Downing Strategic Micro-Cap 09 February 2022

Downing Strategic Micro-Cap (DSM) is a highly differentiated investment trust. The managers aim to benefit from valuation inefficiencies at the smallest end of the UK’s stock market and use the investment trust structure to access these opportunities without worrying too much about the illiquidity of the underlying investments.

DSM has a highly concentrated, high-conviction portfolio assembled by a truly active manager. Aside from the levels of research and due diligence that the team perform when selecting investments, their active approach can also involve them proactively engaging with the senior management or board in order to effect a catalyst to boost the valuation. DSM is by definition a ‘value’ investment strategy based on fundamental analysis, with a longer investment timeframe than most.

Performance since IPO has perhaps not been everything that the board and manager would have hoped. However, it is perhaps not surprising to have seen DSM underperform the more growthy AIC UK Smaller Companies peer group. Having a very different portfolio to the peer group means that DSM might be expected to deliver very different returns. This has been particularly evident this calendar year (2022), which has seen it outperform more growth focussed trusts by a considerable margin.

DSM’s discount widened dramatically during 2020. More recently, DSM’s board have been buying back shares regularly at wide discount levels. The latest share buyback was on 27/01/2022, which we estimate was at a discount of c. 19.1%. Combined with the manager’s estimated underlying discount that the portfolio trades at, DSM remains a truly ‘deep value’ opportunity.

The size of company that DSM invests in is significantly smaller than many institutional investors will contemplate. As such, DSM offers an idiosyncratic exposure to companies that are unlikely to be found in other funds or portfolios. It is perhaps unsurprising that during January, when the AIC UK Smaller Companies sector has stumbled thanks to inflation fears and rising interest rate expectations, DSM has performed well in absolute terms and on a relative basis, up by 3.3%% (Source: JPMorgan).

In our view, the stark outperformance of the peer group so far this year (2022) highlights how DSM does offer a differentiated return profile, which at certain times may add to diversification. The managers appear confident of the underlying recovery potential when the UK economy is finally able to shrug off COVID-19. A combination of a recovery in DSM’s companies earnings, and higher multiples if the market starts to rate them more highly, could be a powerful cocktail for shareholder returns.

At the same time, DSM trades on a wide discount to NAV, and the board are buying shares back. At current discount levels, DSM seems well-positioned for investors looking for a very differentiated and idiosyncratic exposure to the UK Small Cap space. DSM might be considered a classic value play, and so if current momentum continues, this discount might be expected to narrow. Nonetheless, we caution the discount has at points been wider during the recent past.