Investing Basics: Investing in micro-caps with investment trusts

It takes all sorts of companies to make an economy function. Most investors are conscious of the power of diversification to some degree – investing across sectors, geographies and asset classes. However, there are still areas of the market that are relatively untapped by private investors. One such area is micro-caps.

This may be due to both the unique characteristics of the asset class and the misconceptions regarding it. Whether it’s the illiquidity associated with the smallest companies, or the association with the black box processes of private equity and venture capital, these factors can present a complicated picture that leaves many investors disincentivized to invest in the market.

Here, we aim to bring clarity to these concerns and examine the forces that impact micro-cap investing.

A specialist sector

The majority of private investors will never have considered investing in micro-cap companies. This may in part be due to several assumptions associated with the segment: that companies at this size will almost certainly be private, that the sector will consist entirely of speculative technology names (or conversely unambitious mom and pop-type businesses), or that most investors looking at the smallest businesses land on the same few names for their portfolios.

None of these are true, but the assumptions are understandable. For instance, over 1000 companies are publicly-listed with a market capitalisation of under £150m. Many of these are profitable, established businesses with clear growth paths, such as regional publishers and beauty product manufacturers – far from the speculative pre-profitable technology often associated with companies of this size. Furthermore, with a universe that large, there is a big enough pond for investors to fish in.

On the other hand, some of the assumptions around this segment are more accurate. Notably, after two decades in which newer firms have become business behemoths, the growth potential for micro-caps may be significantly greater than for large-cap peers. According to research from Grant Thornton¹ published to mark the AIM market’s 25th anniversary in 2020 (The AIM or ‘Alternative Investments Market’ is where the UK’s smallest companies list first’), AIM companies grew by 40% year-on-year over their first three years following IPO – outpacing both private company peers and large-caps.

A further benefit of considering this end of the market is that the investment universe is regularly refreshed. Through spin-offs, listings and mergers new companies and/or company structures are constantly emerging, offering investors fresh ideas and opportunities.

Effective due diligence

This doesn’t mean though that investing in micro caps is without challenge.

Lack of analyst coverage is an oft-touted issue when investors look down the market cap spectrum. While mega-cap names in the FTSE 100 can be covered by an average of 20 analysts, small-cap names with a market capitalisation of approximately £1bn or less are typically covered by fewer than four analysts. This gulf widens further when it comes to the smallest companies, with many micro-cap businesses covered by no analysts all.

As a result, successfully investing in micro caps requires each prospective investor to take an especially deep look through a company’s balance sheets, operational practices and individual markets. For an individual investor this level of due diligence is a significant challenge, in terms of time, skill and access.

Although the listed micro-cap universe is in many ways very different from the private equity one, the due diligence techniques employed by private equity investors – rigorous investigation of a business, its peers and its management – are useful in this arena too. With this in mind, investing through managers with experience of this sort of approach could be a helpful route for private investors.

The risks of looking micro

The need for experience is especially evident when considering the particular risks of investing in micro-caps. These are threefold: corporate viability, volatility and liquidity. Smaller companies by their nature have fewer capital resources to draw on, and less access to external financing options, meaning that they are more vulnerable in times of market stress.

Smaller-cap companies’ share prices tend to be more volatile, as they have relatively fewer shareholders so an individual holder’s change of sentiment can rapidly have an impact – and the market can turn rapidly negative on the whole segment in periods of economic downturn.

Further, this smaller shareholder base means that liquidity can be a challenge for investors in micro-caps. This is where the investment trust structure shines when it comes to micro-cap investing. With the shares of investment trusts themselves traded freely on the stock exchange, investment trust shareholders know that there is daily liquidity should they need to redeem their investment, regardless of the liquidity of underlying assets. As with all trusts, there is a risk that the market underappreciates the trust’s portfolio value and that it therefore trades at a discount to net asset value.

¹ https://www.grantthornton.co.uk/globalassets/1.-member-firms/united-kingdom/pdf/publication/2020/economic-impact-of-aim-june-2020.pdf