How to increase shareholder value through small-cap investing

For the value investor with a medium-term view, the lower end of the stock market represents a rich hunting ground for “hidden gem” or “fallen angel” companies, which can often benefit from management, strategic or operational initiatives to unlock, grow or realise shareholder value.

To see how this works in practice, we can examine the characteristics of private equity investing that can be applied to this end of the market. 

Well-researched investments

In public market strategies, many open-ended investment companies adopt a highly diversified approach, desiring a low volatility of returns profile, usually in relation to an index benchmark and enhancing their overall portfolio liquidity through smaller position sizes. 

To adopt a PE mindset, a concentrated portfolio of the very best potential investments is needed that focuses on the valuation and liquidity options at the end of the targeted investment period, not the day-to-day variation. Five to 10 materially engaged investments is practicable.

Portfolio concentration allows significant positions in a small selection of compelling companies, naturally providing considerably more time for the investor to spend on each holding, both before purchase and afterwards.

Higher levels of understanding, engagement and due diligence that result from this focus tend to de-risk the investment. In contrast, more diversified portfolios lack the time required to sustainably and effectively engage with all their companies or lead change.

Full operational oversight and influence

In public markets, a single investor is unable to exceed 29.9 per cent of the issued share capital, otherwise a takeover bid must be made. Full control, as achieved in PE, is not possible. The next best thing is considerable influence over a company. This is achieved through a significant holding that allows powerful voting and shareholder rights. 

Many shareholders tend to want change but do not have the time, expertise or influence to lead it, and thus a significant shareholder can act as the catalyst

The minimum needs to be 5 per cent, which allows an extraordinary meeting to be called of all shareholders. However, influence can also be achieved through appointments to the board in a non-executive capacity and through the successful proposal of candidates into key positions. These require the support of the majority of shareholders and this influence can be enhanced if other shareholders agree with the initiatives. 

Companies are often aware that change is needed, but prevaricate, lack the pace or skillset necessary, or are resistant to change. Many shareholders tend to want change but do not have the time, expertise or influence to lead it, and thus a significant shareholder can act as the catalyst. 

If management change is needed, appropriate incentive arrangements will need to be adopted to align the new team effectively with shareholders. Public market investors need to evolve their thinking so that these incentives can effectively compete with PE packages, otherwise genuine talent will migrate.

Defined time horizons

There is a lot of evidence to suggest investor holding periods have shortened materially over recent years. Short-termism appears rife in public markets. Annual reporting and compensation periods affect investor psychology as the year progresses.

PE fund investments typically have a minimum of three to five-year investment plans. This approach can be adopted with confidence in closed-ended vehicles such as investment trusts without the demands of daily fund liquidity.

Maintaining focus on value

An attractive entry valuation is a critical component of a successful investment, whether public or private. There are a number of factors that make entry valuations compelling in UK small-cap listed equities.

Investor sentiment towards UK equities has been poor in recent years as the global equities narrative has proven more alluring than the domestic market plagued by stagnant economic growth, concentrated large-cap indices in a handful of mature industries, Brexit and political turmoil.

In reality, UK small companies often have significant overseas exposures, generate exciting levels of growth and exceed more than 700 companies across a wide range of sectors.

Consistent investor outflows have contributed to a gradual de-rating when compared with almost all other overseas stock markets and the valuations at which private transactions are completed. It is no surprise that both overseas investors, trade buyers and PE companies are launching takeover offers in this space.

A reduction in available research on the smallest companies, a loss of broker interest due to collapsed dealing commission rates, and a growing concentration of UK small-cap assets under management in larger companies has created an inefficient market.

Outstanding value typically appears when companies have disappointed their shareholders. This occurs through a loss of management effectiveness, poor financial control, weak strategic development, unmet growth plans, and often poor acquisitions or capital allocation. 

Investor sentiment towards UK equities has been poor in recent years as the global equities narrative has proven more alluring than the domestic market plagued by stagnant economic growth and political turmoil

General economic conditions are cyclical and can amplify profitability issues, leading to financial stress through excess leverage. Change replaces complacency with energy, unearths inefficiencies, catalyses strategic change and the path to recovered profitability and ultimately fair value.

Once a value trap has been ruled out, the focus needs to be on what operational and strategic improvements can be made, and what level of sales and profitability could be achievable if effective management was in place.

Valuation work is necessary relative to peers, history, private transactions and, most importantly, in relation to the company’s future cash flows. Scenario analysis regarding possible strategic, trade or PE buyers of the company in the longer term is required.

Using leverage

PE has mainly used leverage to effectively enhance returns for investors. Financial stress is the number one risk to the permanent destruction of shareholder value and thus should be considered very carefully.

In recent years, manipulated low interest rates and the emergence of a “shadow” banking sector has provided the PE industry with favourable conditions to access cheap debt. The environment has now changed, and we expect PE to use less leverage than in the past decade to generate their target returns.

Public markets are uncomfortable with higher levels of leverage, regularly de-rating companies on this basis. The opportunity typically resides when a balance sheet is stretched, but not distressed, which has led to a reduced valuation on the equity to compensate for elevated financial risk.

If the operational plan and strategic actions can accelerate the reduction in leverage, then multiple expansion will ensue and value to equity shareholders rises, often itself in a geared fashion.

A fully repaired balance sheet provides a further attraction to those parties interested in providing the exit option to shareholders.

Richard Staveley is portfolio manager of the Rockwood Strategic Investment Trust