The rise in volatility since the start of the year should lead to attractive valuations at the bottom of the market cap scale, according to Livingbridge’s Ken Wotton. 
FE Alpha Manager Wotton (pictured), who oversees the four FE Crown-rated LF Livingbridge UK Micro Cap fund, said his high-conviction smaller companies strategy has performed well since the start of the year, as markets have seen an uptick in volatility.
Indeed, the fund has risen by 2.24 per cent compared with a 3.5 per cent loss for the average IA UK Smaller Companies member.
“At the moment, the environment is pretty good from our position,” said Wotton, whose universe consists of sub-£250m stocks. “We’ve seen relative performance pick up because this environment is exactly suited to our style.
“We do pretty well in a falling market: historically we tend to outperform when markets are a bit more volatile and small-caps are not performing quite as well.
“If you look at 2011 and 2014, both of those were years when the UK smaller companies sector had a negative year, but we still made a positive return.”
Annual performance of fund vs sector since launch
Source: FE Analytics
However, Wotton said the more recent increase in volatility in markets suits the team’s long-term, quality-focused approach to small-cap investing.
“It’s a delicate balance. I don’t want there to be a massive market correction,” he said. “And I’m not expecting one to come imminently.”
The FE Alpha Manager noted the impact of the EU referendum on the fund’s performance in 2016, when it underperformed on a relative basis because of the domestic focus of many micro-cap stocks.
He said companies with pure overseas earnings in the small-cap space delivered 50 per cent returns, while domestic-focused stocks were up by just 1.5 per cent.
“We weren’t too concerned about it because we were happy with the fundamentals of [our] companies and jumped in to top up some holdings quite materially when they were stressed,” he said.
Wotton said: “In 2017 we were marginally ahead of the average fund but some of the top performing funds were exposed to some of the very highly rated, good quality momentum names, things like Fevertree, Purplebricks and Keywords.
“Some of them are very good companies but they were trading on P/E multiples of 50x, 60x, 70x. That’s not our style we wouldn’t invest in companies on those kind of ratings.
“So, when momentum is outperforming we will underperform on a relative basis.”
After a year defined by low volatility, Wotton is now starting to see a number of opportunities at the bottom of the market cap scale.
Rolling 12-month volatility of fund vs sector & index over 2yrs
Source: FE Analytics
He said: “I think [volatility] does suit our style, but I think the current environment has two elements to it. One being the increase in volatility and that creates opportunities for us.
“When we have high conviction in the company and have done work on the fundamentals it creates a pricing opportunity either to top up or add new holdings.”
Wotton added: “Another factor is that after two years of pretty buoyant smaller micro-cap IPOs [initial public offerings] ... there is a decent stream of company fundraising to do acquisitions or investment in growth opportunities.”
The manager said many companies that he targets are still looking for money to grow while some private equity backers are trying to exit positions, creating more investment opportunities.
“Markets are still at pretty decent levels, [in terms of] the valuations of companies you can get,” said the Livingbridge manager.
“There are plenty of things which are at sensible multiples based on the growth they say they are going to deliver.
“There are enough businesses that are good quality coming in at multiples I can rationalise, yet the multiples are high enough that PE [private equity] or founders are willing to use public markets rather than sell to private equity or do something privately.”
One headwind for the small-cap space is the potential impact of Brexit as the two-year Article 50 notice period expires, which might see the number of companies coming to market dwindle.
“I would expect the deal flow to tighten up significantly at the back end of this year, once we’re six months out from Brexit,” said Wotton. “I expect advisers to be saying ‘if you’re going to go, go before October otherwise you might have to wait’.
“That might be too pessimistic but I would expect that the uncertainty factor means if you don’t have to go you won't.”
The manager said he typically focused on less cyclical areas of the small-cap universe in search of companies with the potential to double profits over a three-to-five year holding period.
As such, the LF Livingbridge UK Micro Cap fund invests in four core non-cyclical sectors: consumer, TMT (technology, media & telecommunications), business services, and healthcare.
“We’re not stockpickers, we’re not deep value or special sits or anything. We’re looking good quality growth companies,” he said. “We describe our style as GARP [growth at a reasonable price] with a quality overlay to it.”
Wotton said his focus on the micro-cap space also gives him an advantage, as many companies will often be “below the radar of mainstream investors”.
“They’re not very well-known businesses and as a result of that – and some of the issues around liquidity because they’re smaller – they trade at a material discount,” he said.
“At the end of December, the sub £250m cohort was trading at just under 20 per cent discount on a P/E [price-to-earnings] multiple basis to wider Numis plus AIM index.”
Performance of fund vs sector over 3yrs
Source: FE Analytics
The LF Livingbridge UK Micro Cap fund has delivered a 53.08 per cent total return over the past three years, compared with a gain of 48.01 per cent for the average IA UK Smaller Companies fund.
It has an ongoing charges figure (OCF) of 0.99 per cent.