Bargain hunting with micro cap trusts

If small can be beautiful, maybe really small is even more stunning. New research from Kepler Trust Intelligence makes the case for micro cap stocks – shares in the smallest companies with a listing on a public market – and the investment trusts that offer exposure to them. It makes interesting reading in the context of the relatively low valuations on which UK smaller companies now trade.

The big picture is that long-term data supports the idea that small acorns can grow into mighty oaks. Going back to 1955, global stock markets have delivered average annual returns of 6.3% a year, with the UK market offering 6.5%. UK smaller companies have been much stronger, delivering 9%. But UK micro cap stocks have done even better, producing annualised returns of 10.5% over that period.

These really are very small companies, at least when they’re starting out. The average company in the MSCI UK Micro Cap Index is currently worth around £100 million. By contrast, the average business in MSCI’s UK Small Cap Index is capitalised at £1.4 billion. Investment trusts investing in micro caps will typically consider businesses worth as little as £20 million.

That partly explains the superior long-term performance that has – in the past at least – been on offer. Some of these enterprises will inevitably fail, but those that succeed are starting from a low base, offering investors the opportunity to get in very early. Rapid growth can generate significant returns; there’s also the potential for a business to be taken over, often at a premium to its market value.

Another reason to get excited about micro caps is that this is one area of the stock market where it is still possible to unearth a diamond in the rough. Large teams of analysts now follow every move made by bigger businesses, and as a result, these companies rarely surprise, for good or for bad. By contrast, far fewer analysts keep an eye on the 600 or so micro caps on the UK market; Kepler’s research says many have no analyst coverage at all, while others might be followed by one or two. This makes for fertile hunting ground for those on the look out for opportunities that other investors haven’t uncovered yet.

Moreover, there’s plenty of choice. That universe of 600 micro cap stocks in the UK is a large one. It’s spread across multiple sectors of the market – and while many of these businesses are largely domestically focused, others do much of their business in overseas markets.

There’s one other reason to consider micro caps right now – these businesses currently look cheap by comparison to how they’ve been priced in the past. As Kepler reports, the MSCI UK Small Cap Index currently trades at the lowest forward price-to-earnings ratio of all its global small cap peers and is nearly a third cheaper than its US equivalent.

It's always hard to know when the market will turn – maybe these businesses will get even cheaper before they bounce back. But in the meantime, this creates potential for M&A activity, as buyers, including international acquirors, take advantage of depressed valuations. Indeed, data from Peel Hunt shows 5% of UK public companies were in offer periods in 2024, more than in any year since 2019. And where deals did go through, the buyer paid an average premium of 36% over the share price.

It’s possible to go searching for micro caps yourself. But many investors will prefer the comfort of a fund run by a professional manager with experience in this area of the market. This way, you’ll get diversification and risk management, as well as benefitting from hands-on investment expertise; micro cap fund managers tend to be highly engaged with the businesses in their portfolio.

An investment trust structure, moreover, has particular advantages. Very small companies are often illiquid, which poses challenges for managers running open-ended funds. Investment trusts don’t have to cope with that. Plus they can take on gearing to supercharge returns, though this adds to risk too.

There is only one specialist micro-cap investment trust, River UK Micro Cap, though other funds in the UK Smaller Companies sector, such as Rockwood Strategic, also have exposure to the bottom end of the market.