Results analysis: Downing Strategic Micro-Cap

• Over the financial year to 28 February 2022, Downing Strategic Micro-Cap’s (DSM) NAV increased by 5.3%, versus the FTSE AIM All‐Share which was down 12% over the same period, representing significant outperformance over the period.
• The DSM portfolio consists of “value stocks, dynamically managed with strong balance sheets, appropriate to the foreseeable economy and held at modest valuations”. This is a ‘value’ strategy, in that the portfolio constituent’s quoted prices are significantly below the value at which DSM’s managers place their achievable market value.
• The board aims to manage the discount of shares to NAV, taking up loose stock where necessary, and the discount has averaged around 15% through the year. The board has announced that it plans to provide a significant redemption point on 31 May 2024, assuming no serious market disorder. That redemption will enable shareholders to redeem or have a matched sale for up to 50% of their holding. In the Chairman’s view, this should “encourage the market to improve its rating of the company’s shares as we move towards that redemption point”.
• DSM’s chairman said “DSM has now achieved two years of distinctive performance. It deserves more market attention”. The manager states that they are currently “positive on the prospects for our holdings which are generally cheaper than the wider market, with stronger balance sheets and good growth prospects from the compelling products or services they provide”.

Kepler View

Downing Strategic Micro-Cap (DSM) is a highly differentiated strategy, and one that employs the advantages of the investment structure to enable it to provide a very different exposure for investors than would be found in many other smaller company trusts. As the manager eloquently summarises it, DSM “invests in small, unloved, and overlooked UK companies under £150m market capitalisations (at the time of investment). These are typically good businesses with a core asset or earnings quality which is unrecognised by the market”. As we note below, performance in the calendar year to date perhaps reflects a change in the fortunes of DSM, in being the only trust in the UK Smaller Companies sector to have increased its NAV.

During the year, there has been plenty of activity within the portfolio. The managers aim to use strategic catalysts to unlock value over a three‐to‐seven‐year investment horizon, and the managers note that evidence is mounting that “the strategic catalysts put in place are making a difference”. During the financial year, one of the most significant events was the partial repayment of Real Good Food loan notes which returned £6.0m across the holding period, generating an IRR on the returned investment of 11.3%, and de‐risking the investment, which was previously one of the largest exposures. DSM also participated in a fundraising for FireAngel, which has helped it to restructure – and is now demonstrating significantly improved gross margins. The team also helped to facilitate the refresh of the board at Digitalbox which the DSM team think positions the business strongly for the future.

Over the year, DSM invested in six new companies deploying £11.1m in cash, and follow on investments in five existing holdings, deploying £3.4m of cash. New investments that continue to be in the portfolio include National World, Centaur Media, Norman Broadbent, Tactus Limited, and one toehold where the team are still building a position. DSM exited in full from five positions, raising £6.8m in cash. At the period end the company had net cash of £3.8m, around 8.8% of net assets.

Performance since IPO has perhaps not been everything that the board and manager would have hoped. However, performance during the last financial year has been impressive, in a period which has seen the peer group struggle. At the time of writing, year to date DSM’s NAV is +4.6% (06/05/2022, source JPMorgan Cazenove) which is significantly ahead of the simple average of the UK Smaller Companies peer group which is down 16%, with some more growth trusts down more than 30%. This will be gratifying for shareholders, and in our view reflects the idiosyncratic exposure and deep value approach of the managers.

Despite this strong performance, DSM’s discount has widened from the average level during the last financial year, and is currently wider than20%. In our view, this offers clear attractions given the resilience shown so far this year during very difficult markets and the deep value characteristics of the underlying holdings. With the board now giving clarity on a redemption opportunity in 2024, over time this should focus minds on DSM representing a classic value play itself. If current NAV outperformance continues, the discount might be expected to narrow should the market, to paraphrase the Chairman, give the trust the recognition it deserves.

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