Gervais Williams and Martin Turner
Miton UK MicroCap Trust Managers
For information purposes only. The views and opinions expressed here are those of the authors at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Globalisation in action
Globalisation can be defined as an economic period when global supply in traded goods is so plentiful that it exceeds demand. It imposes a downwards pressure on global inflation, nicely offsetting inflation in local services.
During times of crisis such as the 2007/8 global financial crisis, demand can be scaled up through an ongoing excess supply in traded goods, via interest rate cuts and additional demand created through programmes such as Quantitative Easing.
The net effect is that nearly all asset prices have appreciated well for years, in part due to additional growth during globalisation, and in part due to asset valuations rising and rising as bond yields moved to ever lower levels. Furthermore, as borrowing becomes ever cheaper, most governments, corporates and consumers scale up their consumption, which is reflected in rising profit margins as well, they have reached exceptionally high levels recently.
And closer to home
Many UK equity funds have generated attractive absolute returns for clients over the last few decades. In general, those looking to generate the best returns have scaled up their risks – via taking additional market risk (Beta) for example – and often outperformed.
We worry that such strategies carry additional risk as we move beyond globalisation’s hay-day, with high-Beta strategies at risk of delivering disproportionately disappointing returns for investors. As their return is principally reliant on capital appreciation driven by Beta, the downturn is often accompanied by a large proportion of investors liquidating together, amplifying the downside for investors investing on a longer-term basis.
At worst, if numerous holdings were using negative cashflow to generate very rapid growth, these holdings may need to raise additional capital from their shareholders, carrying the risk of stock specific insolvencies, and a permanent loss of capital for their shareholders.
Taking an active interest
Genuine active management isn’t just about maximising the upside, but also better managing downside risk than others, so that returns have a good chance of being less reliant on stock market appreciation, and more resilient to stock market setbacks over the longer term. Both factors (maximizing the upside and minimizing the downside) have the potential to add value for investors, but when adverse risks are present, we hope that our investment strategy will continue to have a good chance of delivering premium alpha driven returns, whereas others might be more vulnerable to structural beta and systematic events.
In what specific ways does the Miton UK MicroCap Trust strategy differ from others?
In contrast to many other UK small and micro-cap investment vehicles, our strategy doesn’t seek to select stocks with high-Betas. Let us work through the logic behind our approach here:
Cashflow is king.
We believe a portfolio of quoted small and micro-cap companies generating abnormally large cash surpluses could deliver attractive longer-term returns in the coming years. Abnormal cash surpluses often occur after a business reaches the end of a long period of investment, or sometimes when a novel market trend becomes more mainstream. Whilst the share prices of businesses generating surplus cash may not rally as quickly as high-Beta stocks, in general they not only have greater upside potential in our view but can succeed even when equity markets themselves are flatlining.
If their share prices stay low, they can choose to use their new cashflow to buy back shares. Others might pay a dividend, bringing in new buyers and generating an upwards reset of the share price. Alternatively, companies generating abundant surplus cash can use it to accelerate their growth, by scaling up investment in their operational teams or product range. Others can use surplus cash to buy businesses that offer major corporate synergies. Finally, a company generating a stream of good and growing cashflow is attractive to third-party businesses, which may lead to takeover offers at premium valuations.
Strength in numbers
A portfolio investing via a list of concentrated holdings may work for more mainstream small and mid-cap strategies, investing as an example 2% of a portfolio in each holding. The problem comes with when considering micro-caps, as by their nature, they may not be large enough to reach an arbitrary 2% portfolio weighting. So, a small-cap portfolio with a short list of holdings has the problem that it may have to exclude all quoted micro-caps, irrespective of the strength of their investment case.
Hence, institutions typically only become interested in investing in micro-cap companies after their share prices have massively outperformed, and their market capitalisations and equity valuations have risen dramatically. At this point arguably they have become small-caps.
In our experience, quoted micro-caps have the advantage of standing on what appear to be distressed valuations, and yet still carry bags of upside potential. Effectively, quoted micro-caps are sometimes literally too small or too cheap for institutional investors to buy in sufficient size.
We certainly don’t have these restrictions, and as a result the Trust portfolio typically has over 140 holdings. This allows the portfolio to invest in a number of overlooked micro-caps which in turn should mean that it can access this greater upside potential.
Micro-cap be nimble, Micro-cap be quick.
Thirdly, micro-caps don’t just mimic larger companies in diminutive form. Typically, they are less mature, and as such often operate in new and innovative industry sectors that haven’t become large enough for the mainstream companies. Furthermore, being small they often have scope to be nimbler and more opportunistic than their larger counterparts.
During global recessions, smaller companies often have commercial advantages over large-caps. Whilst these periods are challenging for all companies, sometimes demand in less mature industry sectors persists, so they can continue to thrive during global recessions.
Furthermore, whilst the mainstream stocks can and do acquire over-levered businesses debt-free from a receiver at knock down prices, in general these transactions only add marginally to their prospects. In contrast, the same transaction for a quoted small-cap company typically delivers much larger potential earnings uplift. In the case of micro-caps, sometimes the acquiring business is no larger than the low-cost acquisition, so these deals can be transformational to their earnings prospects.
For all these reasons, the returns on a small and micro-cap portfolio are not necessarily closely correlated with the fluctuations of the mainstream stock market. The investment universe is so wide-ranging that it is possible to diversify stock specific risk more effectively across such a portfolio, when compared with larger, mainstream stocks.
What are the Trust’s prospects given the current investment climate?
As a direct answer to this question, we are more upbeat than we have been for the last three decades for the following reasons.
First, we believe we are on the threshold of a radical change in investor preferences, away from pro-globalisation strategies back to those with less correlated returns, which we expect will favour the UK stock market.
Second, a portfolio investing in stocks that we believe are set to generate significant capital surpluses will have the advantage of minimising stock specific risks, which we believe will be very elevated given the persistence of inflation.
Third, we believe that as many businesses become at risk of becoming insolvent, the greatest upside potential may lie with quoted micro-caps, which currently stand on what we consider low valuations.
Fourth, if markets flatline in future, we believe that strategies delivering premium Alpha become a lot more important.
The bottom line is that we feel the prospects for the Miton UK MicroCap Trust are not just strong. Specifically, we believe its prospects are strong at a time when the outlook for many of the mainstream global stock market indices have become less attractive due to the challenges of inflation.
If this analysis is correct, then we expect that institutional allocations to UK smaller companies will steadily increase over the coming years, driving up their valuations, reducing their cost of capital and making it easier for them to fund capex and acquisitions that may further enhance their growth prospects.
