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Where to find value in micro-caps

Micro cap stocks can offer exciting medium to long term growth potential for investors who take the time to identify the fundamental value that the best smaller listed companies certainly can offer.

Many of these businesses have the potential to more than double their profits within three to five years due to their niche positioning, addressable market opportunity, and ability to be agile relative to larger competitors. Since this is an area of the market that is under-researched and often misunderstood, there is also an opportunity for investors to benefit from re-ratings, as the rest of the market begins to recognise the valuation story as the businesses grow.

However, picking out such winners requires patience, hard work and a commitment to invest in the resources necessary to properly research such a diverse group of businesses. As an investor that utilises an experienced team of 50 to support this research, we know that there are no short cuts, but there are certain qualities to look for when it comes to assessing prospective investments:

 

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  • Quality of management. The strength of the business’s management team will likely be the most important factor in its future success, so this should be the priority area for would be investors in any micro cap company. It’s not just the strategic vision of the company’s management that’s important, vital though this is, but also its understanding of how to operationalise that vision in practice; managers must be able to execute on their strategy.
  • Market opportunity. This is all about the size of the addressable market that the business has the potential to target. The better investors’ understanding of the true scale of this market at a granular level, the better they will be able to value its potential. But it is also important to identify key growth drivers – how achieving greater share of this market is possible in practice.
  • Understanding of the value proposition. Investors need to be convinced that the business’s management has a crystal clear understanding of why customers are buying from them and how they might be persuaded to buy more in the future, or of course, how new customers will be brought onboard. We believe this requires in depth understanding through research of the business’s customers and target markets as well as its leadership team.

 

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  • A clear and simple strategy. A management team that cannot articulate an easily understandable strategy for its business is unlikely to be able to execute it and deliver the growth promised. We always consider whether the management team can demonstrate how the business strategy is deployed in day to day operational decisions that deliver its objectives and importantly how these can help create value over the longer term.
  • Strong financials. The strength of the business’s balance sheet, revenue model and cost structure will inevitably impact on its ability to deliver sustainable growth over the medium to longer term. Evaluating quality of earnings today is a valuable indicator of whether the business model is capable of delivering sustainable profitable growth.
  • Valuation upside. Ideally, investors are also looking for businesses where there is scope to secure returns from a re-rating as well as growth. Often micro caps can be found to trade on a valuation discount to the wider market because they are less well understood or not as thoroughly researched. Spotting these opportunities early is key to unlocking this additional value potential.

These criteria not only provide investors in micro cap stocks with an opportunity to identify the best business, but they also help to mitigate risk. This is especially important in an area of the market that is very often associated with elevated levels of volatility. By systematically applying these screens to potential investments, it is possible to exclude higher risk businesses from the portfolio and reduce overall volatility.

If the process sounds simple in theory, the practice is anything but. Successful investment in micro cap stocks requires a great deal of groundwork; and with little external research available on many of these businesses, that work falls to investors themselves.

 

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For this reason, we believe that good micro cap investors are able to draw on a broader and deeper team of specialists. At Livingbridge our ability to call upon expertise spanning both private and public businesses, provides us with experience and a deep understanding of particular sectors or industries. Without this knowledge and resource sitting behind the fund manager, we feel it isn’t possible to do the groundwork required to build conviction across the universe of potential investee businesses.

The upside of this conundrum is that the micro cap sector is also the area where the greatest untapped value is to be found. We believe it’s where there is the greatest chance of finding a rough diamond that other investors have yet to come across. While those who don’t put in the work are likely to get found out, we believe that the opportunities for investors able to commit to micro caps are genuinely exciting.

 

This article was originally published by What Investment, 22nd March 2018.

If you’d like to find out more about the LF Livingbridge UK Micro Cap please contact investments@livingbridge.com.