If you’re looking for stocks that the market routinely undervalues, micro-cap companies, the smallest businesses within the small cap sector may offer a potentially happy hunting ground, with research suggesting many companies trade at sizeable discounts. 
By micro-cap, we mean those constituents of the Numis Smaller Companies plus AIM index that have market capitalisations of less than £250m. That’s about three-quarters of the 1,000 or so stocks in these indices, where the largest companies have capitalisations of up to £1.5bn.
Looking at the 12-month forward price to earnings ratios on which companies in these indices trade, micro caps have, on average, been between 10 and 25 per cent cheaper than the index as a whole over the past five years. In other words, the market regularly values the typical micro-cap stock more cheaply than its larger counterparts.
There are several reasons why this discount applies. One important factor is that many investors simply do not know about these companies. They tend to attract less attention from professional research organisations and brokers are less likely to take the time to study micro caps and therefore to promote them to clients.
It’s possible, moreover, that this shortfall of knowledge and understanding is going to get bigger. The MiFID II regulation that came into force in January this year requires fund managers to separate out the cost of research they use when disclosing their charges. Many analysts expect this increased scrutiny of research cost to lead to less of it being commissioned and developed, in which case it is likely to be the smallest companies where brokers cut back first.
The discount also applies as the market for micro-cap stocks can sometimes be less liquid. Many institutional investors are explicitly prohibited from investing in companies with market capitalisations below certain thresholds. Trading in smaller shares is often much thinner. This isn’t necessarily a problem. The stocks can still be traded and the lack of institutional investors is a big part of the knowledge opportunity, but valuations reflect a discount to compensate for this relative lack of liquidity.
Securing value
The existence of the micro-cap discount prompts an obvious question: is there a way for investors to profit by identifying businesses due for a re-rating? One possibility could be to take the traditional approach adopted by value investors, who seek out stocks they believe the market has overlooked and then hold on to them until other investors wake up to the anomaly. This is certainly an option in the micro-cap sector, but the risk is that you’ll have a long wait, many micro caps remain overlooked, unfair though this may be, for considerable periods.
An alternative would be to take a growth investment route. Micro caps that deliver consistent improvements in sales and profitability should, by definition, get steadily bigger. In time, such companies will no longer be micro-cap businesses and the market should re-rate them accordingly as they attract more attention and become investment possibilities for institutions.
This growth strategy offers investors the potential for a valuable double whammy if successful. They get a benefit from the consistent growth of the business, possibly from both dividend and capital gains, but they also get a boost from the re-rating. As the discount at which the business trades relative to the rest of the market shrinks, investors could effectively get an additional bonus.
Hidden gems
In our view the secret to successful micro-cap investment, isn’t only identifying the unpolished diamonds that other investors have yet to spot, though this is part of the challenge; it’s also a question of picking out those stocks where you can see a clear path to unwinding the valuation discount.
By focusing on genuinely smaller companies and developing a high conviction portfolio of growth companies we hope not only to generate good long-term risk adjusted returns but also a portfolio that has low correlation to the wider UK small cap sector because it is doing something very different to other peer group funds.
Ken Wotton is a fund manager at Livingbridge Equity Funds. The views expressed above are his own and should not be taken as investment advice.