Small-cap investing, particularly in the UK, demands active management. It is not an area of the stock market whose returns are captured by passive trackers.
For the value investor with a medium-term view, the lower end of the stock market represents a rich hunting ground for “hidden gem” or “fallen angel” companies, which can often benefit from management, strategic or operational initiatives to unlock, grow or realise shareholder value.
To see how this works in practice, we can examine the characteristics of private equity investing that can be applied to this end of the market.
Well-researched investments
In public market strategies, many open-ended investment companies adopt a highly diversified approach, desiring a low volatility of returns profile, usually in relation to an index benchmark and enhancing their overall portfolio liquidity through smaller position sizes.
To adopt a PE mindset, a concentrated portfolio of the very best potential investments is needed that focuses on the valuation and liquidity options at the end of the targeted investment period, not the day-to-day variation. Five to 10 materially engaged investments is practicable.
Portfolio concentration allows significant positions in a small selection of compelling companies, naturally providing considerably more time for the investor to spend on each holding, both before purchase and afterwards.
Higher levels of understanding, engagement and due diligence that result from this focus tend to de-risk the investment. In contrast, more diversified portfolios lack the time required to sustainably and effectively engage with all their companies or lead change.
Full operational oversight and influence
In public markets, a single investor is unable to exceed 29.9 per cent of the issued share capital, otherwise a takeover bid must be made. Full control, as achieved in PE, is not possible. The next best thing is considerable influence over a company. This is achieved through a significant holding that allows powerful voting and shareholder rights.
The minimum needs to be 5 per cent, which allows an extraordinary meeting to be called of all shareholders. However, influence can also be achieved through appointments to the board in a non-executive capacity and through the successful proposal of candidates into key positions. These require the support of the majority of shareholders and this influence can be enhanced if other shareholders agree with the initiatives.
Companies are often aware that change is needed, but prevaricate, lack the pace or skillset necessary, or are resistant to change. Many shareholders tend to want change but do not have the time, expertise or influence to lead it, and thus a significant shareholder can act as the catalyst.
If management change is needed, appropriate incentive arrangements will need to be adopted to align the new team effectively with shareholders. Public market investors need to evolve their thinking so that these incentives can effectively compete with PE packages, otherwise genuine talent will migrate.
