UK equities have been far from popular in 2020. Loaded with companies hit hard by the coronavirus crisis, a wave of dividend cuts and Brexit uncertainty, the UK market has become even more of a contrarian play. However, there are glimmers of hope in unexpected places.
UK smaller companies indices have enjoyed a stronger recovery than the likes of the FTSE 100 since April. And investors with a focus on some of the smallest companies argue that opportunities stemming from this year’s crisis could ultimately pay off.
River and Mercantile UK Micro Cap Investment Company (RMMC) invests in stocks so small that many ignore them. Its manager, George Ensor, buys into companies with a market capitalisation of less than £100m, which analysts and larger funds tend not to focus on. Mr Ensor and his team look at companies with a free float of between £20m and £100m – a process that tends to throw up around 450 stocks. They screen companies based on various metrics, seeking those that have “potential, valuation and timing”. These are stocks that trade cheaply, and have the potential for substantial growth and a possible catalyst to trigger strong returns.
“We want companies that are fundamentally attractive at a significant valuation gap to what we see as fair value," explains Mr Ensor. "We want to buy good businesses cheaply with possible earnings upgrades. We try to take big positions in circa £50m growth companies on attractive valuations. They can compound maybe 30, 40 or 50 per cent earnings growth per annum. As we move up earnings might double and we get a re-rating.”
Mr Ensor and his team screen stocks before assessing the fundamentals and deciding whether to invest in them. Because of their focus on fundamentals, not surprisingly turnover in the trust has risen amid the sell-off of February and March.
At the start of 2020 the team felt that markets were in a late-cycle stage, something that prompted them to reduce cyclical exposure. They also moved away from what Mr Ensor describes as a “more expensive than benchmark” approach where they paid for growth. The trust had around 6 per cent of its assets in cash at the start of the year, so its investment team were relatively well positioned to pick up new holdings, including cyclical names, amid the sell-off.
New additions to the trust included City Pub Group (CPC), which raised money at a 60 per cent discount to the book value of its freehold pubs. “That was a business in a very challenging position," says Mr Ensor. "But my view was that at 50p [per share] there was a very negative view on the long-term earnings [prospects]. That was likely to be one of the better operators [in its sector]. If you can buy a well-run pubs company with asset backing, that’s a sensible move to make.”
Mr Ensor and his team like “survivors” in difficult sectors such as City Pub Group.
They also bought retailer Joules (JOUL). “They have 125 stores mainly in market town high streets,” says Mr Ensor. “They are better exposed than city centre shops might be. They also have an online business that has seen massive growth in the crisis.”
Other UK consumer cyclical businesses added to the trust included Cake Box (CBOX) and Revolution Bars (RBG).
Although Mr Ensor and his colleagues tend to focus on companies identified by their screens, some of their investments fall into a number of themes. These include 'disruption', which they express via holdings such as Alpha FX (AFX), which could be considered to be disrupting banks, and Keystone Law (KEYS), which is arguably disrupting the legal world. Joules also fits into the disruption theme because of its focus on e-commerce, as does Science in Sport (SIS).
Mr Ensor and his team also favour companies with competitive advantages such as Diversified Gas & Oil (DGOC), a low-cost producer in the US. This and consumer self-care business Venture Life (VLG) also meet their preference for companies that acquire other businesses.
Mr Ensor does not automatically sell holdings if they breach the £100m threshold. Alpha FX and Diversified Gas & Oil, for example, have market caps worth about £431m and £754m, respectively [as of 6 October]. Instead, he sells holdings that he thinks have reached fair value, the investment case for which has been undermined by events or appear to be losing earnings momentum. He also also sells stocks if a better opportunity comes up.
Positions exited this year include XLMedia (XLM), an online lead generation business that struggled following a change in Google’s algorithm. Mr Ensor and his team also sold Driver (DRV) because of “higher conviction elsewhere”.
River and Mercantile UK Micro Cap Investment Company is one of a number of funds that focus on this segment of the market, other examples including Liontrust UK Micro Cap (GB00BDFYHP14) and Downing Strategic Micro-Cap Investment Trust (DSM). But Mr Ensor argues that open-ended micro-cap funds are more likely to invest further up the market cap scale than River and Mercantile UK Micro Cap Investment Company, and says that Downing Strategic Micro-Cap has more of a private equity style of investment. He suggests that River and Mercantile UK Micro Cap's closest rival may be Miton UK MicroCap Trust (MINI).
Due to River and Mercantile UK Micro Cap Investment Company's focus on smaller companies, its board monitors its size. If its net asset value (NAV) reaches a size of around £110m to £125m it would look to give capital back to shareholders to return the NAV to around £100m. The trust had net assets of £96.5m as of 5 October, according to Association of Investment Companies data.
