When we conceived the Liontrust UK Micro Cap Fund five years ago, the aim was to construct a vehicle which allowed investors to capture the early stages of a company’s growth on the stockmarket. At its heart, it is about providing capital to some of the UK’s best and brightest entrepreneurs, participating in their success to drive returns for the Fund’s investors. These early days can see explosive growth, but are not without their risks, which we seek to mitigate by using the Economic Advantage investment process – key elements of which have been applied to the team’s funds since 1998.
The micro cap end of the market has other desirable characteristics, one being that it is a relatively uncrowded playing field. The number of professional investors who concentrate their efforts on combing the smallest businesses on the market for the success stories of tomorrow are few. It is therefore possible to make strong returns from companies at this early, fast-growth stage of their evolution before they get big enough for others even to consider investing, and then benefit from increasing demand for their shares when others do start to take notice.
The Liontrust UK Micro Cap Fund only considers companies with market capitalisations of under £175 million for initial investment and will look to gradually exit holdings when they exceed £275 million, a level at which they appear on the radar of many more investors. This capital can then be recycled into new, smaller ideas and hopefully the process will repeat itself. As a result, most of the Fund’s successful stock picks will naturally outgrow the micro cap space (with many of them ‘graduating’ to other funds in the Economic Advantage range which have higher market cap boundaries).
Over the five years since launch, a total of 43 stocks have exited the portfolio. The reasons for exit include exceeding the Fund’s upper market cap threshold of £275 million (14 stocks) and companies being taken over (12 stocks), as well as other triggers of our sell discipline (most commonly, if the equity ownership of senior management and board directors falls below our 3% limit).
Those stocks that exceed the Fund’s market cap range often do so through a combination of earnings growth (as companies successfully deliver on their growth plans) and a rise in the valuation ratios at which their shares trade. The latter can reflect increased investor confidence regarding a company’s prospects as it builds a track record of delivering growth; it can also result from the simple laws of supply and demand as a larger pool of investors take an interest as the company grows into their target size range.
The chart below shows how earnings growth and an expansion in the price-earnings ratio (P/E) have combined to drive very strong returns for the 14 stocks to outgrow the Liontrust UK Micro Cap Fund so far. We see no reason why the Fund should not continue to be able to exploit the structurally lower valuations of the smallest companies on the market as its prime hunting ground for new ideas. Returns should be boosted by holding on to these businesses as they grow up and grow into the higher ratings enjoyed by their larger listed counterparts.
These success stories graduating from the Fund necessitate a strong pipeline of attractive micro cap investment ideas to take their place in the portfolio. On this, there is good news. There are more than 1,200 companies capitalised at under £250 million (a close proxy for our universe) on either London’s Main Market or AIM (Alternative Investment Market).
We monitor this universe closely, looking for companies that might meet our investment criteria. In addition, lots of new companies join the market every year. Since the start of 2020 – a tough period to be seeking a stockmarket listing – more than 70 new stocks with a market cap of up to £175 million have joined the Main Market and AIM.
Below we highlight five stocks that have outgrown the Fund and five current holdings that we think could follow in their footsteps, plus a company that had left the Fund and has now returned:
dotdigital & Attraqt
dotdigital was sold from the Fund after more than doubling its earnings during its four-year holding period. The company’s core software product enables omnichannel digital marketing. This allows clients to build, launch and manage customer engagement campaigns quickly and efficiently and to monitor vast amounts of useful data in terms of how people are engaging with the campaign.
While dotdigital’s products help to drive customer traffic to websites, current Fund holding Attraqt helps ensure the right information is displayed when they get there. Attraqt is a provider of site search, visual merchandising and personalised product recommendation software to internet retailers such as ASOS and JD. The company possesses all three of the primary intangible strengths the Economic Advantage process seeks to identify: intellectual property, strong distribution networks and high (>70%) recurring revenues.
Focusrite & Gear4Music
Focusrite is an audio products group that develops hardware and software for the high-quality production of recorded and live sound. In recent years it has expanded its global footprint, now deriving 39% of revenues from the US, 43% from Europe, the Middle East & Africa and 18% from the rest of the world. Its 2020 revenues rose more than 50% to £130 million. The shares delivered a return of almost 200% for the Fund, driven by both ratings expansion and profits growth.
Gear4Music is the largest retailer of musical instruments and music equipment in the UK (with around an 8% market share) and has a strong presence in 19 European markets via bespoke e-commerce platforms. We think it could replicate Focusrite’s success and in time grow market share in Europe to rival the UK. In our view, the intellectual property that underpins Gear4Music’s online platforms and its well-developed distribution network give the company significant barriers to entry and pricing power.
Ideagen & Sopheon
Ideagen, a software supplier to highly regulated industries and which has now graduated from the Fund, specialises in integrated risk management covering governance and compliance. The company’s software plays a crucial role in their blue-chip customers’ operations, and therefore develops an inherent ‘stickiness’ that helps each new customer drive organic growth.
Sopheon also provides software solutions to large customers, helping manage the process of innovation and new product development within organisations. Return on investment for Sopheon’s customers is quick and high, thanks to a reduced time-to-market for new products and services, an improved success rate of new product development, and a reduction in costs associated with research & development projects. Sopheon counts an impressive number of blue-chip companies as customers, including Pepsi, P&G and Philips. The Fund holds the stock on the basis of its intellectual property and an embedded distribution strength. We are also hopeful that the company can follow in Ideagen’s footsteps in increasing its proportion of recurring revenues as customers adopt software-as-a-service tool. Companies which have successfully trodden this path to higher-quality recurring revenue streams have often unlocked significant further ratings expansion.
Learning Technologies Group & Mind Gym
Both companies operate in the human capital management market. Learning Technologies, which specialises in providing content and software for the fast-growing e-learning space, saw its shares rise by more than 80% before the Fund sold its position. We think Mind Gym also has the potential to deliver strong returns as it capitalises on the digital opportunity.
Mind Gym is a corporate training business which applies the principles of behavioural science to effect change within the corporate environment. It possesses strong intellectual property within a suite of bite-sized tutorials or “workouts” it has created, and it is able to deliver them via a global network of coaches, historically predominantly through classroom-based training. Although the Covid-19 crisis had a significant impact on the business as clients cancelled face-to-face training, the company had a very strong balance sheet and has used the disruption of the pandemic to accelerate investment in its virtual and digital training proposition, better positioning it for a more digital future.
Mortgage Advice Bureau & Belvoir Lettings
Mortgage Advice Bureau is one of the UK’s largest mortgage broker networks, operating a quasi-franchise model. The Fund benefited from share price growth of over 140% before the holding was sold due to exceeding the market cap limit.
Belvoir Lettings has also built up a strong distribution network via franchising and is now the UK’s largest franchised lettings agency with almost 400 businesses across five brands. A key part of its expansion into offering financial services alongside its lettings and sales was the acquisition of Mortgage Advice Bureau’s largest franchise.
Quixant & Quixant!
We occasionally see perfectly good prospective investments enter our micro cap universe after moving the wrong way – falling down through the £175 million boundary. This has happened with one of the Fund’s former success stories, Quixant – which supplies embedded computer platforms into the heavily-regulated casino gaming machine market. We originally sold shares in Quixant after they more than doubled from initial investment, sending them well above our maximum market cap.
However, thanks to a series of profit warnings triggered by a slowdown in sales at one of the company’s largest customers, the shares tumbled back into our range. In the belief that the company still possesses Economic Advantage through its intellectual property and distribution network, with long-term prospects still intact, we added the position back into the Fund. This has proven to be a poor short-term decision, thanks to the heavy toll taken by the Covid-19 crisis on Quixant’s largest end-market. However, we are encouraged by the company strengthening its relationships with key customers through a very challenging time, and exploring new ways to increase its footprint within those end customers when demand returns. We are optimistic that the company can again deliver attractive returns from current levels as lockdowns ease and the economy normalises.
Key Risks
