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

published 17 September 2019

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.

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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."

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.

Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.

After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.