Disclaimer
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
There’s an incredible opportunity brewing in the smaller companies asset class, according to the speakers at our recent small-cap event. We round up the investment case here.
Global Smaller Companies
Proceedings were started with a bullish message from Nish Patel, manager of Global Smaller Companies (GSCT). He thinks that we could be the start of a long period of small-cap outperformance.
Today’s narrow stock market, led by the Magnificent Seven, reminds Patel of both the 1970s, when markets were dominated by the Nifty Fifty and the late 1990s when internet and telecoms names were in the middle of a bubble.
After both these bubbles had burst, smaller companies went on to outperform large-caps for a long period of time – for 10 years from the late 1970s and for eight years from 2000.
The three catalysts that could spark small-cap outperformance today include disappointing earnings from the Magnificent Seven; continued stock buybacks and M&A activity; and interest rate cuts, which historically benefit smaller firms more than large ones.
Given the Magnificent Seven are four times the size of the US small-cap market, if investors fled large caps for small firms it “would be like trying to pour a bucket of water into a small cup”. Translation: when small caps start to recover, share prices will move quickly.
GSCT stands to benefit thanks to its full global investment remit. As well as investing mainly in developed markets, the trust can also invest in the faster-growing emerging market segment, which it does by partnering with the top EM fund managers.
This all gives it access to the very best small-cap opportunities from across the world.
Miton UK MicroCap
A changing macroeconomic environment could see the UK stock market, and small and micro caps specifically, massively outperform the US market over the next decade or more, said Gervais Williams, manager of Miton UK MicroCap (MINI).
The post-1980 world order that saw rampant globalisation ushered in a long period of benign, low inflation thanks to the ever-lower cost of imported goods. Wiliams sees the new world being characterized by an unsettled geopolitical order and nationalistic agendas that will lead to reshoring and volatile inflation readings.
Before the mid-1980s, inflation zigged and zagged, sometimes spiking high, sometimes bringing deflation – both of which are bad for companies, Williams said. If we return to this pattern, the global stock market could flatline for decades because of its reliance on the likes of Nvidia and Apple.
The UK market massively outperformed the US index in the 1970s and could do so again. Within that, small companies could thrive. For Williams, globalisation has favoured ‘bigness’, but nationalism will favour small caps.
MINI is well positioned to benefit from this new era, not only because of its focus on micro-cap stocks. The trust is well-diversified across a wide range of companies and sectors – yes, it has 19% in technology, but it also has 16.5% in materials (read: mining), and 13.3% in financials.
One success story the trust has had is Yu Group, an energy and utility solutions supplier. Since MINI invested four years ago, the share price is up 25 times – outperforming even Nvidia – yet the valuation remains depressed.
Rockwood Strategic
Richard Staveley, manager of Rockwood Strategic (RKW), talked to the opportunity within the trust’s portfolio, which is very different from its small-cap peers. The trust has just 20 holdings and targets an internal rate of return (IRR) on each of 15% a year. Essentially, they seek companies that can double their money over a five-year holding period.
Of the eight companies already exited, only one came in below that 15% target level, with many more well above it. The good news is that private equity houses have record levels of dry powder, so the bids should continue to roll in.
Staveley highlighted a few exciting opportunities in the portfolio today.
When RKW invested in FundingCircle, a technology platform that facilitates lending to small, often family-owned, businesses, earlier this year, the company’s market cap had fallen from £1.5 billion at its 2018 IPO to £110 million. That valuation was despite the business having £175 million of unrestricted cash in the bank, £50 million of restricted cash and a loan portfolio of £60 million. The market cap is already up to £328 million, but Staveley thinks it can still double from here.
Hostmore, which owns the TGI Fridays brand in the UK, recently announced it had bought TGI Fridays Inc, the global brand, from its private equity owner. Hostmore will own about a third of the brand globally.
Rockwood has returned 82% over the past three years, while the average UK smaller companies investment trust is down about 2.5%. Staveley said that this impressive performance had come amid a tricky backdrop of depressed sentiment and he’s hoping for a slightly easier backdrop.
AVI Japan Opportunity
Small caps in Japan have suffered the same trends (lack of interest, poor performance versus large companies and depressed valuations) as those elsewhere in the world, said Joe Bauernfreund, manager of AVI Japan Opportunity (AJOT).
However, there are some real catalysts that are specific to Japan itself. These come in the form of the corporate governance reforms that were kicked off by Abenomics 10 years ago and seem to finally be hitting their intended targets.
Japanese firms have built up huge amounts of cash over the years but did little with it, leading shareholders to assume that this money belongs to the companies themselves, not the owners of the business. In addition, for years, there’s been a prestige associated with being a listed company meaning companies have had an aversion to being privately owned.
This is all changing. Companies are more receptive to activist shareholders (as long as engagement is done respectfully and, ideally, privately) and are happier to let their business be taken private, whether that comes from a private equity buyer or a management buyout.
This has led to a massive increase in share buybacks, while the number of activist resolutions tabled at AGM has risen from just four in 2014 to 71 last year.
AJOT stands to benefit because of its high-conviction portfolio and its focus on taking meaningful stakes in companies where it can privately engage and drive change.
The trust used its 23% stake in NC Holdings, a £48 million conglomerate, to successfully lobby for a higher payout ratio that eventually resulted in a takeover bid by another large shareholder at a substantial premium to the share price. That has allowed AJOT to exit with an attractive IRR over a holding period of about three years.
