Gervais Williams and Martin Turner
Miton UK MicroCap Trust plc – Trust Managers
A MINI recovery
Given its decline during 2022, it is reassuring to see the net asset value of the Miton UK MicroCap Trust (“MINI”) just beginning to recover as we move into 2023. We expect inflationary pressures to ease considerably in the coming months, as the costs of moving goods around the country and energy prices decline. At the same time, despite the country’s zero Covid policy just beginning to relax, we believe any recovery in China’s economy could be subdued, because we see the economy as vulnerable to a banking credit crunch in the next few quarters.
At present we feel MINI’s holdings are standing at unusually low valuations. This is illustrated in the following chart, where the price/book ratio for shares listed in the UK is plotted against their market capitalisations. Market capitalisation refers to how much a company is worth as determined by the stock market. It is defined as the total market value of all outstanding shares.
When you compare a firm’s market capitalisation to its book value you are considering the price/book ratio. The book value of a company is equal to its total assets minus its total liabilities. When a price/book ratio stands below a value of ‘one’, it implies that a company’s valuation would improve if management just sold-up its assets and returned all the capital to shareholders. As at the end of November 2022, MINI had a price/book ratio of 0.87, similar to the FTSE AIM All-Share Index. The FTSE AIM All-Share Index is a stock market index consisting of all companies quoted on the Alternative Investment Market.
UK listed companies – market valuation (capitalisation) compared to price/book ratio
Source: Bloomberg as at 30.11.2022
With a price/book ratio of below ‘one’, voluntary liquidation would be absurd for the Trust’s portfolio of holdings given they are well-positioned in our view to generate cash surpluses from their assets in the future. But it does underline just how far UK-quoted micro-cap company valuations have fallen. If the recovery that we are starting to see in more mainstream company shares, such as those in the FTSE 100 Index for example were to continue, micro-caps have scope for a considerable catch-up. Please remember that on the London Stock Exchange the term ‘micro-cap’ refers to companies with a market capitalisation between £50m and £230m
The effect of increased costs of capital
With interest rates increasing and as a result the cost of capital also increasing, we also expect the prospects for capital-intensive company shares to improve. Rising interest rates are also favourable for capital-intensive financial companies. Banks for example make most of their income from the difference (called a spread) between what they charge for loans and what they pay for deposits. The rate charged on loans is linked to interest rates, and so has been low for years. The price paid for deposits, however, got stuck when the interest rate hit zero. Margins got painfully squeezed, and there was nothing banks could do except focus on costs. As a result, today they have lean cost bases and their loan pricing is rising again as base rates rise.
Focusing in on the case for the UK
Large UK companies, such as banks and energy companies, are typically capital-intensive in nature and fund a stream of dividend payments to investors. Stock markets such as the UK generate a major part of their return via the compounding of dividends, which can be a particular advantage when stock market growth is more limited. Rising inflation may also mean that a wide range of asset classes increasingly move in sequence, rather than in different directions; this can make it ever-more important for investors to focus on diversification away from capital growth investment strategies, towards those that generate returns via dividends and the compounding effect of these over time.
Based on this new focus for investors, we would expect the current selling of UK equities to stop and be replaced with steady purchases. Such a move may improve the trajectory of the UK equity market and help gradually to unwind its lower valuation in relation to other markets. As a side effect, increased buying interest in the UK market could also lead to renewed interest in UK-quoted small and micro-cap companies, as investors increasingly seek to invest in this recently unloved part of the UK stock market.
Bringing all these considerations together, we believe the MINI’s investment strategy today has the potential to perform well compared to the wider UK market. The combination of the low current valuations of UK equities and the recent caution of investors towards UK equities means that there is also potential for this recovery to be long-lived. Although please do remember there is no guarantee of this and while we are positive about the future, it is still by nature uncertain and unknown.
