaround by using their own technology stack to deliver better advertising revenue and ultimately grow the company as well.

The Digitalbox and Flowtech deals show that Nick and Judith’s investment process can work. But they’re also indicative of the long periods of time it can take for those investments to bear fruit. Given the substantial discount the trust trades at today, as well as some of the value-driven tailwinds working in its favour, those investors who are prepared to be patient may find the trust a useful means of getting some small cap exposure in their portfolio.

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