David Kimberley
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Updated 02 Nov 2022
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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.

Downing Strategic Micro-Cap (DSM) has released its half-year results for the period ending 31/08/2022. During the period, DSM saw a 6.7% decline in its net asset value (NAV). The FTSE AIM All Share fell by 14.6% over the same timeframe on a total return basis. DSM takes a value-driven approach to the market and the defensive characteristics that companies in the portfolio possess may have supported this relative outperformance.

The managers deployed £1.9m in the period, taking three new positions and adding to three existing ones. Realisations totalling £4.3m were made in the period under review, with a net gain of approximately £998,000. The trust managers had £5m in cash available to them at the period end, representing 14.7% of NAV. Further deployments of capital remain a possibility and the managers have a list of potential investments that they are prepared to make if valuations hit the requisite levels.

Despite holding up comparatively well in NAV terms over the six months to 31/08/2022, DSM’s discount widened significantly. The trust’s discount at the end of the period was 23.7%, compared to 14.8% at the end of February. There has been no substantial change to this in the intervening period as the discount sat at close to 25% as at 31/10/2022.

Volatility meant that the trust’s board did not engage in any share buybacks during the period. However, buybacks did start again in October. The board has taken other steps to help manage the discount, including hiring finnCap as broker. Earlier this year, we note that the board proposed plans to redeem 50% of DSM shares in May 2024.

Chairman of the board Hugh Aldous said: “[The UK] needs further funding and economic growth to fuel investment. An important part of that investment should be in good, well-managed, vigorous small companies that meet national necessity and growth. [DSM’s] portfolio matches that descriptor across important sectors. Even in troubled times it has proved resilient (hence the better performance against the market). It remains a portfolio for the future.”

Kepler View

Downing Strategic Micro-Cap (DSM) takes a unique approach to the UK small cap sector, with a highly concentrated portfolio typically comprised of 12 – 18 stocks. Managers Judith MacKenzie and Nick Hawthorn take a value-driven approach to the market and look to invest at the smallest end of the London equity market.

It has been a tough year for markets as a whole but UK small caps have been particularly hard hit. Of the 24 trusts in the AIC’s UK Smaller Companies sector, not one had produced positive total returns in NAV or share price terms in the 12 months up until the end of October.

DSM was no exception to this but despite performing comparatively well in NAV terms in relation to its peers so far in 2022, its discount is now among the widest in the UK small cap sector. As at 31/10/22, DSM shares were trading at a nearly 25% discount.

There are some potential tailwinds that may help to narrow the discount over time. One is the introduction of a share redemption that the DSM board has proposed takes place in May 2024 and means up to 50% of DSM shares can be redeemed at NAV. On the proviso that performance holds up then this may act as an attractive opportunity for some investors and help to tighten the discount.

Moreover, there are some signs the companies in the DSM portfolio may be relatively well equipped to endure what looks set to be a tough macroeconomic environment. The bulk of the companies in the portfolio renegotiated their debts prior to interest hikes coming into play this year. Some are also sitting on a net cash position, meaning they’re less likely to be impacted by rate hikes.

The trust itself has ample cash holdings of approximately £5.1m, or 14.8% of the total portfolio . The managers have a list of companies that they’d like to take positions in and they are well-placed to do so if the opportunity presents itself.

A far less certain possibility is the potential for companies in the portfolio to be acquired. A cheap pound and already depressed valuations relative to global peers have made the UK a more attractive arena for mergers and acquisitions over the past couple of years. Given how concentrated the DSM portfolio is, any takeovers made at a premium would have more of an impact on returns compared to other funds. However, we would reiterate that such an outcome is hard, if not impossible, to predict, meaning investors should not be pinning their hopes on acquisitions.

Looking forward, it’s plausible that the more value-oriented approach the managers take, combined with an already wide discount, could provide a cushion against further falls in the DSM share price relative to its NAV. If performance is steady or improves then, along with the prospective share redemption programme, one would hope that this might lead to a tightening of the discount – though there are no guarantees of course.

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