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Now is a good time to be investing in UK micro caps, says George Ensor, fund manager of the River & Mercantile UK Micro Cap Trust.

This might sound like a bold statement, as investment trusts, micro caps and the markets generally have had a torrid time recently. UK equities have suffered the most, being the most sold peer group in 2022, according to FE Analytics. Add to that UK investors’ long-standing dislike of UK stocks, and the comment looks decidedly contrarian.

But, for Ensor, the bleak picture merely indicates a buying opportunity. He points to a comparison of the US and UK markets. “The US is expensive and fully valued, even without the big tech stocks.” By contrast, “the UK is exceptionally cheap and sentiment towards the UK is very poor.”

Small Cap premium

Ensor notes the small cap performance: over the past two years, small caps have underperformed large caps by 36%. He says: “You have to go back to 1989 to find a greater period of underperformance, and you have to go back 10 years for the UK to have a small cap premium.”

Small caps have historically outperformed large caps by 3-4% per annum, as they tend to grow more quickly and perform more accretive M&A. The investment outlook has been bleak for a while now, but Ensor is bullish. He believes the trust is well placed to benefit from another round of pro-cyclical growth: “Investing in small caps now is a once-in-a-decade opportunity. I think this sets up an opportunity like we saw coming out of 2009. The performance of small caps from March 2009 to September 2021 is about 450%, or double the return of large caps.”

River & Mercantile UK Micro Cap Trust investment strategy

The main challenge of the small cap market is that many of its stocks are highly illiquid. So, what is the investment strategy? Ensor explains, “what we are trying to achieve is to access a part of the market that is typically inaccessible to institutional capital. We are looking to invest in a portfolio of about 40 stocks, which is quite high conviction, in UK-listed companies with a market cap of between £20m and £100m.”

It is a part of the market that is often overlooked by sell-side analysts and investors. As Ensor says, “with less competition for the assets, it is easier to find high-quality or high-growth turnaround stories.”

The trust’s investment strategy is to find relatively early-stage growth businesses that are too small for institutional capital. The aim, Ensor says, is then to “own them and compound the high growth or high return on capital, and preferably both”.

As those businesses compound that revenue growth and returns, they push through the £100m and then the £200m market cap thresholds. In time, their growth makes them more investable for the institutional small cap sector, which often results in a rerating of their shares.

Keystone Law moving through market cap thresholds

An example is Keystone Law, an award-winning technology platform that allows lawyers to work remotely, without the overheads of an office. The trust invested in the company at the time of its IPO in November 2017, when its market cap stood at £50m. The free flow capital Keystone Law offered to the market was £15m. The market cap has since grown to about £150m, and the trust has returned about £25m in capital through dividends to shareholders. Ensor says the trust made a 250% return on that investment. “Remarkably,” he says, “the small cap market since 2017 is actually about flat, up around 1-2%.” Ensor says it is difficult for a fund to have anything but a small position in Keystone Law, because its liquidity profile is ‘challenging’.

“You are probably not going to find a portfolio of such businesses (like Keystone Law)”, says Ensor. Nevertheless, “we think if you can build a high conviction portfolio of 20-40 of those businesses that we can own going up through those market cap thresholds and let the market rerate them as they deliver, then we can create value for our shareholders, returning excess capital when we have it, without the risk of redemptions that you see in the open-ended sector.”

UK Micro Cap Trust is up 82% since IPO

Since its IPO, the trust has gained 82%, which compares favourably with the small cap benchmark performance of 48%, says Ensor.

Independent research in the micro cap sector is scarce. Ensor says micro caps typically have in-house brokers, who will write a couple of pages of research “focusing on the positives”. R&M’s conviction investing style is based on their own research, using a quant system and building models to generate ideas and select candidates for further investigation.

The trust’s closed-ended structure offers two key advantages. The first is risk management. Unlike the typical open-ended Ucits fund, it addresses the significant mismatch between the liquidity profile of the assets and the fund’s redemption terms.

Some of the sub-£100m assets are highly illiquid, yet investors may want to be able to trade those assets daily. A closed-ended structure protects the trust – and the investors – from the risk of a fire sale that can happen when investors rush to sell, as happened with the Woodford Equity Income fund in 2019. The risk management approach also means screening out loss-making companies that rely on debt, except those it deems to be going through temporary difficulties.

£77m returned to shareholders

Another key attribute of the closed-ended trust is that it enables Ensor to control the size of the fund. This enables the trust to make good on its promise to return excess capital to shareholders. “We have always said that, because we are investing with conviction in sub-£100m stocks, we would return capital to shareholders when we have too much capital.”

Over the past five years, R&M has returned £77m to shareholders, after raising £70m for its IPO.

Clear opportunities in these sectors

Ensor is not a sector-driven investor but he does see a number of clear opportunities in certain sectors. Ensor says, “Tech has had a tough time, which means there are some exceptionally cheap tech businesses there. Lots of them are break-even and loss-making, and they are investing to build back the high-quality recurring revenue that investors like.”

One advantage of tech, including the sub-sectors of property tech and healthcare tech, is that companies in this sector do not require lots of capital for growth, leaving them well-placed for when the market turns.

The market may be turning sooner than many think. The Bank of England has already signalled that UK interest rates are set to peak, as inflation in the UK starts to fall. The contrarian Ensor, having bought stocks cheaply, thanks to UK investors’ bearishness on UK stocks, has good reason to be feeling optimistic about the outlook for the River & Mercantile UK Micro Cap Trust.

Stuart Fieldhouse

Stuart Fieldhouse has spent 25 years in journalism and marketing, including as a wealth management editor for the Financial Times group, covering capital markets and international private banking, and as an investment banking correspondent for Euromoney in Hong Kong. He was the founder editor of The Hedge Fund Journal.

Stuart has worked at CMC Markets, supporting the re-launch of its global financial spread betting and CFD trading platforms. He is also the author of two books on trading, published by Financial Times Pearson. Based in The Armchair Trader’s London office, Stuart continues to advise fund managers, private banks, family offices and other financial institutions.

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