Terry Smith’s Quest shows UK micro-caps are incredible bargains, says Odyssean

A valuation tool developed by star fund manager Terry Smith shows UK ‘micro-cap’ stocks trading at their biggest discount to fair value in 20 years, according to Stuart Widdowson of Odyssean investment trust.

A valuation tool developed by star fund manager Terry Smith shows UK ‘micro-cap’ stocks trading at their biggest discount to fair value in 20 years, according to Stuart Widdowson of Odyssean (OIT ) investment trust.

Widdowson, manager of the £153m investment company which picks stocks from the pool of 700 smallest UK listed companies under £450m, said the Quest cashflow analytical approach created by the Fundsmith boss (pictured below) in the 1990s when he ran broker Collins Stewart, identified this end of the market as being unusually cheap.

Investor fears over inflation and rising interest rates had seen micro-caps fall to a 28% discount below their Quest value, in contrast to the 37% premium at which they had on average traded since 2002. This is a sharp derating from the 50% premium the sector stood at two years ago.

Widdowson, who launched Odyssean four years ago, told investors at the Frostrow investment companies conference last month that this was one of the ‘biggest discrepancies’ he’d seen ‘for a long time’.

This was particularly evident because the UK stock market as a whole was cheap with blue-chip FTSE 100 stocks 18% below their Quest value, in contrast to their 20-year average 18% premium.

Widdowson, who invests in a concentrated list of small companies he believes can take steps to unlock their intrinsic value, said this was the first time micro-caps had traded on a lower rating than FTSE ‘large caps’.

‘Pretty much every cost and size is trading below its Quest fair value and this is unusual. Where we invest, we think it’s probably one of the biggest discrepancies of Quest fair value today versus long-term history,’ Widdowson said.

‘UK small companies have never before traded on a discount on Quest fair value. Neither have they ever traded on a wider discount and lower premium than UK large equities. That indicates there’s quite a lot of value today in our market.’

Investors who think Widdowson (above) is right can take advantage of a double discount by buying shares in Odyssean. The trust has deflated to a 9% discount below net asset value (NAV), according to data from Numis Securities. Compared to its previous higher valuation, with the stock trading at a modest average premium of 1% in the past year, this makes Odyssean currently the cheapest investment company in the UK with a ‘Z-score’ of -4.3.

As regular readers of our weekly Trust Watch report know, a Z-score of -2 or below is considered to be significantly cheaper than usual. This makes Odyssean a bit of a bargain for investors happy to put their money into harder-to-trade micro-caps, although Odyssean’s ‘closed-end’ structure as an investment company does mitigate the illiquidity risk.

Despite its derating in the market turbulence, Odyssean has not suffered the steep falls of many small and micro-cap trusts. Its shares have fallen 9% this year in line with the decline in the broad FTSE Small Cap index. (The underlying net asset value has actually risen 1%, which is why the discount has opened up between the share price and NAV).

The share price fall puts it ahead of the 11% average decline in micro-cap trusts and the 24% slump in more mainstream UK smaller company trusts. Over three years it has generated a total return of 51% for shareholders, the best performance of the six London-listed micro-cap funds, beating the 17% return from the Numis Smaller Companies index and the 28% of the FTSE Small Cap benchmark. 

Widdowson, who previously ran rival Strategic Equity Capital (SEC ), tends to pick unloved industrial stocks. Top 10 holdings include chemicals business Elementis (ELM), whose shares are down 16% this year, and printing tech company Xaar (XAR), up 25%.

Technology and media companies also catch his eye with publisher and events company Euromoney (ERM) and information assurance firm NCC (NCC) also in the top 10.

 

Investment company news brought to you by Citywire Financial Publishers Limited.