Micro-caps are often underestimated and misunderstood. Some define all micro-cap stocks as being risky or too volatile to warrant consideration, even within a balanced portfolio. In our view this is unfair.
There are many good quality micro and small-cap listed companies with a robust strategy and business platform, good financial performance, and the right people in place to ensure the business is well placed for sustained growth.
What is the benefit to investors of considering a micro-cap fund in a balanced portfolio? The opportunity to back fast-growing, niche firms which are innovators and disruptors in their sector is rarely available as investors move up the capitalisation spectrum.
Additionally, smaller listed companies can thrive in uncertainty as they can be more agile than their larger peers allowing them to better react to trends and opportunities, and potentially benefit from any upsides and avoid significant risks.
Another positive for investors considering the smaller companies sector is that the IPO market in London has been strong in this segment for the past 24 months, largely due to a combination of attractive valuations and investor appetite for new opportunities. Demand for companies offering growth or an attractive dividend yield remains strong. Investors can take advantage of this opportunity to back companies when they are relatively less well known and understood by the wider market and have more of their growth and value potential ahead of them.
However, micro-cap investing has the reputation of being higher risk for several reasons. One is that they are relatively under researched when compared to companies further up the market cap spectrum. The introduction of Mifid II at the start of the year has further reduced research coverage of smaller quoted companies. But what does this reduced coverage mean for investors, particularly those interested in smaller growth companies?
Indeed, there are some asset managers who are reliant on the research produced by sell-side analysts to maintain their knowledge of a particular stock or sector. With less insight and research, investors considering smaller quoted companies will be faced with less information with which to base investment decisions. While this is a risk for investors, it could also be seen as a real opportunity to secure exposure to small and micro-cap stocks that can draw less attention and often include undervalued, smaller companies waiting for the right catalyst to propel them forward.
When speaking to fund managers investing in micro-caps it is therefore important that investors determine how the underlying companies are researched and how the fund managers look to fully understand these businesses through their own robust processes around stock selection, analysis and research.
Another perceived risk for smaller companies is liquidity. While, on average, smaller companies are less liquid than larger ones, it is often available to those with the right skills, relationships and knowledge to find it.
Additionally, it is important when considering micro-cap stocks that investors back businesses that are not dependent on momentum tailwinds or are overly subject to threats from macro events. One way to mitigate downside risk is to avoid momentum themes and instead focus on companies operating in niche areas of the economy that are relatively resilient to wider economic events. Many of these high-quality companies are still growing and operate in less cyclical areas where management teams are more in control of their destiny and are less concerned by the impact on their firm of potential macro-economic headwinds.
Examples of companies like this are:
• Arena Event Group, a specialist provider of infrastructure and services to Tier 1 global sporting and leisure events such as Wimbledon or The Open.
• Xafinity, an actuarial consultancy providing advice to the trustees of defined benefit pension schemes that have an ongoing multi-decade obligation to their members to account for and manage their scheme effectively.
• Filta, a franchise operator, whose franchisees provide services into commercial kitchens on a recurring contracted basis, focusing on equipment cleaning, maintenance and ancillary services.
• Tax Systems, a provider of corporation tax compliance software to large corporates, enabling them to automate the computation and submission process to improve efficiency and reduce risk.
This contrasts with resource companies or banks which are heavily dependent on macro-economic factors outside the control of their management.
Regardless of your definition of risk, it does not have to be a four-letter word. While ‘low risk’ might not be a term often associated with the world of micro-caps, it is a world of opportunity if one knows how to successfully navigate the risks.
Ken Wotton is a fund manager at Livingbridge Equity Funds
