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.
It takes all sorts of companies to make an economy function. Most investors are conscious of the power of diversification to some degree – investing across sectors, geographies and asset classes. However, there are still areas of the market that are relatively untapped by private investors. One such area is micro-caps.
This may be due to both the unique characteristics of the asset class and the misconceptions regarding it. Whether it’s the illiquidity associated with the smallest companies, or the association with the black box processes of private equity and venture capital, these factors can present a complicated picture that leaves many investors disincentivized to invest in the market.
Here, we aim to bring clarity to these concerns and examine the forces that impact micro-cap investing.
A specialist sector
The majority of private investors will never have considered investing in micro-cap companies. This may in part be due to several assumptions associated with the segment: that companies at this size will almost certainly be private, that the sector will consist entirely of speculative technology names (or conversely unambitious mom and pop-type businesses), or that most investors looking at the smallest businesses land on the same few names for their portfolios.
None of these are true, but the assumptions are understandable. For instance, over 1000 companies are publicly-listed with a market capitalisation of under £150m. Many of these are profitable, established businesses with clear growth paths, such as regional publishers and beauty product manufacturers – far from the speculative pre-profitable technology often associated with companies of this size. Furthermore, with a universe that large, there is a big enough pond for investors to fish in.
On the other hand, some of the assumptions around this segment are more accurate. Notably, after two decades in which newer firms have become business behemoths, the growth potential for micro-caps may be significantly greater than for large-cap peers. According to research from Grant Thornton1 published to mark the AIM market’s 25th anniversary in 2020 (The AIM or ‘Alternative Invesmtents Market’ is where the UK’s smallest companies list first’), AIM companies grew by 40% year-on-year over their first three years following IPO – outpacing both private company peers and large-caps.
A further benefit of considering this end of the market is that the investment universe is regularly refreshed. Through spin-offs, listings and mergers new companies and/or company structures are constantly emerging, offering investors fresh ideas and opportunities.
Effective due diligence
This doesn’t mean though that investing in micro caps is without challenge.
Lack of analyst coverage is an oft-touted issue when investors look down the market cap spectrum. While mega-cap names in the FTSE 100 can be covered by an average of 20 analysts, small-cap names with a market capitalisation of approximately £1bn or less are typically covered by fewer than four analysts. This gulf widens further when it comes to the smallest companies, with many micro-cap businesses covered by no analysts all.
As a result, successfully investing in micro caps requires each prospective investor to take an especially deep look through a company’s balance sheets, operational practices and individual markets. For an individual investor this level of due diligence is a significant challenge, in terms of time, skill and access.
Although the listed micro-cap universe is in many ways very different from the private equity one, the due diligence techniques employed by private equity investors – rigorous investigation of a business, its peers and its management – are useful in this arena too. With this in mind, investing through managers with experience of this sort of approach could be a helpful route for private investors.
The risks of looking micro
The need for experience is especially evident when considering the particular risks of investing in micro-caps. These are threefold: corporate viability, volatility and liquidity. Smaller companies by their nature have fewer capital resources to draw on, and less access to external financing options, meaning that they are more vulnerable in times of market stress.
Smaller-cap companies’ share prices tend to be more volatile, as they have relatively fewer shareholders so an individual holder’s change of sentiment can rapidly have an impact – and the market can turn rapidly negative on the whole segment in periods of economic downturn.
Further, this smaller shareholder base means that liquidity can be a challenge for investors in micro-caps. This is where the investment trust structure shines when it comes to micro-cap investing. With the shares of investment trusts themselves traded freely on the stock exchange, investment trust shareholders know that there is daily liquidity should they need to redeem their investment, regardless of the liquidity of underlying assets. As with all trusts, there is a risk that the market underappreciates the trust’s portfolio value and that it therefore trades at a discount to net asset value.
Case study: Downing Strategic Micro-Cap
Company: Downing LLP
Managers: Judith Mackenzie and Nick Hawthorn
Ongoing Charges: 1.94% (according to its 2023 FY accounts)
Dividend policy: The company has no stated dividend target
Benchmark: The company has no stated benchmark (although it compares performance to the FTSE AIM All Share TR)
Downing Strategic Micro-Cap (DSM) was launched in May 2017 to offer investors capital growth over the long term through investments in a portfolio of a select group of micro-cap companies that the managers believe are undervalued.
Crucial to the trust’s investment thesis is that portfolio companies are in a position to benefit from strategic and operational initiatives, which should then lead to a material upward revaluation by the market. The trust is concentrated in a limited number of companies (between 12-18 holdings) which themselves have market capitalisations of £150m or less, a combination which enables the trust to take a material position in each of its holdings. This then puts the managers in a strong position to support and influence change.
Given the level of involvement and engagement expected in this process, the trust’s investment time horizon is longer term in nature – stated as 3-7 years, but with scope to extend further as macro events can have an unexpected impact on turnarounds. Further, the concentrated nature of the trust means that individual holdings can have a significant impact on the trust’s performance as a whole.
Over the last two years, some of the trust’s investment cases have begun to play out, after a stilted first few years that were of course markedly impacted by the COVID-19 pandemic. The board has announced plans to offer a cash return of 50% of NAV in May 2024.
1) What is the trust’s goal?
DSM aims to generate capital growth over the long term through active involvement in a focussed portfolio of UK micro-cap companies (those whose market capitalisations are under £150m at the time of investment), targeting a compound return of 15% per annum over the long term.
2) What kind of stocks does the manager like?
DSM’s managers favour companies which they believe have been misvalued by the market and where there are clear catalysts for value realisation. They invest in different “buckets”, either sector leaders, self-help or recovery companies, and stable companies with opportunities to expand, although stocks can sit across these buckets.
3) Are investments driven by a particular style?
DSM is a more value-focused trust, which explicitly looks for stocks which the managers believe that the market has misvalued and can be helped to achieve an improved valuation over a 3-7 year time period. With that in mind, the managers look for businesses where they can engage with management to help enact improvements.
4) How many stocks does the trust typically hold?
The managers aim to run a highly concentrated portfolio of just 12 to 18 holdings, in order to have time to work with the management of these companies.
5) What is the trust’s dividend policy?
DSM currently has no stated dividend policy as its managers are focused on achieving capital growth.
6) What are the trust’s ongoing charges
1.94% (according to its 2023 FY accounts).
7) Does the trust have performance fees?
DSM does not have a performance fee.
8) How much attention do the managers pay to their benchmark, and to what extent are absolute returns important?
The trust has no stated benchmark and, as such, the managers do not focus on any particular benchmark. Instead the trust has a stated overall goal of achieving 15% annualised returns over the long term (which they define as at least 5 – 7 years), and this goal is the sole focus of its managers.
9) How much does the trust deviate from its benchmark?
The idiosyncratic nature of the trust, with its ultra-concentrated list of holdings, value focus and emphasis on the smallest businesses, means that it is unique within its peer group.
10) Does the trust use gearing? Is it structural or opportunity-led?
DSM does not use gearing. Instead, given the illiquidity of the underlying portfolio, the managers prefer to have cash in hand in order to take advantage of opportunities when they arise. They aim to keep net cash in the range of c. 7% to 13%.