River and Mercantile UK Micro Cap offers growth at a discount

It takes a brave investor to venture into the world of micro-cap stocks. But hunting at the foot of the stock market is especially bold when so many investors are abandoning risk assets for fear of interest rate rises. While monetary tightening is potentially bad for all equities, smaller companies tend to be more credit sensitive. 

However, the prevailing valuation at the start of the tightening phase is important, as Mick Gilligan, head of managed portfolio services at Killik & Co, points out. Stocks in the FTSE Aim All-Share Index with positive earnings currently trade on 9.6 times next year’s forecast earnings, according to Bloomberg data. That’s in line with the long-term average dating back to 2006 and suggests that current valuations are not excessive – assuming, of course, that earnings growth meets broker expectations.

For investors looking for exposure to smaller companies, River and Mercantile UK Micro Cap Investment Company (RMMC) is a punchy bet that could pay off nicely. While its share price has struggled of late – having fallen 14 per cent in the past six months – the trust’s long-term performance has been strong. Having briefly traded at a premium as recently as August, the recent sell-off in growth shares has pushed the trust’s market capitalisation down to £87mn, more than 14 per cent below its estimated net asset value (NAV) at the end of December.

The trust is a concentrated portfolio of around 40 stocks, selected via a quantitative screening process of “potential, value and timing”. Its manager, George Ensor, looks to buy into companies with a market capitalisation below £100m, meaning he fishes in waters overlooked by most analysts and fund managers. Ensor is looking specifically for stocks that he thinks trade relatively cheaply, have the potential for significant growth and where he thinks earnings upgrades are imminent.

At a time when smaller listed companies are underperforming wider equity markets, life tends to be even harder for micro caps. Ensor knows this all too well. In the final quarter of 2021, 31 of the trust’s 40 holdings underperformed its benchmark Numis Smaller Companies + AIM (ex-investment companies) Index, with only one position meaningfully outperforming. However, positive earnings revisions and or flows into UK equities could turn the tide, and there is a compelling case for both. 

Ensor says that the outlook from an earnings and valuation perspective is reasonable. Currently, profitable small caps trade on an average forward price/earnings ratio of 13, while earnings are forecast to rise by a mid-teen number of percentage points. Both are below trend, likely due to depressed earnings from stocks heavily exposed to a post-pandemic economic recovery.

Just quite how resilient smaller companies prove in the year ahead remains to be seen, but RMMC’s track record offers reassurance. In the five years to 31 January, the trust's NAV and share price growth were 90 and 84 per cent, respectively, according to data from FE Analytics. This compares with 39 per cent for Numis Smaller Companies (ex-ICs) Index.

Portfolio positioning

The trust screens for investments among UK-listed stocks with a free float of between £20mn and £100mn, leaving Ensor with around 450 companies to buy into. Once a stock is in the portfolio, the trust is happy to run its winners, which helps explain why the market capitalisation of its median constituent is currently around £80mn. Stakes in a handful of companies which have grown considerably also explains why the mean company size is, somewhat paradoxically for a micro-cap fund, £140mn. 

The portfolio added eight new holdings last year, a higher rate of turnover than the long-run average. The trust has also continued to return capital to shareholders, in line with an intention to keep its net asset value hovering around the £100mn mark. That ensures it can continue to run a concentrated portfolio of small-cap companies. Capital is returned at NAV, which also acts as a discount control mechanism. The trust returned capital twice last year; £15mn in February and £20mn in May.

The current NAV of £95mn also makes it likely that the any uptick in the portfolio value will help narrow the discount, as the next return approaches. In total, since inception in 2014, the trust has returned £77mn of capital, returning the £70mn raised at its initial public offering (IPO) with interest.

Despite the focus on “potential, value and timing”, Ensor takes a “value neutral” approach to stock selection, preferring quality companies with good growth credentials and strong balance sheets. Nonetheless, the fact that most holdings are in a net cash position means the portfolio is a tad cheaper than its benchmark on an enterprise value-to-Ebitda valuation multiple, but pricier on free-cash-flow-yield. But in this part of the market the expectations set can be as important as the valuations. 

Portfolio holdings

The trust is well diversified across sectors, with its largest allocation to financials at 17 per cent, with holdings including LendInvest (LINV), Distribution Finance Capital (DFCH), and Litigation Capital Management (LIT). Consumer discretionary makes up 16.5 per cent of the portfolio and healthcare 14 per cent, with Instem (INS), a supplier of IT applications to the sector, the portfolio’s largest holding at the end of December.  

LendInvest was a new position last year, which Ensor acquired at IPO. The company is taking share in the UK buy-to-let mortgage market by seeking to offer a better, faster user experience than traditional banks, as its loans are financed largely by institutional capital rather than customer accounts. The company has outperformed expectations since listing and Ensor thinks it looks on track to achieve its ambition of growing cash profits by three to five times over the medium term.

One of the trust'ss largest holdings is Science in Sport (SIS), a global sports nutrition brand which makes up over 5 per cent of its assets. While share price performance has been lacklustre since it listed in 2013 thanks to years of losses, it has just announced its second year of profitability at the Ebitda level, doubling profits from £1.1m to £2.2m – more than 30 per cent ahead of consensus forecasts. 

Risks

Inflation has dominated headlines recently, as rising prices remain significantly above central bank targets in the UK, US and Europe. Domestically, the increase in energy prices and further anticipated interest rate rises could well curtail consumer spending, hurting some of RMMC’s holdings. On a more positive note, the Resolution Foundation estimates that the UK’s household net savings have increased by £200bn relative to pre-pandemic levels, and unemployment is falling, which should help drive wage growth and support spending. Many consumer stocks have seen dramatic price falls since their 2021 highs, so there is also some bad news already priced in.  

Some investors might be put off by the trust’s performance fee, which AJ Bell’s head of investment research Ryan Hughes calls “unnecessary”. The annual management charge is 0.75 per cent, but a performance fee is charged at 15 per cent of outperformance of the benchmark. “The more generalist UK smaller companies trusts have generated similar performance over recent years without charging a significant performance fee on top of their annual management charge,” Hughes says. 

Owing to the nature of the companies the trust invests in, its share price is likely to remain volatile. But given the strong total returns the portfolio has delivered since its inception, the current discount to NAV might not be around forever.