Investors in small-cap funds that are well under their capacity should not assume they are immune to liquidity risk, as this has the potential to cause volatility spikes for every stock in this area of the market.
This is according to George Ensor, manager of the River & Mercantile UK Micro Cap investment trust.
The winding up of the Woodford Equity Income fund is an extreme example of what can happen when fund managers invest in small and illiquid companies without regard for liquidity.
To prevent this type of issue arising in the River & Mercantile UK Micro Cap trust, which invests in companies in the £25m to £50m bracket, it returns capital to shareholders once it rises to between £110m and £125m in size.
Yet Ensor warned this doesn’t make it immune to liquidity risks.
“From time to time, smaller companies underperform because the market gets concerned about downside risks and liquidity,” he said.
“Essentially, our returns come from small- and mid-cap portfolio managers looking at some of the stocks that fall a little bit below their universe and saying, ‘that looks like a really attractive growth business, I'm going to put a position in that in my fund’.
“We see those stocks re-rate on the back of that process, but it can work in reverse when those mid-cap portfolio managers move back up the market scale.”
The pay-off is the higher returns available from small caps: they tend to outperform their larger counterparts by 3 to 5 percentage points per annum over the long term, while micro caps add another 2 percentage points on top of that.
This is one of the reasons why Ensor believes his trust can continue to do well, even after its spectacular performance over the past 18 months.
The trust has made 81.07 per cent since the start of last year, after falling by close to 50 per cent in the crash of February and March 2020 as its discount shot out to more than 30 per cent.
Performance of trust vs sector since start of 2020
Source: FE Analytics
Ensor said that although the small-cap sector sold off along with everything else last spring, he was fortunate to have little exposure to the hardest-hit sectors such as airlines, cruise liners and real estate. He noted these are all capital-intensive businesses, meaning they tend to have assets worth a lot more than the total value of the companies he targets.
In addition, he entered the crisis with a significant cash position, which allowed him to take advantage of depressed valuations.
“There were some really interesting opportunities,” he said. “We don't typically look for recovery businesses that have fallen down into the micro-cap market, but there are times in the cycle when that's very interesting.
“We deployed quite a bit of capital into more cyclical and consumer businesses and that played out very nicely for us. I started buying in in March, but that cyclical risk-on market really started to play out from September-time.”
The manager noted it is not unusual for small caps to do well in the early stages of the market cycle: data from FE Analytics shows the IT UK Smaller Companies sector made 58.29 per cent in 2009 and 33 per cent in 2010.
In addition, he said the valuations of small caps were “extremely attractive” compared with the large caps going into the crash, and although they have moved back towards average levels following three or four months of outperformance, he pointed out they had underperformed for two and a half years before the start of 2020.
And while UK small caps have closed the gap with their larger counterparts, they still look attractive in a global context.
“One of the messages we're certainly getting across to clients at the moment is that while UK equities have rallied, they are relatively cheap versus the rest of world,” Ensor continued.
“If you look at them on a composite of price to book, price to earnings and dividend yield, they are exceptionally cheap.
“That should drive flows into UK equities, and if we've got flows into UK equities, then those flows should trickle down into small caps.”
Source: River & Mercantile/MSCI
It is not all positive, however. Ensor has taken profits from many of his recovery plays, adding that there are many areas of the market where a return to normal is priced in, even though they are surrounded by uncertainty, such as travel and leisure.
On the whole though, he is positive and believes the way many small caps reacted to the coronavirus crisis could be summed up as ‘what doesn’t kill you makes you stronger’.
“I don't think many sell-side analysts have gone through a cycle where you get demand coming back online as quickly as we've seen it come back,” he added.
“And these companies have spent the last 15 months reducing costs.
“For me, the interesting ones are those businesses that have improved their profitability through the crisis. We've seen small caps investing in technology that enables them to reduce headcount. I don't think that’s always in the price.
“One of the things that has certainly struck us is that a lot of companies are going to come out of this crisis with higher margins than they had before.”
Data from FE Analytics shows River & Mercantile UK Micro Cap has made 201.48 per cent since launch in December 2014, compared with gains of 132.51 per cent from the IT UK Smaller Companies sector.
Performance of trust vs sector since launch
Source: FE Analytics
The trust is on a discount of 4.58 per cent compared with 15.5 and 14.75 per cent from its one- and three-year averages.
It has ongoing charges of 1.35 per cent and is not geared.