Micro-cap funds like Henderson Opportunities Trust could bounce back strongly in the event that a no-deal Brexit is avoided, writes Nick Sudbury.
In the last few weeks there has been a small recovery in some of the domestically-oriented areas as the prospect of a hard Brexit has appeared to diminish, but this has yet to reach the UK micro-cap stocks and the funds that invest in them.
British micro-cap companies are often heavily dependent on the domestic economy and a hard Brexit could have a disastrous short-term effect on their profits. Many investors are not willing to take the risk, especially in view of the illiquid nature of the holdings, which means that the investment trusts that operate in the sector are mostly out-of-favour and available on wide discounts.
One of the casualties is the £104m Henderson Opportunities Trust (LON:HOT), whose shares are trading on a 20% discount to NAV. Although it is not a pure micro-cap fund it is heavily exposed to this area and at the end of May had a 55% weighting in the sector with a further 26% in UK small-cap stocks.
Growth, recovery and special opportunities
The fund actually has quite a wide remit and aims to achieve capital growth in excess of the FTSE All-Share from a portfolio of 70 to 100 investments across the whole range of market capitalisations. It focuses on growth, recovery and special opportunities, with the manager looking for relatively unknown but fast growing smaller companies, as well as larger UK stocks where the sentiment has become overly pessimistic.
A good example is its largest position, RWS Holdings (LON:RWS), which provides specialist patent translation services for sectors such as pharmaceuticals and is one of the biggest companies operating in these markets. This dominant position enables it to generate good operating margins and double-digit organic growth.
Another is Zoo Digital (LON:ZOO), a company that provides dubbing and subtitling services for content producers such as Netflix. Unlike traditional studios, its software allows freelance actors to record from home, thereby providing the content more quickly. There are also a few larger out-of-favour stocks including HSBC (LON:HSBA) and Johnson Matthey (LON:JMAT).
Fallen out of favour
Over the last ten years the NAV total return is an impressive 204%, which is well ahead of the 118% gain in the benchmark and All Companies peer group, but most of this outperformance came at the start of the period. In the last five years the NAV growth was just 30%, the same as the peer group, while the shares have returned a paltry five percent as the fund has fallen out-of-favour.
At the end of August it had 95 holdings and net gearing of 14%. Ongoing charges were a reasonable 0.84% and the shares were yielding 2.4%, although income is clearly not the main objective. Over the last few years the discount has averaged around 16%, but it is currently out at 20%.
If we somehow end up with a calamitous last minute hard Brexit or a bad deal then domestically-oriented funds like Henderson Opportunities Trust would be likely to suffer a further de-rating, but on a two- or three-year view it looks cheap and in any other scenario should pick up much more quickly.