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

The ten highest dividend yields on Aim
Income investing

The ten highest dividend yields on Aim

Rupert Hargreaves picks the highest-paying dividend stocks on Aim, London’s junior market for small and medium-sized growth companies.
29 Jun 2022
A Europe-focused investment trust that’s back on form
Investment trusts

A Europe-focused investment trust that’s back on form

Alex Darwall’s European Opportunities investment trust deserves another look after a difficult spell, says Max King.
28 Jun 2022
The ten investment trusts with the highest dividend yields
Investment trusts

The ten investment trusts with the highest dividend yields

Investment trusts are one of the best ways to participate in the stockmarket, and the way they are structured means they can maintain their dividends …
23 Jun 2022
Three ways to cash in on the digital infrastructure boom
Share tips

Three ways to cash in on the digital infrastructure boom

Two established investment trusts and a business with great potential stand out in the digital infrastructure sector.
16 Jun 2022

Most Popular

UK house prices are definitely cooling off – but are they heading for a fall?
House prices

UK house prices are definitely cooling off – but are they heading for a fall?

UK house prices hit a fresh high in June, but as interest rates start to rise, the market is cooling John Stepek assesses just how much of an effect h…
30 Jun 2022
The ten highest dividend yields in the FTSE 100
Income investing

The ten highest dividend yields in the FTSE 100

Rupert Hargreaves looks at the FTSE 100’s top yielding stocks for income investors to consider.
22 Jun 2022
Five dividend stocks to beat inflation
Share tips

Five dividend stocks to beat inflation

During periods of high inflation, dividend stocks tend to do better than the wider market. Here, Rupert Hargreaves pick five dividend stocks for incom…
30 Jun 2022