UK Micro-Cap Trusts: The Dark Before the Dawn?

It has been an annus horribilis for UK micro-cap stocks and the trusts that invest in them, with two results announcements last week showing just how bad things have been. With sentiment as negative as it is, it could actually be a good time to acquire some exposure to this area, as long as you can stomach the inevitable volatility next year.

The interim results for the £64m Miton UK MicroCap Trust (LON: MINI) for the six months to the end of October revealed a 29% NAV total return loss over the period. In share price terms it was even worse with a decline of 31.8% as the discount, which currently stands at about seven percent, widened.

Micro-caps – defined by MINI as stocks with a market value of less than £150m − have underperformed the larger companies in the small-cap universe and this has detracted from the trust’s relative performance. The managers say that the prospects for most of their holdings have not deteriorated, although some have certainly sold off.

Has the write-down gone too far?

Writing in the accounts the chairman said that ‘microcaps… now stand at significantly attractive valuations.’ He went on to add that: ‘With the constraint on capital that comes with inflation, the relative strength of UK quoted company balance sheets should be a considerable advantage, especially compared to those with substantial debt burdens.’

Despite MINI’s underperformance the managers, Gervais Williams and Martin Turner, believe it has led to a significant longer term opportunity. They note that the aggregate price-to-book valuation of the portfolio reached an unusually low level of 0.8x by the period end, which was almost half that of the UK market as a whole.

Analysis by Kepler Trust Intelligence says that the challenging conditions have had a disproportionate impact on smaller and micro-cap strategies compared to their large cap counterparts. They believe that the sell-off in share prices seen this year is a significant overshoot and although market sentiment may not improve immediately, MINI’s track record suggests it may generate strong returns when it does so.

Long-term opportunity

Another casualty is the £61m River & Mercantile UK Micro Cap Trust (LON: RMMC) whose results for the year to the end of September disclosed an NAV total return loss of 48%. As you might expect, the discount widened over the period and currently stands at 12%, although the longer term performance is comfortably ahead of the benchmark with a gain of 87.7% since inception in December 2014.

Writing in the latest end of November factsheet, manager George Ensor said that sentiment remains depressed and positioning remains cautious. “Whilst the recovery is unlikely to be linear and further downside to earnings expectations is probable, the medium term opportunity for shareholder valuation creation is extremely attractive.”

The trust’s concentrated portfolio of 40 micro-cap stocks has been in the eye of the storm and suffered accordingly, but the valuations are obviously a lot more enticing now. If you think that interest rates are near to their peak and that the recession will not be as deep as expected then this is the type of asset class that has real recovery potential.