Fans of small cap stocks are being treated to two new investment trusts targeting the lower end of the market cap spectrum.

The Stewart Investors-managed ScotGems investment trust will launch in June, targeting smaller companies in the emerging markets space. Keep reading this article to get the full details on that product.

Before we discuss ScotGems, it is also worth noting the fresh launch (9 May) of Downing Strategic Micro-Cap Investment Trust (DSM) which has raised £54.4m to invest in very small companies.

It is run by the same people behind the MI Downing UK Micro-Cap Growth Fund (GB00B2403R79) which has achieved 18.5% annualised return over the past five years, according to Morningstar.

The new investment trust will be very concentrated, targeting a mere 12 to 18 holdings and investing in companies worth less than £150m at the time of the first investment.

Fund manager Judith MacKenzie believes Downing Strategic Micro-Cap Investment Trust would be particularly suited to someone investing in a SIPP (self-invested personal pension). ‘This is a five to 10 year investment; don’t invest in the micro-cap investment trust if you only have a two to three year view,’ she says.

What's the plan?

The investment trust plans to take between 3% and 25% equity stakes; the upper end implies that Downing could potentially become the biggest single shareholder in a company.

MacKenzie says she expects to work very closely with the investee companies, meeting them every month and helping them such as finding appropriate directors, accessing capital and identifying ways in which to achieve operational efficiencies.

A few holdings in the existing growth fund have been earmarked by MacKenzie and her team being as suitable companies to also have in the investment trust portfolio.

She wouldn’t disclose their identities, merely saying investments will be made only when these companies need to issue new shares such as for an acquisition or to boost working capital.

What's on the shopping list?

One preferred route for Downing is to buy a stock very cheaply which has clear turnaround potential. Another is investing in a business that is trading significantly below its intrinsic value and where Downing has spotted a means by which to drive a share price re-rating.

The micro-cap segment arguably has the greatest opportunity to invest in a company trading too cheaply. There is very little analyst research at the bottom end of the market, so most investors either aren’t aware of the opportunities or they have no benchmark by which to work out if something is cheap, fair value or expensive.

Very small companies may also be in much greater need for third party assistance on financing and strategy versus larger businesses, so a hands-on fund manager like Downing can find stocks where the management are receptive to suggestions for strategic change or improvement.

MacKenzie says she and her colleagues spend a considerable amount of time undertaking due diligence on stocks, potentially as long as 18 months. That’s a key reason why she won’t touch IPOs (initial public offerings), saying the stock market listing process is ‘too abbreviated’. Mining and early-stage tech companies are also ignored.

How will it pick stocks?

Before deciding on an investment, the fund manager looks at areas such as quality of management, cash flow, sustainable margins, balance sheet strength and the potential catalysts to drive up the value of a business.

Favoured businesses include those with positive free cash flow, asset-backed companies like housebuilders and manufacturers.

Previous examples of Downing’s investments include business supplies group Office2Office. It was a mess of a business with very low profit margins.

‘We picked up shares when Hugh Cawley joined as finance director. He had a good reputation at sorting out complex operational structures. The market cap was £7m and Hugh managed to generate £7m of free cash as well,’ says MacKenzie.

‘I looked at the business and saw it had a nice document management division with long term contracts and good return on capital. I thought that bit alone was worth two to three times the market cap. I thought we could sell some of the other bits to Staples as they were looking to build scale in the UK.

‘Eight to nine months into our due diligence we went out and bought as much as we could. We got 5%, but I would have had 25% if I could have got it.

‘We weren’t the only ones to realise the value potential in the business. Private equity firm Endless ended up making a takeover offer and paid a 98% premium to what we had paid for our shares.’

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Topical example of a turnaround story

A more topical example of something in the Downing growth fund is Hornby (HRN). Just to clarify, this isn’t something guaranteed to also appear in the new investment trust; we’re merely discussing the company as an illustration of how the Downing team spot opportunities.

Hornby’s shares have fallen by 64% in the past five years. In particular, the Scalextric owner’s share price took a nasty blow in early 2016 when it issued its fourth profit warning in three years.

‘The company’s problem is that it cannot supply enough products to meet demand, and they also weren’t paying attention to margins. We’re helping them sort it out. However, it could take another three to five years for its turnaround to be realised,’ says MacKenzie.

Say hello to ScotGems

The forthcoming ScotGems investment trust launch will also be a high conviction portfolio, albeit slightly higher up the market cap spectrum than the Downing product. It will have the ability to invest globally, although it is expected that the portfolio will initially be tilted towards emerging markets and Asia Pacific.

Retail investors will be able to take part in ScotGems’ IPO offer from 5 June through their stockbroker or investment platform provider. The investment trust is expected to hit the stock market on 26 June.

ScotGems’ lead manager Ashish Swarup says the trust will invest in companies with a market cap below $2.5bn. He hopes the average market cap of new investments will be under $1bn and says ‘the sweet spot’ is $500m to $1bn.

Looking for ideas

Co-manager Tom Allen says he and his colleagues meet over 1,000 companies a year, seeking ideas for some of their other funds including Stewart Investors Asia Pacific (GB0033874214) and Stewart Investors Global Emerging Markets (GB0033873919).

They often come across interesting companies which are too small to be included at meaningful levels in these funds. ScotGems could therefore become a natural home for such investments.

It will take meaningful positions in 20 to 30 stocks where it has high conviction. ‘A $500m market cap company might only represent a 1% position in a normal all-cap fund. We want it to represent a 5% to 6% position in a small cap fund, which is more meaningful conviction,’ says Allen.

The initial portfolio is likely to include a handful of stocks which already feature in other Stewart Investors funds.

Family favourites

Stewart Investors has already built up relationships with various family-run businesses in Asia, particularly in India. This is likely to be a key source of investments in the future. For example, Allen says the asset manager has invested in a number of companies owned by a particular family which has led to a new opportunity.

‘We look at the boards certain family members sit on,’ explains the fund manager. ‘For example, one person has appeared on the board of a small company founded by someone with whom they went to university. We’ve taken a closer at the company and found its board is full of very good people.’

Another example of a potential investment is an engineering outsourcing business where a second generation family CEO has woken up a sleepy company.

‘They are willing to forego short-term profitability for long-term benefits. We met lots of people in the company, including junior staff, to see if they were buying into the vision of the CEO.

‘This is one of the opportunities with small caps. Most investors would screen data to find ideas; qualities such as stewardship which is central to our strategy don’t show up in the numbers for a long time,’ adds Allen.

As an asset manager, Stewart Investors plays close attention to quality of management. It likes long-term owners including family-controlled companies who are investing today so the next generation owners take over a solid business. It also prefers companies resisting the pressure to take on lots of debt or do share buybacks.

Who might like ScotGems?

Allen believes ScotGems is best suited to someone with at least a five to seven year investment time horizon. ‘Our style is very conservative and one of our key characteristics is preservation of capital. We’d expect not to keep up with a rising market.’

Don’t let that cautious remark put you off. Stewart Investors has a very good track record in not only beating relevant indices but, more importantly, also delivering positive returns for investors.

For example, its Global Emerging Markets fund has achieved 11.2% annualised returns, net of fees, over the past 10 years versus 7.4% from the MSCI Emerging Markets index.

Stewart Investors’ Asia Pacific Fund has achieved 13% annualised return over the same time period, compared to 9.3% from the MSCI AC Asia Pacific ex-Japan index.

It is worth noting that the asset manager runs its portfolios without reference to a benchmark index and the aforementioned Global Emerging Markets and Asia Pacific funds have different structures and policies to ScotGems. (DC) 

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