What makes small, small?

Financial professionals are probably among the most adept people in the world when it comes to linguistic gymnastics. What may mean one thing in normal circumstances, can mean quite another when it appears in the marketing material for an investment fund.

Take the word ‘small’, for example. It’s hard to imagine some of the biggest companies on a given exchange fitting that description. And yet there are funds which invest in ‘small’ companies that end up holding these sorts of firms.

To be fair, this is an extreme example and there isn’t always malintent behind this process. Sometimes there is just a large grey area when it comes to figuring out what makes a ‘small’ company ‘small’.

For example, a FTSE 250 firm is obviously going to be smaller than a FTSE 100 one. And yet relative to many companies listed on AIM, the FTSE 250 company is likely to look gigantic.

The informational edge

With that in mind, it doesn’t seem unreasonable that many UK small cap funds tend to cluster around companies that sit between the large caps of the FTSE 100 and the tinier firms further down the market.

Companies like CMC Markets, Future, and Watches of Switzerland have all become mainstays of UK small cap funds over the past couple of years. That may be alright for some investors, who just want exposure to something that’s not the large caps at the top end of the market.

But for many, those sorts of businesses would still hardly fit the small cap bill they’re looking for. Yes, they may not be sitting alongside the likes of BP and Shell, but they’re still businesses that often have multi-billion pound market caps.

Perhaps more importantly, lots of small cap investors want to gain an informational edge on the wider market. The sorts of firms mentioned above may receive less analyst coverage than their larger peers, but they still receive plenty of attention from both research teams and the press. Gaining an edge via good research is still possible then, but not as much as investors might like it to be.

Investing in the microverse

Fortunately there are still options available to investors looking to get exposure to some of the smallest firms on the London Stock Exchange today. Arguably the clearest example of this is Downing Strategic Micro-Cap (DSM).

The investment trust lives up to its name by focusing on the truly ‘small’ end of the London listed equities market. Companies in the portfolio, which also includes some unlisted businesses, typically have market capitalisations below £150m at initial investment.

Fund managers Judith MacKenzie and Nick Hawthorn tend to take a value-oriented approach to the market. That can mean looking for businesses which the DSM team believe are undervalued relative to their current share price. Alternatively, it can mean picking firms that are still trading at higher valuations but which offer good value for money based on their prospective growth opportunities.

The small size of the companies the trust invests in also means that the managers are capable of taking relatively large stakes in firms. That enables them to work with company management on changes that can enhance shareholder value over time.
The reason they’re able to do this is that these sorts of firms tend to be unloved by the wider market. Partly this is because large funds often can’t take stakes in micro-caps because of liquidity constraints.

It also goes back to that issue of research coverage. In some instances, there may be no analysts covering a particular firm. For the DSM team that means there is more opportunity to carry out detailed proprietary research and uncover attractively valued companies.

A shift to value?

Of course, neither of those two factors is a guarantee of success and, since launching in 2017, DSM has struggled at times to see returns on its investments. But that may have also been because of some of the stylistic headwinds that were working against the trust.

It’s been very painful to be a value investor over the past few years. For smaller companies, where share prices can often take a long time to catch up with fundamentals, that’s arguably been truer than any other area of the market.

As we head into 2022 there do seem to be signs that this is changing though. Political instability and inflation mean investors seem increasingly unwilling to pay vast sums of money in return for promises of future cash flows that may not arrive.

At the same time, some of the companies in the DSM portfolio, which is typically a highly concentrated collection of 12 to 18 stocks, are starting to produce the goods and are seeing share price increases as a result.

Publisher Digitalbox, for example, has had multiple earnings upgrades since the trust invested and its share price has risen as a result. The same is true of other holdings, like engineering group Hargreaves Services.

Its still early days, and the world is even more uncertain than usual at the moment, but these could be promising signs for DSM. Against that backdrop and given that the trust trades at a 20% discount at the time of writing, those seeking exposure to the smallest companies on the market may find the trust appealing.

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