Since the EU referendum, most conversations about investing in UK equities have focused on our largest companies. As investors piled into these stocks, both the FTSE 100 and FTSE 250 – which experienced an initial sell-off in the days following the Brexit result but subsequently bounced back – have reached all-time highs. The result is that these companies are now looking expensive.
At the other extreme of the UK stock market, our very smallest companies are, by contrast, looking like good value. A decade ago, they were trading at a slight premium to large caps but in the past five years or so, they have traded at a discount that has ranged from 5 to 25 per cent. Today, they trade at an 18 per cent discount.
This end of the market is also very dynamic. It is home to more than a thousand companies and the make-up is constantly changing. Some companies grow out of the index, merger and acquisitions can be rife, initial public offerings are increasing and some simply fail. As a result, only a third of the current listed micro-cap universe existed 10 years ago.
Owing to this constant renewal of the universe, it is generally under-researched. The recent volatility in the marketplace has just accentuated the opportunities. Invest in the right stock early enough and good money can be made over the long term.
A fund that invests in these companies that I particularly like is Wood Street Microcap. With assets under management of less than £70 million, it is something of a hidden gem itself.
It has been managed by Ken Wotton since launch in 2009. He has the support of a 40-strong specialist team at Livingbridge. Livingbridge, which is probably best known for running the highly successful range of Baronsmead venture capital trusts, has been investing in smaller companies since 1995. Its expertise lies mainly in the UK, although the company also invests in Australia.
The team has experience of working with companies and management teams before they come to the stock market and this can give them a real advantage over their peers. It is not unusual for them to invest in unquoted companies with values as low as £5m, although most holdings are initially between £50m and £250m. They will continue to hold successful investments that have grown beyond this size.
When selecting stocks, the team are looking for companies that can double their earnings over a five-year period. It does not buy companies that do not make money and it avoids high-risk sectors such as oil, mining and property, instead focusing on the areas where they have expertise – namely the sectors of business services, financials, healthcare and education, consumer plays and technology.
This fund is unusually concentrated for a smaller companies portfolio with only 40 holdings. This increases the potential for higher returns, but also increases risk. So investors are heavily reliant on the team’s skill in choosing the right investments.
The manager mitigates this risk by using rigorous analysis and by only investing in profitable companies with low levels of leverage. The size of the fund itself allows the manager to exit positions relatively quickly and easily if necessary.