Ken Wotton explains the lessons he has learned from a decade of micro-cap investing

The primary home of micro-cap companies, AIM, has considerably evolved and expanded since its launch almost a quarter of a century ago. In particular, over the past decade – the lifespan of the LF Gresham House UK Micro Cap Fund – the market’s popularity has grown significantly.

This is not a surprise, with an increasing number of investors noting the exciting opportunities afforded by this fertile hunting ground for undervalued and relatively unknown unique companies. However, selecting winners among smaller niche companies is not easy.

Below, we share some of the lessons we have learned over the past decade and some of the reasons why investors should not overlook the compelling characteristics of micro-cap stocks.

Always be alert: Investing in micro caps never ceases to excite. New small companies regularly come to market to access capital, which they deploy to conduct transactions and reinvest in business growth. In fact, micro caps can be considered a ‘self-replenishing opportunity set’, whereby there is a constant renewal of the investment universe – only 60% of current listings existed ten years ago. For micro-cap investors, this means continuously being on the lookout and deploying resources rapidly to research these dynamic newcomers, particularly as growth names move quickly.

Be aware of re-rating: As these small and dynamic companies grow, investor awareness increases, and this can often cause share prices to be rapidly re-rated. While this can be hard to anticipate, micro-cap investors need to factor in a company’s re-rating potential. One re-rating can provide a phenomenal kicker to overall returns, on top of the compounding benefit of earnings growth over several years. Over the past decade, our fund returns have repeatedly benefited from this phenomenon, with an evolving set of stocks powering the overall performance each year.

Do your research: Success stories such as Fever-Tree and ASOS brought AIM to the attention of investors. However, larger small caps have been receiving most of the attention and the micro-cap space – companies with a market cap of between £50-250m – is still relatively uncompetitive. This should remain the case, owing to the pervasive lack of research and lower liquidity making it harder for larger funds to compete in this market. Many micro caps remain under-the-radar – a perfect opportunity for investors willing to invest in the resources necessary to conduct their own proprietary research.

Emphasise your edge: With investors now more receptive to the appeal of smaller companies, the asset class has become an easier sell. It is now time for investment managers to highlight the unique selling points that differentiate them from the crowd. At Gresham House, for example, our competitive advantage lies in a high-conviction approach, which relies on proprietary research. Our robust process has allowed us to identify high-quality companies, such as digital marketing agency Next15, which we purchased in the first year of the fund and watched the share price appreciate almost ten-fold.

Insist on quality: As recognition of AIM has increased, the composition of the market has changed considerably. Mainstream investors seduced by fast-growing, disruptive companies demanded higher standards of governance and quality of business. As a result, the number of companies listed on AIM has diminished, but the quality has increased. This welcome development has improved the opportunity set to include more stable, less speculative companies. It remains large, with micro caps below £250m market cap making up over three-quarters of the companies featured in the Numis Smaller Companies Index plus AIM.

Have a feel for governance: With more companies now meeting AIM compliance measures, it has become even more important to determine whether governance is simply a box-ticking exercise or if there is true due diligence. Investors in emerging companies need to be able to trust management teams at the helm. Undertaking a deep dive by getting as close to companies as possible, engaging in dialogue with independent board members and assessing the company culture and alignment of interest with shareholders, are key to making high-conviction calls.

Always stay sceptical: Sources of company data have multiplied with the sophistication of technology, but micro-cap investors still rely heavily on face-to-face meetings. While both are invaluable, the key to building knowledge and triangulating a view on the market’s opportunities lies in finding external sources of validation. Investors should never be satisfied with what a company says or what the data shows. Being sceptical and going the extra mile by leveraging our extensive smaller company and private equity network to track down niche experts have allowed us to successfully identify winners over the past ten years.

Uncover discounts: Smaller companies have typically offered discounts compared to larger, more well-known names. Between micro and small caps, the price to earnings multiple discount has fluctuated between 10% and 25% during recent years. However, with the introduction of MiFID II and the unbundling of research costs, coverage of the micro-cap market is likely to be further diminished, which could lead to even greater discounts. So, the more micro caps are ignored by the market, the more investors should pay attention.

Build relationships: Micro caps have remained largely immune from the rise of passive funds, due to the inherent inability to engage with management teams, as well as liquidity restrictions. Investing in smaller companies requires intensive resources to carry out in depth research and conduct face-to-face meetings. The resulting relationships investors form with businesses are key to trading low-liquidity stocks. Being actively engaged and in constant contact with companies can help investors be among the first to know when a buying opportunity arises. For this, patience is required.

Participate in deals: Being a micro-cap investor provides the opportunity to go beyond returns and add value to the economy by championing entrepreneurship. Because micro caps are often raising money from equity markets to grow their businesses, there are more opportunities to participate in deals, such as IPOs, than for investors in larger companies. We are very active in this space and the value we generate by being active in fundraising deals is disproportionately large for our size.

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