From Formula 1 to Haynes manuals: UK small caps driving returns, December 2019

In March 2016, Liontrust built on their exceptional UK smaller companies’ franchise with the launch of a Micro-Cap fund, which specifically targets businesses worth up to £150m.

Three years or so later – and despite the huge cloud Brexit has placed over the UK economy – it has returned just over 70%* to investors and has firmly established itself as an option for those looking to tap into burgeoning UK businesses.

We recently caught up with co-manager Matthew Tonge to talk all things micro-cap.

Could you tell us why more than a third of the fund is currently sitting in technology stocks?

“As with the UK smaller companies fund, the micro-cap offering follows the economic advantage process where a company must have at least one intangible asset: intellectual property, a strong distribution network, or high recurring revenues. Intellectual property includes patents, copyrights, trade secrets or some kind of know-how.

“Distribution networks within the micro-cap market tend to be electronic, rather than physical. For example, look at estate agency Rightmove – an estate agent can’t do their job without using that software – it has become embedded in their workflow.

“For recurring income, I like to use the example of a high street clothes retailer that opens on a rainy day. The retailer is likely to sell more coats but it’s impossible to know ahead of time how many coats you will sell. We like businesses that get paid X amount a month for a number of years, regardless of any conditions, as this can allow you to plan for future income or growth.

“We also want management to own over 3% of the business, be profitable and have its headquarters in the UK. If you put all of that into the mix there are a lot of software companies that appear on our radar.”

Has it been harder to find opportunities in this area of the market given the Brexit backdrop?

“This year we’ve found lots of opportunities. Around 25% of the fund changes each year as companies become too big for our purposes or are acquired.

“A good example would be AB Dynamics, which tests autonomous cars. When we invested in them, they were only involved in robotics and testing vibrations in cars. Since then they’ve grown, and they now invest in advanced car simulators with Formula 1 team Williams. It’s become a fully internationalised company and we’ve had to sell it now as its worth more than £500m.

“The nature of the micro-cap universe is to ride successful companies until they reach a certain size and then re-invest in other companies – there’s always been plenty of alternatives during the life of this fund.”

Do you want to give us an example of an exciting opportunity you’ve invested in?

“I’d highlight Haynes Manuals, which publishes car, motorcycle, scooter and other specialist topics in both print and digital form. They’ve been doing this for 50 years, but the digitisation has been a big step for them.
For example, if you have a new Ford car and it has a fault you drive it to an independent garage where the mechanic will plug in certain software and find up to 50 things which could have potentially led to the error. They then have to go through those 50 things in turn to find that error.

“What Haynes has done is that it has used all of the software obtained from those garages around the UK and they now know if you have a fault on your Fiesta it usually means nine times out of 10 it is a certain part that has gone wrong. For a mechanic that is an essential tool because it means you check that part first to save lots of time. Ford don’t tell you that – it is Haynes – they’ve gone from offering a manual to be a high-end software provider which is embedded in your business.”

Do you always welcome the news that one of your underlying holdings has been acquired?

“Usually they are acquired at a premium, which is always a good start, but it does mean we have to find a new idea. The only real negative is we lose out on the long-term return of the company to our portfolio. This year we’ve seen five of our underlying business bought, which is not a surprise given the value of Sterling has made British companies attractive to foreign firms.”

How do you manage liquidity issues within a micro-cap strategy?

“The best way to manage liquidity is to be patient. We are long-term investors and the average holding in our smaller companies’ fund is 10 years. If we have to wait two months to buy or sell a holding it doesn’t really matter, and we also hold a reasonable cash allocation for additional liquidity. Small and micro-caps have been proven to outperform larger companies in the medium to long-term. Investors have to take on the liquidity constraints as part of that trade-off.

*Source: FE Analytics, total returns in sterling, 9 March 2016 to 13 December 2019

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Matt's views are his own and do not constitute financial advice.


Published on 17/12/2019