Micro Caps Under The Microscope

Published in Investing on 28 November 2012

Owain Bennallack chats with Guy Feld, co-manager of the Marlborough UK Micro-Cap Growth Fund.

This is the first part of a two-part podcast transcript in which Owain Bennallack chats with Guy Feld, co-manager of the Marlborough UK Micro-Cap Growth Fund.

According to stock-market historians, you can beat the main market by a wide margin by investing in the smallest listed companies. Guy Feld, senior fund manager at Hargreave Hale, should know -- he co-manages the Marlborough UK Micro-Cap Growth Fund, where he spends his days researching, meeting with, and investing in tiny companies that are barely a blip on the typical fund manager's radar. Discover how he researches these micro-cap companies, and why he thinks this sector always presents the best opportunities for investors, in this episode of Money Talk.

You can read the second part of the transcript here.

You can listen to or download the full podcast here

Owain:

Hello, and welcome to Money Talk, the regular investing podcast from The Motley Fool. I'm Owain Bennallack, and my guest today is Guy Feld from Hargreave Hale. Guy is the co-manager of the Marlborough UK Micro-Cap Growth Fund, which he runs alongside the veteran small cap specialist, Charles Hargreave. They spend their days fishing in the shallowest end of the UK market, sorting through the tiny under-valued minnows that, who knows, could eventually grow into the behemoths of tomorrow. Good morning, Guy.

Guy:

Good morning, Owain – it's great to be here.

Owain:

Thanks very much, it's good to have you here. Now, one thing that really interests me about your fund, from my kind of cursory investigations, is that you genuinely do invest in small-cap companies. Your cut-off is a market capital of about 100 million, when you make an investment, and a good few of your investments are in fact into companies that are smaller than 50 million. So this really is true small-cap investing, isn't it?

Guy:

Yeah, we use the term micro-cap, and in terms of that remit, there are very, very few other institutional vehicles that give you exposure to the very smallest segment of the UK equity market.

Owain:

Yeah, well, that's perhaps not surprising, because in my experience, private investors seem to have given up on the UK micro-cap sector at the moment in recent years, which perhaps is not overly surprising, when you consider that even only the likes of BP or Lloyds, or RBS or the like, in recent years has been a rollercoaster. What, in two minutes or less, are they missing out on?

Guy:

A very simple, one word – it's performance. This fund started in October 2004; we've trebled it. We give you a very highly-diversified exposure to some of the most exciting and dynamic companies in the UK equity market, and as I say, it's high risk-managed, so you do have to roll with the punches, but we can absorb the punches well, and still capture the upside that these companies represent.

Owain:

Yeah, I mean we'll get on in a moment to how perhaps you manage those risks, because clearly you do to a degree that would be difficult for a private investor to manage, unless they were significantly wealthy, and had an awful lot of free time. But before we get onto that, I've dug up some numbers to, I have to say, further your case, Guy, which is an analysis of the returns of the Hoare Govett Smaller Companies Index by Elroy Dimson and Paul Marsh, who are both professors of the London Business School. These chaps compared the returns from the Smaller Companies Index (that's the Hoare Govett Smaller Companies Index), and the main market from 1955 to 2012, and they found that, if you put £1 into small caps, and you reinvested all the income, then theoretically that would have been worth £2,963 by the start of 2012, compared to just £598 from the FTSE All-Share, which is pretty amazing. But even more amazing, £1 invested in what they call the Minnow Index, which is the very smallest of the smallest companies, would have compounded to £6,671, so you've 6,671 timesed your money by the start of 2012, which, on the face of it, is more than eleven times the total return over the same period from the main market. Why are there not more micro-cap funds, Guy? That's incredible, isn't it?

Guy:

Yeah, so as I said, it's about performance. Those are very long timespans that you're referring to there, and of course you can shuffle around the statistics, and get different or less flattering performance returns, but over the long term, they definitely do outperform. It takes a lot of time and effort; we have a big team here at Hargreave Hale running this fund, and we've got six or seven people inputting into meeting the companies, gathering intelligence, coming up with ideas. It is absolutely not something that most people could do, but we believe the performance record stacks up, and as part of an overall asset allocation exercise, we feel strongly that small companies should be part, very much part of overall equity exposure.

Owain:

I guess, with something like that index, they're presumably not taking into account the liquidity constraints and the changes, and the knowledge of the sector and whatnot, as in 1955, I wouldn't have thought a great many people in the City were combing within the micro-cap market.

Guy:

Absolutely. That's why one has to take these statistics with a pinch of salt, and in fact in recent times there's evidence to suggest that the small caps have underperformed, particularly in the mid-cap. However, over the long term, you should be able to do very very well. The point is, it's by definition a very inefficient segment of the market. There are less people who even know about these stocks, who know what they do, who have access to management, who take the time to lift up the bonnet and see what's going on, and the rewards for doing that correctly are higher than anywhere else in the equity market.

Owain:

I'm sure that the underperformance that they've had recently has got to be down as much to investor disinterest in stocks in general as the sector, but there's also been the economic cycle, if you can even call it a cycle though; the cataclysm of the last few years that we've been trudging through. Presumably these sorts of smaller companies would have had limited access to bank funding and the like, even if they were trading well?

Guy:

It really does depend on the type of company. We have plenty of small companies that generate cash, they've got order books, they've got recurring sales, particularly in the technology and the software area, and they have no problems at all securing data centre companies, you know – you've seen what's happened to Telecity, and there are lots of good cash-generative companies that are very attractive bank lending propositions. Sure, there are very loss-making speculative companies, and they're going to rely on institutional shareholders, but a lot of them have loyal shareholders who are prepared to take a longer view. So it really does depend, I think, is the answer to that. The other thing to bear in mind, I think, is that this financial crisis, which was the worst obviously in living memory, had a very purging effect on small companies. A lot of them have gone by the wayside, but the ones that are left are as lean as they've ever been, and their cost bases are really tight, so they're in good shape to benefit from stabilisation and hopefully recovery.

Owain:

OK, so turning to your own fund, I see that your portfolio is very widely diversified, with some 222 companies at my last count.

Guy:

229, as of today.

Owain:

There you go – you've added seven, while I've been researching. So do you invest in that many companies to try and capture the hopefully excellent returns that, those micro-cap, small-cap, sectors have delivered over the long term? Is it for risk management reasons? Or is it an acceptance that, with these sort of little companies, blasting them with a shotgun and seeing what you hit, it's got to be part of making sure you kind of hit some of the big ones, or the future big ones.

Guy:

So there are two key points here: it's about managing the downside, but also capturing the upside. So to go to the first point, it's about the best-laid schemes of mice and men – you can do all the work in the world, you can still get it wrong, and things come from the left field. There are so many variables – markets change, etcetera. In 2006, you may recall that the US government banned a whole industry, the internet gaming and bookmaking industry, and you saw the devastating impact, and a whole sector there, as an example of that. Our view is, we want to be able to roll the punches better than other people, that's why we cap our earnings at 2%. If that does happen, we're not going to be there with 5, 7, 10% of the company, and really suffer. That's extremely important to us, but also bearing in mind the illiquidity of these stocks, which exacerbates that impact. But on the plus side, on the positive side, we also want to be able to take advantage of anything really exciting that comes along. There was an IPO of a small company called WANdisco (LSE: WAND) recently, which has doubled very quickly. We want to have powder dry, and rules that accommodate to take advantage of very good new situations, which come along all the time.

Owain:

So, in the case of that IPO, that was a matter of, because you have such wide diversification, you always have the ability to add another new holding.

Guy:

I think the problem for some people are rules. If they're extremely rigid and ossified, that can be tying your hands behind your back, and you can miss out. We like something, and opportunities come along at very short notice. We want the flexibility to be able to take advantage of those situations.

Owain:

So if you were a kind of scurrilous journalist like I am, and you were writing an article about small caps, you'd almost certainly say something along the lines of, here's the chance to buy the new Microsoft or the new Glaxo, or the whatnot, when it's small. By capping exposure, do you not curb your potential performance? If you cap it at 2%, don't you miss out if the company really delivers some growth?

Guy:

So we've got examples of companies that we've averaged up, and averaged up over time, and made a lot of money out of. Obviously the fund's grown, so 2% becomes a bigger number doesn't it? Yeah, if the next guy takes a huge 5, 10 position in Apple, he looks like a genius, but it's important never to forget the bombs that do go off, and if you look at our performance on a risk-adjusted basis, looking at volatility, we come out probably better than anyone else, for the reasons I've just mentioned.

Owain:

OK, well some private investors argue perhaps, because they'd like to believe it's true, that smaller companies are easier to understand than large companies, because there are less moving parts. Do you agree with that?

Guy:

So, yes and no; again, it does depend. So Prezzo is a lovely little restaurant company – what's that all about? It's about the rents and the property; it's about the tomatoes and the onions and what they cost, and it's about the staff costs.

Owain:

About the research to place the product, I would have thought?

Guy:

Not my stock actually, it's one of my colleagues, but I mentioned this company, WANdisco. If I start talking about active database replication, DConE software version control, and revolutionising data management outstored, you'd probably glaze over at the eyeballs, wouldn't you?

Owain:

You're actually not reading that – it came straight off the top of your head! I've got a computer science degree and I didn't understand a word of that.

Guy:

Yeah, the tech sector's actually one of my special bents. But no, in terms of the amount of work required to analyse a company, if you look at AB Foods, obviously you've got many more divisions. You've got a spreadsheet with many more pages in it, but actually most of the businesses are not that difficult to understand. But to say there's a lack of complexity in the small cap world would be somewhat misleading, I think.

Owain:

A ridiculous generalisation, if it comes to WANdisco, by the sounds of it. OK, well, say that I wanted to start looking for exciting companies the Guy Feld way – how would I begin? Obviously, I could invest in your fund, but if I was going to sally forth myself, would I, would you typically start with the shares screen, or are you watching the news announcements and just generally what's happening in the sector?

Guy:

So, I'm very much against rigid philosophies and systems, and I think that all systems break down, and I see myself as a pragmatist; I see myself as flexible. I can draw ideas from all sorts of sources. I try and keep my eyes and ears open all the time. I might do a value screen on a PEG particularly, I'm quite fond of those, or PE. I might pick up on directors' purchases – that's led to one or two very good ideas. Also I like to look at themes, I suppose I'm interested in technology. We've made a lot of money out of things like mobile data, and other phenomena, that are just coming to the fore, and create a wave that small caps can ride on. Looking every day at lots and lots of RNSs, there may be an event trigger which can change potentially sentiment towards a stock. That's how we got into Tracsis actually, they had a very good trading statement. And management change, interesting; a big contract win, interesting; M & A, interesting; and to top it all, I spend a lot of time talking to CEOs, CFOs, brokers, analysts, going to industry conferences and networking, as you get older and wiser, that network builds up, and you get a multiplier effect, so it all comes from all those sources.

Owain:

So I mean that's obviously a huge universe of potential investments. You sound a bit like Gwyneth Platrow, going into my local pub – will anyone kind of come and have a word? – maybe they will. So with all those candidates, what would be the ideal micro-cap share? When would your eyes really light up?

Guy:

So I can give you some traits of really attractive micro-caps. I've discussed this with Giles, and we had a good think about them. He makes a very good point – a truly ideal micro-cap is the one that generates cash quickly. It bootstraps itself quickly from internal cashflow, can fund its own growth from internal cash generation. They're very rare, very, very rare, and I think RM, if you're familiar with the educational IT company, in its early days, is one of the few companies that actually was able to do that.

Owain:

Because quite often they just keep issuing new shares, don't they? – and you just get diluted away.

Guy:

Yeah, particularly the more speculative, loss-making, jam tomorrow stories – they often come back cap-in-hand, when thing move to the right. When I say, move to the right, and contracts don't come, customers don't come, etcetera, etcetera. Other companies, particularly in IT services, can start generating cash very, very nicely, very quickly. Tikit has been a super experience for us, that specialises in IT services for the law firms, a very nice cash-generative company that's just been acquired by BT, or going to be acquired by BT. Other attractive features, if I may carry on – so IP, intellectual property, really good intellectual property is extremely valuable. A company called Lo-Q (LSE: LOQ), which I hold personally, is a virtual human management software company. The guy who founded it spent two hours queuing up at a rollercoaster in the States, and what happened when he got to the front of the queue – it broke down. He went back to his garage, and built some software.

Owain:

Oh, I didn't know that.

Guy:

This is a very, very interesting company, because there are a lot of people out there who will pay a premium not to have to queue, or do something else with their time, like feed the kids, or go to another ride.

Owain:

For people who don't know, this is the thing where you can effectively take a place in a queue without being in the queue?

Guy:

In a virtual queue, yes, so you're paying your $20 or $30 bucks, or whatever it is, and you're going away, you're going to a less popular ride, or you're going to the restaurant, and it'll vibrate, and you'll come back. Anyway, there's a lot they can do with that IP, and they've got some valuable patterns there. That's a good example of that one. Poorly understood mispriced situations – private investors, they can get into a terrible funk, and they can throw things out of the window into the gutter willy-nilly. They haven't got the psychological strength to bear the pain often, and to look through to the medium to long term. There's a company called Corac, again which I own, is a revolutionary air compressor technology company; new management there, who's much more commercial, and it looks like they're at a very interesting potential long-term inflexion point, but that was thrown into the gutter for a long time, and that's one I'm quite interested in. Again, companies giving you proxy for fast-growing and niche markets; Smart Metering Systems, my colleagues follow. This whole area of smart metering is very much a five, ten year growth story. They've done exceptionally well. We like companies with very highly-motivated management teams, with good ownership of the company. CML Microsystems I'm going to talk about, and Sagentia, are examples of that. The other thing is, following the man, or in this case, the woman, the people we know and trust who've made us a lot of money. They earn a lot of respect, and loyalty. Vin Murria of Advanced Computer Software (LSE: ASW), they supply financial accounting systems and healthcare systems. Vin's made us more than three times our money currently with Advanced Computer; prior to that, trebled our money with the Computer Software Group. So when she comes through the door, we listen carefully. And finally, I do look at the charts a bit – I know some of your followers look at the charts. Looking at breakouts on volume can be very lucrative as well.

Owain:

That's quite a list, Guy. I have to say, you sound a bit like some of my single female friends.

Guy:

I'll take that as an insult, right!

Owain:

Just in terms of, they want the house, the car – they don't seem to want them to already be family men, but I'm sure obviously it's quite a strong filter. I mean, it seems an underwhelming question, but given that you're looking for all of that, how important does management come into that? You've mentioned that a track record, particularly if they've made money for you, which is understandable, you do like. How important is meeting management to your approach?

Guy:

With small companies, it's especially important. They're not always going to pay for the best management, and the quality is extremely mixed, to put it mildly. The worst-case scenario are the crooks, obviously. You have to see the whites of their eyes, but it's like interviewing someone for a job, it's not an exact science, and you get it wrong. But it's extremely important, and we've got a lot of experience at Hargreave Hale, and a lot of people have been around the block, and they remember bad pennies turning up again, all of this – this is what we do for a living, so that's quite helpful. Body language in meetings – very important. Some CEOs are exceptionally ebullient, you know they're on a real high; others, shifty, no eye contact, evasive answers to questions – it's all very straightforward. That's often quite important and reliable. The other thing I do is keep extensive notes. I spend a lot of my time writing up meeting notes, very very important. What did this guy say last time, when I saw him six months ago? What's happened to the story? Has it changed? Why has it changed? He said he was going to deliver – he didn't deliver. So this is what's going on, this is very important.

Owain:

Just as an aside, I often think private investors over-estimate the value of meeting management, but they're only meeting usually a small number of managers, so then they can be bowled over by them; whereas if you're meeting a lot, you're not going to be like, someone on a blind date who's got her first tick in the box. I don't know why I'm doing all these dating metaphors!

Guy:

It's more than that. We're getting a good hour with these guys. If I want to go and see them, 99% of them will let you go, and I spent half a day in Derby with Tracsis. You learn a lot from that, and you just get much more access as professionals, and that's what you're paying for.

That was the first part of a two-part podcast transcript in which Owain Bennallack chats with Guy Feld, co-manager of the Marlborough UK Micro-Cap Growth Fund.

In the second part of the transcript, Guy discusses some of his specific holdings. Just click here to continue reading.

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