Downing Strategic Micro-Cap 14 July 2023

Downing Strategic Micro-Cap Investment Trust's (LON:DSM) managers, Judith MacKenzie and Nick Hawthorn, focus on companies at the smallest end of the market, typically looking at companies with market caps of less than £150m. The managers take a fundamental, valuation-orientated approach to identifying holdings. This leads them to have a value bias, in contrast to many peers. When they find these ideas, the managers back them with conviction, resulting in a highly concentrated Portfolio of between just 12 and 18 holdings.

Performance has been challenging for the team relative to the AIC UK Smaller Companies peer group. The managers believe that the recent increase in M&A activity has put the valuations of UK smaller companies back in the spotlight. There has been one takeover in the portfolio in the past financial year, but the managers have suggested this could be a bigger feature over the next couple of years, as they believe their holdings remain significantly undervalued versus their intrinsic values. As the portfolio is highly concentrated, any takeover in the portfolio could have a material impact on Performance. By focussing on micro-caps, the managers can take a significant stake in companies, which provides them with the opportunity to have input on their future direction. This means they could encourage firms to accept a takeover if it is in the best interests of them as shareholders.

In January, the board reiterated the date for a potential redemption option for shareholders. This would allow investors the opportunity to request up to 50% of their investment back as cash at NAV, in May 2024. The board has been active in trying to narrow the Discount of the trust and, since the announcement, this has narrowed further and is now trading in line with the five-year average, having previously traded considerably wider.

We believe that DSM stands out for a number of reasons. Firstly, the managers’ focus on micro-caps, with an eye for valuation, means the Portfolio is unlikely to have much overlap with many other trusts in the peer group. This portfolio is also highly concentrated, meaning the managers can interact with their companies, often encouraging changes in leadership and strategy to try and unlock value. We believe this approach has become particularly pertinent in the wake of increased M&A activity, especially in UK smaller companies. The managers have already encouraged one holding into private hands, resulting in a materially positive impact on Performance. While never a guarantee, we believe there is considerable scope for this to be a feature going forward. This could be especially beneficial in DSM due to the concentrated nature of the portfolio.

The board has also reiterated, and set a date for, a 50%-redemption point. We believe this offers an element of protection for investors. The board has been active in trying to narrow the Discount, which has borne fruit in the past year, and the redemption point could lead to a further narrowing. We think as 31/05/2024 comes closer, investors may better appreciate the potential opportunity to have a cash return, which arguably puts a floor under the discount.