The case for investing in micro caps through funds
Macroeconomic uncertainties, the return of volatility and political turmoil suggest diversification will prove a key investment watchword in 2019.
One way in which investors can diversify portfolios is by allocating funds to UK micro caps, often agile and fast-growing minnows offering better value relative to larger caps; they fly under the radar of big institutional investors and are generally less well researched than their larger corporate cousins.
‘MINI’ IS READY TO MOTOR
Open-ended funds offering specialist exposure to the asset class include Liontrust UK Micro Cap (BDFYHP1), LF Gresham House UK Micro Cap (BV9FYS8) and FP Octopus UK Micro Cap Growth (BYQ7HN4).
In the investment trusts (closed-ended) universe, Shares recently enjoyed a briefing with smaller companies guru Gervais Williams, who co-manages Miton UK Microcap Trust (MINI) alongside Martin Turner, a collective currently trading at a 4.2% discount to net asset value (NAV).
For the half year to 31 October, Miton UK Microcap Trust’s NAV fell 12.4%, reflecting the general move in markets but not helped by a plunge in the share price of business energy services play Yu Group (YU.AIM), pummelled by an accounting bolt from the blue.
Yet Williams insists this is a moment when the characteristics of the trust’s micro cap approach, with a strong valuation discipline and a focus on financial robustness, could come to the fore.
Smaller companies are more prone to share price volatility and smaller balance sheets can make them more vulnerable to financial shocks. This makes packing the right companies important and that’s where the expertise of a fund manager can be an advantage.
Williams points out micro caps operate across a wider range of industry sectors than those companies contained in the mainstream indices, which are increasingly dominated by giant global companies in a narrow band of sectors.
Consequently, micro cap returns aren’t usually correlated with the daily or monthly moves of larger quoted companies, thereby offering diversification for investors.
Referring to globalisation of trade and then the asset price-distorting impact of QE, Williams says: ‘You’ve had 30 years where basically returns have been very satisfactory and being entirely truthful, you didn’t need any micro caps in your portfolio because you would have made money with a dartboard. Housing, bonds, equities, it all went up.’
Yet with globalisation in retreat and QE being unwound, global growth is slowing, reality is hitting home and valuations matter.
Williams believes ‘one of the key drivers of premium return going forward will be that most asset allocators willingly, or dragged by their investors, will increase their participation outside the FTSE 350.
‘Specifically into small caps and specifically into small and micro caps. That is a sensationally exciting moment because the UK market is one of the few international markets where we’ve still got a vibrant community of small micro caps. We believe that small micro is on the verge of a long term secular period of outperformance.’
Williams generally looks for ‘recovery, overlooked, more value’ situations rather than stratospherically rated go-go-growth stocks that can fall back to earth.
‘We’re very keen on doing a large number of meetings to try and pick up on those kinds of opportunities, so that if we believe the recovery is coming, our entry price is very low and the risk/reward can be very attractive.’
MINIS AND MICROS
Yu Group had been ‘over-accruing profit and sales in some cases’ laments Williams who is nonetheless sticking with this longer-term portfolio holding and reassured by ‘a very strong balance sheet’.
Williams is excited by unloved cybersecurity and intelligence firm Falanx (FLX:AIM), whose transformational partnership with US-based software company SolarWinds means ‘the share price could be a multiple of what it is now’.
The trust has also been building up a position in Mercantile Ports & Logistics (MPL:AIM), investing tens of millions into a new port facility in Mumbai.
And the micros maestro also sees value in overlooked Conygar Investment Company (CIC:AIM), a property play that is ‘going to be surprising on the upside’ and is trading at ‘below its tangible asset value’, not to mention Cerillion (CER:AIM), ‘brilliant at helping mobile companies to deal with software solutions on billing in particular’.
Another way to gain exposure in the investment trusts space is via Downing Strategic Micro-Cap Investment Trust (DSM), a concentrated portfolio of 12 to 18 holdings aiming to generate a 15% per annum compound return through a value approach that includes exerting influence through strategic stakes.
‘We are value investors in the micro cap space,’ says lead investment manager Judith MacKenzie. ‘We get the catalysts in place, we get the companies to be a bit more marketable and we’re pretty much the dominant shareholder in every position.’
Portfolio positions include recovery situation Real Good Food (RGD:AIM), refocused on cake decoration and food ingredients, refinanced and under new management and with ‘upside value to come from the turnaround’ according to MacKenzie, who sits on the board as a non-executive director.
The fund also has a stake in private company financing specialist Duke Royalty (DUKE:AIM).
There is also endurance sports nutrition tiddler Science in Sport (SIS:AIM), which recently acquired premium performance nutrition brand PhD Nutrition for £32m.
Another under-the-radar outfit held is FireAngel Safety Technology (FA.:AIM), the smoke alarms and CO alarms supplier benefiting from some ‘great regulatory drivers’ and generating ‘decent margins. It has had growing pains, but FireAngel is on the block for change over the next 6-12 months’, insists MacKenzie.