Downing Strategic Micro-Cap 16 November 2022

Downing Strategic Micro-Cap (DSM) is a highly concentrated trust focussed on companies at the smallest end of the UK stock market. The managers look to capitalise on market inefficiencies to find undervalued opportunities. Despite being a headwind for a number of years, the trust’s value-orientated approach has contributed to a period of relative outperformance this year (see Performance), and the managers believe the majority of the portfolio is well financed and should be resilient to a period of stagflation.

In the context of GBP’s weak performance relative to other currencies and also the UK equity market’s low valuation, many commentators have said they expect an ‘M&A wave’ of foreign-led corporates and private equity to buy UK companies on the cheap. As we examine in the Portfolio section, DSM’s significant portfolio holdings have characteristics that we believe acquirors might find attractive when sizing up an M&A target. The concentration of the portfolio, with nine holdings that each represent over 5% of NAV, means that if any were taken over, there could be a meaningful impact on NAV.

Irrespective of the M&A potential the managers believe that their portfolio is priced at distressed valuations. They believe that markets are pricing in a negative economic outcome but not considering a recovery, and that as such, valuations do not reflect fundamentals.

We note DSM already has a significant cash balance, at 14% of NAV (see Gearing) which provides defensiveness and firepower. Any sales (from M&A or otherwise) would add to these resources (as we discuss under Discount).

These are challenging times for investors, the UK economy and UK companies. In DSM’s managers’ view, their portfolio companies are battle-hardened and were positioned for tough times already, given DSM has outperformed it peers year to date. That said, this is a highly concentrated portfolio, meaning that if any of the portfolio constituents hit a road-bump, shareholders will feel it. On the other hand there is clear upside potential, given companies are ‘priced to go’ valuation-wise, and could be potential M&A targets.

As we examine in the Portfolio section, many of the financial characteristics that acquirors look for are exhibited by DSM’s companies, and with UK assets still considerably cheaper to a dollar investor, they might now look very tempting indeed. The concentration of the portfolio means that if one or more of DSM’s holdings is bid for, the effect on the NAV will be meaningful. This is in contrast to much more diversified trusts, where single stocks do not tend to have much of a direct influence (for good or for bad) on short-term NAV performance.

DSM is still trading on a very wide discount to NAV in absolute terms. The managers’ contention has for some time been that the underlying holdings’ valuations are so low they will offer protection in a broad market sell-off. This year has proven that case, with DSM’s NAV not having fallen as far as that of its growth-orientated peers. The concentrated portfolio clearly brings potential specific risk, but for investors wanting an exposure to managers who are actively overseeing a portfolio of companies that are positioned for challenging economic conditions, and which may benefit from an M&A wave breaking on UK shores, DSM must be a potential candidate.