Tapping into economic recovery through the UK's booming smaller companies

After years in the wilderness following the vote to leave the EU, the UK is now emerging as one of the most attractive markets for investment across the globe. This revival in fortunes is due in part to the success of the UK’s rapid vaccine rollout, and the potential for a strong economic recovery as the country has emerged from lockdown over the summer. 

With almost all Covid-19 restrictions now removed and as people embrace the ‘new normal’, where should investors look for the best opportunities for tapping into the recovery? 

Small is beautiful 

As UK small/micro-cap investors with a strong value bias, we believe that this part of the market is currently very attractive. In the first half of 2021, UK smaller companies represented the top performing IA sector, generating a total return of c.20%1. Despite this impressive performance, it is an area of the market that is often overlooked. This is fundamentally due to inefficiencies and a lack of analyst cover both on the buy and sell side, meaning UK micro-caps continue to look undervalued. 

Compared to larger peers, and those in other geographies, UK small caps look cheap, with a forward median PE of 16.1x compared to the S&P on 22.5x2.  It is therefore no wonder that the level of corporate activity and inward buyers to the UK small cap market is so buoyant. This has begun to reach the micro-cap sector and we expect to see more activity as earnings improve to pre-pandemic levels. 

A further positive for the asset class is the potential for superior investment performance - it has long been understood that smaller companies outperform their larger cap peers over the long term. They can afford to be more agile in the face of evolving demand and often fulfil very specific needs and operate in niche markets. Many small businesses have survived Covid-19 and emerged stronger and with more operationally efficient business models.  

However, the very smallest UK companies, with the greatest potential for growth, tend to be under researched and are not well covered by analysts. The introduction of MiFID II has exacerbated this, and we believe that there is only 0.6 of an analyst per company covering companies in the sub £150 million market cap space. However, less cover and poorer quality research creates opportunities to find those businesses that are not priced correctly, relative to their intrinsic value and growth potential. 

How do you access this opportunity? 

There are a number of ways of investing in small and micro-cap companies, but we believe that investment trusts are an attractive option, given that they are ideally suited to investing in less liquid assets. This is because investment trusts have the advantage of their closed-end structure, which allow managers the freedom to buy and sell holdings as and when they want rather than have their decisions dictated by fund flows. This is in contrast to the equivalent open-ended funds which run the risk of trading suspensions and the forced selling of assets to meet redemptions. 

Regardless of sometimes challenging economic conditions, investment trusts continue to be traded on the stock market as we witnessed through the pandemic. Typically, their discounts – when the share price is less than the NAV per share - will widen, and it may not be a good time, but shares may still be sold. This discount also offers an attractive entry point for investors to take advantage of market sentiment. 

Importantly, the manager of an investment trust does not have to sell underlying assets in order to fund redemptions because those investors wishing to sell their shares do so on the open market, to other investors. The closed-ended structure allows investors to harness the long-term benefits of investing in less liquid assets without the managers being forced sellers, or buyers, on bad days in the market.   

Bargain trusts – trading at a discount 

There are several excellent investment trusts focusing on UK small and micro-cap companies – many of which are considered cheap because they are currently trading at a discount. There is considerable variation in the investment strategies adopted by managers such as the number of holdings, market cap bands, their levels of borrowing or ‘gearing’, the types of instruments they invest in, and the size of the positions they take in individual holdings.  

The Managers actively engage with the underlying companies 

The Downing Strategic Micro-Cap Investment Trust (DSM) is almost unique in the space as it is a concentrated portfolio of between 12-18 positions in companies under £150 million market cap at initial investment. The Trust is strategic in that we take influential positions of between 3-25% of the underlying equity in businesses that we believe are undervalued and could benefit from strategic and operational initiatives to drive performance and unlock shareholder value.  

A significant equity holding allows the managers to be strategic, to engage closely with aligned management teams and put catalysts in place to drive returns. Following extensive due diligence, the managers develop plans where they have tangible levers to help generate better performance.  In turn, that better performance will ultimately lead to better earnings and cash flow, ultimately leading to an improved share price too. When these catalysts play out, the aim is to close that gap between the value of the company today and what they believe it's actually worth. 

It can take time for these strategic catalysts to play out and DSM has a long-term investment horizon, with a rough lifecycle for this type of investment of between three and seven years. DSM is currently trading on a c.14% discount to NAV3, which the managers feel is unjustified given the quality of the portfolio. 

Tapping into the rebound 

Investment trusts can offer reliable streams of income, the opportunity for strong long-term growth, and access to less liquid assets in a stable, closed-ended structure. For investors looking to take advantage of the recovery in markets and positive outlook for the domestic economy, UK small and micro-cap investment trusts make a compelling opportunity for attractive returns in the short, medium, and longer term.  

1 Shore Capital, Capital Markets, Downing Strategic Micro-Cap Investment Trust - “Portfolio recovery – moving up the J-curve" Research Note 26 July 2021 

2 Factset S&P 500 and FTSE Small Cap report, 27 September 2021 

3 As at 28 September 2021 

For more information visit: downingstrategic.co.uk 

About Downing Fund Managers

Downing Fund Managers (DFM) is part of Downing LLP, a company with over 30 years’ experience and more than £1.4 billion AUM. DFM was founded in 2010 as a boutique investment house with a value-based style that favours a private equity approach to investing in public markets. The range of mandates covered by DFM now consists of five funds – all different from, and complementary to, each other. DFM are also committed to the Principles of Responsible Investment, which can make investments more rewarding by being profitable for our investors. 

Risk warning: Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Please note target returns are not guaranteed. Investments in this fund should be held for the long term and are higher risk compared to investments solely in larger, more established companies. Values may be affected by fluctuations in currency exchange rates and may cause the value of your investment to go up and down. Diversification may not be achieved and investments may be in the same sector. Opinions expressed represent the views of the Fund Manager at the time of publication, are subject to change, and should not be interpreted as investment advice. Please refer to the latest full Prospectus and KIID before investing; your attention is drawn to the risk, fees and taxation factors contained therein.  

Important notice: This document is intended for retail investors and their advisers is for information purposes only. It does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. Downing does not offer investment or tax advice or make recommendations regarding investments.  

Downing LLP is authorised and regulated by the Financial Conduct Authority (FRN: 545025).  Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.