Gervais Williams and Martin Turner
Miton UK MicroCap Trust Managers
For information purposes only. Any 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.
Investing involves risk. The value of an investment can go down as well as up which means that you could get back less than you originally invested when you come to sell your investment. The value of your investment might not keep up with any rise in the cost of living.
Premier Miton is unable to provide investment, tax or financial planning advice. We recommend that you discuss any investment decisions with a financial adviser.
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 causes downwards pressure on global inflation, nicely offsetting any inflation in local services.
During times of crisis such as the 2007/8 global financial crisis, consumer and company demand can be boosted through the creation of an excess supply in traded goods, through interest rate cuts and the creation of additional demand through programmes such as Quantitative Easing. Please see our glossary of key terms to learn more about Quantitative Easing.
The overall effect is that nearly all asset prices have gone up in value for years, in part due to additional economic 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 through lower interest rates, most governments, companies 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 portfolios have generated attractive returns for clients over the last few decades. In general, those looking to generate the best returns have scaled up their level of risk and often outperformed.
We worry that such strategies carry additional risk as we move beyond globalisation’s hay-day and are at risk of delivering disappointing returns for investors. As their return is reliant on capital growth driven by market movements, the downturn is often accompanied by a large proportion of investors selling assets all together, amplifying the downside for investors investing on a longer-term basis.
Taking an active interest
Genuine active management isn’t just about maximising the positive periods of return, but also managing periods where there are falls in markets, 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 positive returns, whereas others might be more vulnerable to market risks and major financial 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 invest in companies that are closely aligned with the movement of stock markets. 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 large cash surpluses within their business can 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 niche market trend becomes more mainstream.
Whilst the share prices of businesses generating surplus cash may not rally as quickly as companies that move closely in line with stock markets, in general they have greater potential for positive returns in our view which means they could 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 for their company’s shares. 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 a major synergy.
Finally, a company generating a stream of good and growing cashflow is attractive to third-party businesses, which may lead to takeover offers at good valuations.
Strength in numbers
A portfolio investing via a list of concentrated holdings may work for more mainstream small and medium sized company 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 risen strongly 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 appear to have the advantage of low market 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 carries the potential for future positive returns from overlooked micro-caps.
Micro-cap be nimble, Micro-cap be quick.
Thirdly, micro-caps don’t just mimic larger companies in smaller 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 to look to take opportunities more quickly 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 businesses 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 positive returns. In the case of micro-caps, sometimes these deals can be transformational to their prospects.
For all these reasons, the returns on a small and micro-cap portfolio are not necessarily closely aligned to the fluctuations of the mainstream stock market. The investment universe is so wide-ranging that it is possible to diversify company 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, which we expect will favour the UK stock market.
Second, we believe that a portfolio investing in companies that are set to generate significant cash surpluses will have the advantage of minimising company specific risks, which we believe may be very elevated given current high inflation.
Third, we believe that as many businesses become at risk of becoming insolvent, the greatest upside potential may lie with quoted micro-caps, currently standing on what we consider cheap share prices.
Fourth, if markets flatline in future, we believe that strategies that have the potential to deliver positive returns in such market conditions 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 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 capital expenditure and acquisitions that may further enhance their growth prospects.
