Ignore micro-cap shares at your peril

Micro-cap companies are increasingly coming to the attention of small company fund managers and the latest indication of this is the offer of shares in new investment company River and Mercantile UK Micro Cap Investment Company Ltd. Recent performance by these micro-cap companies has not generally been good because of the tough market conditions, but these are long-term, rather than short-term, investments.

River and Mercantile wants to raise up to £100 million from an offer for subscription and placing at 100p a share, which closes on 27 November.

It is not just River and Mercantile that is attracted to micro caps, though, in September Downing published "Micro-cap: Why small is beautiful", a booklet on the attractions of micro-cap companies.

Octopus Investments has £22 million of funds in the CFIC Octopus UK Micro Cap Growth Fund. This is completely separate to the fund manager's VCTs and IHT portfolios, which will also have some micro-caps in them. According to Octopus fund manager Paul Stevens: "We see quite a lot of businesses that may be mispriced on AIM".

Last year, the Marlborough Nano Cap Growth Fund raised £90 million within days of the opening of its offer. All this goes to show how the focus is starting to switch from what are generally called smaller companies, which could be valued at up to £1 billion, towards much smaller companies that are a size where there is enormous room to grow if they have a significant potential market combined with strong management.

What is a micro-cap?

Downing defines companies with a market value of less than £100 million as micro-cap and it believes that the real value is below £50 million. This is because larger funds generally do not like investing in these companies because of a lack of liquidity. According to Downing, companies with a value of less than £50 million are trading at a 29% discount to the valuations of companies with a market value of between £150 million and £1 billion.

River and Mercantile is focusing on "companies with a free float market capitalisation of less than £100 million at the time of purchase" so they could have a market value of more than £100 million if some of the shares are tightly held. Most of the companies will be quoted on AIM and there will be 30 to 50 shareholdings. Net debt can be up to 20% of NAV at the time that the borrowing happens. Philip Rodrigs will manage the company. He is a former manager of the Investec UK Smaller Companies Fund.

No dividends are planned but redemptions of a portion of shareholders' shareholdings could happen in the future in order to keep the NAV at around £100 million. This is to ensure that all the holdings can have a meaningful impact on performance and the fund can produce high returns. At least £10 million will be redeemed at any one time. Shareholders will be able to vote on the continuation of the company in 2019.

The key to these micro-cap funds is that they are not trying to beat a specific index. They are purely based on stock picking. Lack of research on these micro-cap companies provides an opportunity to find unappreciated companies.

Proof that small companies do outperform

Research by academics Elroy Dimson and Paul Marsh, particularly their work on the Numis Smaller Companies Index, has shown the outperformance of the smallest companies over decades. They have calculated that £1 invested in the bottom 2% of the Main Market in 1955 would be worth more than £11,000 now. The outperformance has been less marked in recent times, but this could be about to change.

Miton chief executive and smaller companies fund manager Gervais Williams has recently published his latest book "The Future is Small". Williams believes that AIM, which he describes as "a magnet for smallness from around the world", has the potential to be the best performing world market for many years to come. He says that in recent decades global growth has been fuelled by increasing debt but world growth is now stalling. This means that micro-caps are attractive again.

Williams believes that individual stock picking will be increasingly important. He is particularly keen on what he calls "regular businesses with good cash flow" rather than the more speculative micro-cap companies.

Institutions have been moving away from the smaller end of the market over many years, but Williams argues that investors will start to move down the market cap range. However, it will take institutions years to get back into micro-cap investments because of the difficulty in buying significant stakes in these companies.

Smaller companies are more dependent on the UK economy than their larger counterparts so the positive outlook for the UK makes this a good time to launch a fund, according to River and Mercantile. The positive UK outlook will increase business confidence and encourage investment.

Due diligence is important. No investor, no matter how experienced, is going to get it right every time, but the degree of risk can be reduced through due diligence.

Lower the risk

One risk is the potential illiquidity of micro-cap companies. This means that the micro-cap fund managers need to be careful what they buy because they need to be prepared to hold for the longer-term to get the main benefits and even if they wanted to sell they are likely to find it difficult.

One of the companies that has done well for Downing and some of the other micro-cap fund managers is AIM-quoted transport resources optimisation and reporting software provider Tracsis. The company has a strong record of organic and acquisition growth and, at 400p, the share price is eight times the level it was five years ago.

In the year to July 2014, revenues more than doubled from £10.8 million to £22.4 million, helped by an initial revenue contribution of £514,000 from rail management software systems provider Datasys, which was acquired in May, and the previous year's purchase of traffic data provider Sky High. Pre-tax profit jumped from £3.3 million to £5 million. The dividend was improved from 0.7p a share to 0.8p a share.

The strong balance sheet and cash generative nature of the business is another of the attractions of Tracsis. Net cash was £8.7 million at the end of July 2014 even after paying for the latest acquisition.

Tracsis consistently beats the forecasts in the market. House broker WH Ireland tends to start the year with relatively easy targets to achieve and then upgrades as the year goes on. The 2014-15 profit forecast is £5.5 million, which appears modest growth, but the level of UK orders for condition monitoring equipment can vary and the timing is difficult to predict. There is also potential upside, following recent pilots, from potential North American railway orders for the company's remote condition monitoring technology. Further acquisitions would also boost profit. The shares are trading on 24 times prospective earnings for 2014-15.

When a company performs as well as Tracsis this can attract liquidity to the market in the shares and Downing has trimmed its stake, but it still owns 5.82% of the company.

It is not easy to identify companies that can perform as well as Tracsis but it can be done with hard work. One of the keys is to look for companies that can grow over a number of years rather than ones where there could be short-term jump in the share price. Williams says that investors' "need to be more focused on the tortoise rather than the hare".