The UK micro-cap sector is a “fertile hunting ground for undervalued and relatively unknown unique companies”, according to veteran investor Ken Wotton, and is growing in diversity and opportunity. 
Wotton (pictured) and Brendan Gulston have marked the 10-year anniversary of the £172.4m, the five FE five Crown-rated £172.4m LF Gresham House UK Micro Cap fund by discussing the lessons they have learned and the reasons why investors should consider “the compelling characteristics of micro-cap stocks”.
Always be alert
The first lesson is that investors should be constantly aware of the ever-changing pool of stocks available in the micro-cap sector.
“New small companies regularly come to market to access capital, which they deploy to conduct transactions and reinvest in business growth,” said Wotton.
“In fact, micro caps can be considered a ‘self-replenishing opportunity set’, whereby there is a constant renewal of the investment universe – only 60 per cent of current listings existed ten years ago.”
Awareness of re-rating
Having recognised that the state of stocks available in the micro-cap sphere is a fast-changing picture the next lesson is to recognise the quick changing re-rating of share prices, a factor which the fund has repeatedly benefited from, according to Wotton.
He said: “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.”
Research capabilities vital
The managers of the LF Gresham House UK Micro Cap fund also advised investors to conduct their own thorough research. As the sector suffers from a lack of coverage and in-depth research this leaves some potentially bountiful stocks going under the radar, making the micro-cap space relatively uncompetitive.
“There are about 1,000 companies and there are so many companies that people don’t cover or they won’t have forecasts on the market,” said co-manager Gulston. “Hundreds of these companies therefore get no air time and there’s no information really from a research analyst.
“So, our approach has always been that we do our own in-house research. We don’t rely on external broker research. Our whole philosophy is about having a private equity approach to public investing.”
He added: “If you look at the number of clients that brokers have it’s in the hundreds, so a FTSE 100 company has 10-20 banks pouring over them writing research, jostling to try and become their broker or adviser.
“If you look at the long tail of the micro-cap universe there’s just nowhere near that level of broker competition.”
Always stay sceptical
Another key lesson learned by the managers is the importance remaining sceptical when presented with data or conducting face-to-face meetings.
“The key to building knowledge and triangulating a view on the market’s opportunities lies in finding external sources of validation,” said Wotton. “Investors should never be satisfied with what a company says or what the data shows.”
Uncovering discounts
The lack of coverage in the micro-cap space can give rise to “valuation anomalies” where stocks trade at a discount to their intrinsic worth, according to Gulston (pictured). 
The managers said that stocks at the lower end of the market cap scale can trade at discounts of 10-25 per cent to price-to-earnings valuations compared to large-cap companies.
This means that micro-caps begin to look far more attractive as they offer a greater potential to generate value.
Emphasise your edge
It’s also important to differentiate yourself from your peers, with Gulston noting that the vast range of stocks in the micro-cap universe means that you have more opportunity to significantly differentiate your portfolio away from your investors compared to the large caps.
Alongside deploying their resources for intense, in-house research Wotton believes that the LF Gresham House UK Micro Cap fund’s edge lies in its high conviction approach allowing it to back high-quality companies with strong growth potential.
Insist on quality
The focus on quality is an important point and one that has been enable by a significant change in the micro-cap sector highlighted by Gulston (pictured) over the past decade as the reputation of stocks listed on the Alternative Investment Market (AIM).
“The reputation of AIM used to be as quite a high risk, high growth exchange for companies,” he explained. “But, they were a lot less credible back then than they are now, and now there’ve been a number of high profile success stories.”
Examples of higher-quality growth names include companies such as Fever-Tree and ASOS, which have helped to bring AIM to the wider attention of investors.
“AIM has gone from strength to strength,” he added, “and it continues to attract way more companies than it has done before and continues to be very dynamic. If you look at the number of companies who were on AIM about five years ago it’ll be a fraction is still there.”
A feel for governance
Another important lesson of the past decade is how important it is for a potential investment to have proper governance practices.
Wotton said: “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.”
“Governance is really important,” added Gulston. “We want to try and create an alignment between us as shareholders and management and we’re trying to make sure that the people who do the day-to-day of the business and are running the operation have good oversight form the chairman who’s independent and who’s going to challenge them.
“Otherwise you’re just going to have a CEO and a management team that do what they want. We look at chairman and executive management and how much skin in the game do they have.”
Participating in deals
The final lesson is the value of being able to take part in deals. The nature of the micro-cap space means there are more opportunities for capitalising on deals – such as initial public offerings or merger & acquisition activity – because of the greater need for funding from the equity markets.
Wotton describes this as “championing entrepreneurship”.
“It’s the same in the private space as it is in the public space,” said Gulston. “The people that we’re backing are entrepreneurs. There’s a constant innovation and they are constantly finding a new way to do something and create a business doing that. And I think that should continue into the future, and hopefully over the long term.”
He added: “For the longer term, I would expect AIM micro-caps to still be a really interesting place to invest.
“Sectors like tech and healthcare you’re still getting really, really interesting niche businesses who are disrupting certain parts of the market. And that’s part of small-cap investing.”
As such, the fund’s managers avoid areas such as natural resources and commodities sectors where there is little innovation as well as higher risk early-stage biotech companies or very early stage technology companies.
Gulston explained that: “We won’t invest in cyclical sectors or sectors where the success of a business is outside of our control. “That helps us take out a lot of the things that tend to be more risky or more variable in terms of earnings.”
Performance of fund vs sector since launch
Source: FE Analytics
The LF Gresham House UK Micro Cap fund has made 348.50 per cent over the past 10 years compared with a 293.28 per cent. It has an ongoing charges figure of (OCF) 0.98 per cent.