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OPINION

A bumpy playing field in micro-caps

A bumpy playing field in micro-caps
October 8, 2014
A bumpy playing field in micro-caps

There are two lessons here for private investors. The obvious one is that the very smallest companies on the stock exchange can have exceptional growth prospects – prospects groups capitalised at £100m, let alone £1bn, cannot match. Tracsis made £584,000 in pre-tax profit for the year to 31 July 2010. It has yet to report results for the financial year just finished, but the house broker WH Ireland expects it to make £5m. This growth has naturally been reflected in the share price, which has risen from 38p – the price at which Ms MacKenzie invested – to 360p.

But there's a subtler lesson, too. Downing has been able to boost its returns from Tracsis in ways unavailable to private investors. Perhaps contrary to popular perception, micro-cap investing is an area where professional stock pickers are at a clear advantage.

First, Downing did not buy in at the stated price. If you'd looked at your stockbroker's trading screen in March 2011, you'd have read that the shares were on offer for 51p, with a bid price of 46p. This is what private investors buying a couple of thousand shares would have paid. But Ms MacKenzie picked them for up 37p by cutting an off-market deal with Leeds University, which founded Tracsis in 2004 with help from incubator IP Group (IPO). "We hardly ever deal at the offer price," she says.

Second, Ms MacKenzie helped the company widen its shareholder base by introducing it to new investors – effectively taking on the job of the house broker. This encouraged a re-rating and made it easier for Downing to take profits (though it still owns a 6 per cent stake). Shares in the 200 profitable UK companies with a market capitalisation of less than £50m currently trade on a median earnings multiple of 14 times – a discount to the wider market on 17 times, presumably because few investors look at them. But that discount is not much use to investors unless a catalyst can be found to close it. Downing works with non-executive directors to introduce incentive schemes that encourage management to focus on an exit. It sometimes also hunts down trade buyers for companies in its portfolio.

Finally, fund managers enjoy privileged access to board members at small companies. Ms MacKenzie says she speaks to the managers of the 25 to 30 companies she holds on a more or less monthly basis. This doesn't help boost specific stock returns, but it can help avoid a mistake, which comes to the same thing. Fund managers are not necessarily getting 'inside' information ahead of the market – which by law would force them to stop trading in a stock (though that also happens). But they can benefit from lots of context, additional explanations, site visits and statistics. These give a much more complete insight into what makes a company tick than the jargon-heavy, fact-light financial statements typical of Aim companies. We know this at Investors Chronicle because we also benefit hugely from speaking to management teams.

Of course, private investors can still make big returns from small-cap investing. The performance of Aim since it was launched in 1995 has been infamously poor, but more balanced small-cap indices have performed extremely well. The Numis 1000 index, which tracks the performance of the bottom 2 per cent of the UK market by capitalisation, excluding investment trusts (average market cap: £188m), has generated 17.6 per cent a year since 1955, according to research by professors Elroy Dimson and Paul Marsh at the London Business School. That compares with 12 per cent for the FTSE All-Share.

The outperformance is even stronger if the index is given a value tilt, based on the ratio of stocks' book value to their market value. This supports the intuitive theory that the micro-cap market is inefficient, making it easier to find bargains. Richard Power, head of smaller companies at Octopus Investments, says his team is "happily finding businesses growing at 30 per cent a year on 11-12 times earnings".

Private investors would be foolish to ignore the bottom end of the stock market. The returns on offer are among the best available from any asset class. But they should be aware that the playing field, despite regulators' best efforts, is hardly level. It's almost a cliché among micro-cap fund managers that their approach is "more like private equity than public equity" – which says it all. It may be worth paying a professional for that private advantage.