Opportunities among the micro-cap stocks

Micro-caps are often underestimated and misunderstood. Some define all micro-cap stocks as being risky or too volatile to warrant consideration, even within a balanced portfolio. In our view this is unfair. There are many good quality micro and small-cap listed companies with a robust strategy and business platform, good financial performance, and the right people in place to ensure the business is well placed for sustained growth.

What's the benefit to investors of considering a micro cap fund in a balanced portfolio? The opportunity to back fast-growing, niche firms which are innovators and disruptors in their sector is rarely available as investors move up the capitalisation spectrum.

Additionally, smaller listed companies can thrive in uncertainty as they can be more agile than their larger peers allowing them to better react to trends and opportunities, and potentially benefit from any upsides and avoid significant risks.

Another positive for investors considering the smaller companies sector is that the IPO market in London has been strong in this segment for the past 24 months, largely due to a combination of attractive valuations and investor appetite for new opportunities. Demand for companies offering growth or an attractive dividend yield remains strong.

Investors can benefit from this opportunity to back companies when they are relatively less well known and understood by the wider market and have more of their growth and value potential ahead of them.

However, micro-cap investing has the reputation of being of higher risk for several reasons. One is that they are relatively under-researched when compared to companies further up the capitalisation spectrum. While this is a risk for investors, it could also be seen as an opportunity as small and micro-cap stocks can draw less attention and often include undervalued, smaller companies waiting for the right catalyst to propel them forward.

When speaking to fund managers investing in micro-caps it is important that investors determine how the underlying companies are researched and how the fund managers look to fully understand these businesses through their own robust processes around stock selection, analysis and research. This is particularly important with the introduction of the MiFID II Directive in January which is likely to result in reduced coverage of smaller listed companies as asset managers source significantly less research from banks and brokers.

Another perceived risk for smaller companies is liquidity. Whilst on average smaller companies are less liquid than larger ones it is often available to those with the right skills, relationships and knowledge to find it. Choosing a manager who understands liquidity in the micro and small cap market place can therefore be a critical factor to help drive long term returns.

Additionally, it is important when considering micro-cap stocks that investors back businesses that are not dependent on momentum tailwinds or are overly subject to threats from macro events. One way to mitigate downside risk is to avoid momentum themes and instead focus on companies operating in niche areas of the economy that are relatively resilient to wider economic events.

Many of these high-quality companies are still growing and operate in less cyclical areas where management teams are more in control of their destiny, and are less concerned by the impact on their firm of potential macro-economic headwinds. Examples of companies like this are:

Arena Event Group, a specialist provider of infrastructure and services to Tier 1 global sporting and leisure events such as Wimbledon or The Open.

Xafinity, an actuarial consultancy providing advice to the trustees of defined benefit pension schemes that have an ongoing multi-decade obligation to their members to account for and manage their scheme effectively.

This contrasts with resources companies or banks which are heavily dependent on macro economic factors outside the control of their management.

Regardless of your definition of risk, it doesn't have to be a four-letter word. There are opportunities to achieve high risk-adjusted returns with relatively low volatility, by investing with specialist smaller company fund managers or in multi-cap funds. So while "low risk" might not be a term often associated with the world of micro-caps, it's a world of opportunity if one knows how to successfully navigate the risks.

Ken Wotton is fund manager at Livingbridge Equity Funds.