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The risks and rewards of micro-cap funds

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14/10/2015
As Liontrust becomes the latest group to launch a dedicated micro-cap fund, we look at the risks and rewards of investing in companies at the bottom end of the market cap spectrum.

Micro-cap funds differ from their smaller companies peers in that they typically only invest in companies with a capitalisation of less than £250m at the time of purchase.

While growing in popularity, the micro-cap fund sector remains niche.

In addition to the newly launched Liontrust product, there are only a handful of funds available to UK retail investors which take a micro-cap specific approach. These include the Marlborough, CFIC Octopus and PFS Downing Micro Cap Growth funds, the Miton UK Microcap trust and the Wood Street Microcap Investment fund.

Typically, micro-cap shares are mixed in with larger capitalised stocks in more general funds.

A broad universe

Giles Hargreave has managed the Marlborough UK Micro Cap Growth fund since 2004 and holds a significant proportion of sub-£150m companies.

“UK micro caps offer superior long-term growth potential to the juggernauts of the FTSE 100. These faster-growing firms are often innovators and niche players and their size means they can deliver a more nimble response to changes in the market,” he explains.

“Also, when a small company succeeds, its earnings can increase at a faster rate than would be possible for an established large cap business trading in a mature market. When profits rise sharply, share prices should follow suit.”

Another appeal of the micro-cap market, Hargreave says, is the vast number of stocks to choose from. Combined, the Alternative Investment Market or AIM and FTSE Fledgling indices are home to almost 700 different micro caps, operating in every sector. Some are dynamic tech firms, others innovative consumer brands and pharmaceuticals.

However, a micro cap doesn’t need to be the next Facebook, or even operate in the tech sphere, to deliver sizeable returns.

Richard Power, manager of the CFIC Octopus UK Micro Cap Growth fund, has found success with non-disruptive businesses such as recruiter Staffline Group and wealth manager Brooks Macdonald.

The case of Brooks Macdonald is a clear example of the growth potential of micro caps. The firm’s initial public offering in 2005 valued the company at £350m, and it is now worth £7bn. Its share price has risen accordingly from £1.40 to £17.50.

One of the reasons micro caps can grow to such a degree is fewer analysts research them compared to larger caps. In theory, this leads to widespread mispricing, allowing investors to purchase shares at a discounted level and sell them for a significant profit later.

Unsellable

Mike Prentis, manager of the Blackrock Throgmorton trust, which invests predominantly in UK small and mid-cap companies, broadly supports the notion that micro-cap stocks offer overlooked value. However, he says the flipside is investors may never acknowledge the value of a micro cap, which means shares might never increase in price, and they can be very difficult to sell.

“A common issue is investors taking a “wait and see” approach to micro caps, waiting and seeing which micro caps last long enough to reach small-cap status,” says Prentis.

For Dan Nickols, lead manager of the Old Mutual UK Smaller Companies fund, his gripe with micro-cap stocks is they are difficult for larger investors to access.

“Most have relatively few shares freely trading as they are predominantly owned by management,” he says.

Too small

Nickols is also wary of micro caps because of their performance and for this reason, precludes them from his fund.

“If you accept AIM as a proxy for micro-caps, the market performs poorly when compared with the NUMIS Smaller Companies Index,” he explains.

“Last year, the FTSE AIM All-Share Index returned -1.6 per cent overall, the NUMIS 8.9 per cent. Fourteen AIM stocks went bust, while a single NUMIS stock did. In 2009, 8 NUMIS stocks went bust, compared to 58 AIM.”

In response, micro-cap manager Power says these stocks are often sold off unnecessarily when the wider market suffers periods of volatility. He points to mid-2014, when turbulence in the FTSE led to a micro cap sell-off, despite many stocks remaining in good shape.

“[Micro cap] stocks have a tendency to get buffeted, but this often has more to do with wider sentiment than the quality or health of individual companies,” he states.

He acknowledges that the more micro-cap stocks an investor holds, the higher the percentage chance of their investments failing. As a result, whether you have the stomach for micro caps very much depends on your appetite for risk.

Other common misgivings include: stocks rarely paying dividends; their size making them vulnerable to takeovers and aggressive competition; and the fact they operate on indices with lightweight reporting requirements.

Despite these uncertainties, Prentis isn’t totally hostile to the space. His fund holds micro, small and mid-caps. His rationale is simple: why focus on just one capitalisation size. By diversifying across all three, an investor can reap the benefits of each, while insulating against constituent risks.

Spotting a winner

While acknowledging micro caps can be a “minefield”, Power says successful stocks have common features. They are businesses that have already made a profit, in which the owners have a large percentage of their personal wealth invested.

He has some simple advice for investors interested in the space.

“Read up as much as you can, make sure you understand fully what the company does, and why and how it could become profitable.

“View micro caps as a long-term investment prospect. This means holding tight during market instability, and resisting the urge to sell if a stock is on a good growth trajectory. Investors should wait, and continue to reap the rewards.”

The single-stock risk of micro caps can be mitigated by investing in a fund with a large, diversified micro cap portfolio. Hargreave’s fund, for example, comprises more than 200 holdings.

Although they come with a fee, fund offers value by carrying out due diligence on a company, including face-to-face meetings with companies to assess their viability.

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