Realise the big potential in micro-cap stocks with this investment trust

The Downing Strategic Micro-Cap Trust had a disappointing start. But it's finally looking like it's ready to achieve its potential.

It's been a wretched two and a half years since the Downing Strategic Micro-Cap Trust (LSE: DSM) raised £54m to invest in struggling companies that needed active management input to sort them out. The net asset value has fallen by 27%, the share price by 34% and one investment has been completely written off.

The team led by Judith MacKenzie had such a good record with their Growth Fund following the same approach that targeting an annualised return of 15% (over three to seven years) for Downing seemed reasonable. So the micro-cap trust's lousy start has been disappointing.

The best explanation comes from Nick Greenwood, manager of Miton Global Opportunities Trust. "The Downing style," he says, "throws up two or three opportunities a year and requires a lot of heavy lifting, including sitting on boards of directors and changing management." Finding 12-18 opportunities in the year they set themselves to become fully invested was demanding and led to some rushed investments.

Gaining hands-on experience

MacKenzie accepts there was an element of truth in that. Achieving turnarounds has taken longer and required more input than initially expected. "No matter how much interviewing you do, it's only when you are invested and involved on the board that you really find out what is going on." The 13 firms invested in during the first two years required 17 board changes, 12 management changes, five restructurings, 15 acquisitions and six disposals.

The result is a "J curve" in terms of return on investment: major downside to share prices during the period of disruption to the business before the actions are rewarded with a rising share price. This has required more patience than expected, but the team has also learned to be more ruthless with firms. "We've tended to back firms with owner-managers and high levels of insider share ownership, but [their] boards don't like to be challenged."

The portfolio is now 88% invested in 12 firms. "The justification for investing was that we had a management team to sort the business out and we thought we could exit despite working-capital problems," says MacKenzie. No new investments are expected; the cash is available for the opportunistic topping up of holdings or to participate in further fund-raisings.

A tasty main holding

The holdings vary from 2% of the trust to 18% and from 4.5% of the equity of the company invested in to 16%. The largest investment, mostly in loan notes, is in Real Good Food, a company with a total market value of just £7.2m. But the range for the other companies is £30m-£142m.

Turning Real Good Food around has been problematic; MacKenzie only found out about serious corporate governance issues after she joined the board. Still, steady progress has been made in rationalising its five divisions and cutting excessive costs. Similar progress in the other investments should result in significant capital appreciation. The team thinks the portfolio valuation can rise by 60%.

This has prompted an investment worth 7% of DSM from Greenwood. He also thinks "micro-caps have suffered a perfect storm as they are perceived to be domestic and exposed to Brexit. Fund managers are consolidating and far fewer than before can now buy the smallest firms. Finally, post-Woodford there is a witch hunt against firms with poor liquidity." So the valuation of smaller companies, especially very small ones, is depressed while the outlook for DSM's investments has at last turned up. Yet Downing estimates that they trade on just 6.2 times their earnings per share. DSM's shares, meanwhile, trade on a 9% discount to net asset value. They finally look ready to achieve their potential.

Recommended

Where to find deep value in investment trusts
Share tips

Where to find deep value in investment trusts

Professional investors Nick Greenwood and Charlotte Cuthbertson of the Miton Global Opportunities trust pick three of their favourite investment trust…
15 Feb 2021
Why investment trusts are the connoisseur’s choice of fund
Investment trusts

Why investment trusts are the connoisseur’s choice of fund

Investment trusts have justified their reputation as the best type of collective investment in 2020, says Jonathan Davis.
7 Dec 2020
Why investors should take investment trusts up on their free lunches
Investment trusts

Why investors should take investment trusts up on their free lunches

Investment trusts are brilliant, says Merryn Somerset Webb. Perhaps the most brilliant thing of all about them is the fact that investors can meet and…
16 Nov 2020
Four investment trusts for income investors to buy now
Investment trusts

Four investment trusts for income investors to buy now

Some high-yielding listed lending funds have come through the crisis with flying colours. David Stevenson picks four of the best.
12 Apr 2021

Most Popular

The bitcoin bubble will burst: here’s how to play it
Bitcoin

The bitcoin bubble will burst: here’s how to play it

The cryptocurrency’s price has soared far beyond its fundamentals, says Matthew Partridge. Here, he looks at how to short bitcoin.
12 Apr 2021
What does the Coinbase listing mean for bitcoin and other cryptocurrencies?
Bitcoin

What does the Coinbase listing mean for bitcoin and other cryptocurrencies?

As the bitcoin price hit new highs, the world's biggest cryptocurrency exchange, Coinbase, listed on the stockmarket. John Stepek looks at what that m…
15 Apr 2021
Lab-grown meat: the new agricultural revolution
Soft commodities

Lab-grown meat: the new agricultural revolution

Vegan alternatives are taking off, but the future of food technology lies in lab-grown meat – cultivating steaks and burgers from animal cells, says A…
16 Apr 2021