Liontrust UK Micro Cap Fund

The Liontrust UK Micro Cap Fund returned -6.3%* in January. The FTSE Small Cap (excluding investment trusts) Index and the FTSE AIM All-Share Index comparator benchmarks returned -3.4% and -9.9% respectively. The average return of funds in the IA UK Smaller Companies sector, also a comparator benchmark, was -7.7%.

Concerns over inflationary pressures and the monetary policy response were a feature of 2021, but central banks were largely happy to take a wait-and-see approach. In January, statements from the US Federal Reserve delivered a strong message that quantitative easing would finish in March, with US interest rates also likely to be raised in the same month and continue to be hiked through 2022 at a faster rate than had been anticipated.

As well as driving up bond yields (US and UK two-year government bond yields both rose around 30bps to 1.1% and 1.0% respectively), the prospect of higher interest rates prompted a sharp equity market rotation away from ‘growth’ stocks – which suffer from higher discount rates applied to their future forecast earnings – and towards ‘value’ stocks, which, by contrast, are viewed as short-duration assets less affected by discount rates.

The rotation shows up dramatically in MSCI index data: the UK value series outperformed its growth equivalent by 12 percentage points in January alone.

The Economic Advantage investment process applied to this Fund is a bottom-up, stock-picking process. We do not set out to achieve any style bias outcomes within the Fund. But because the process seeks out dependable, consistent businesses with barriers to competition, high financial returns and strong balance sheets, there is an observable style footprint that emerges: a tilt towards ‘quality’. The investment process doesn’t actively target companies with high forecast EPS (earnings per share) growth, but this often goes hand-in-hand with the characteristics it does seek, such as high cash flow return on capital; this is particularly true when the process is applied to smaller companies, as it is in this Fund.

In a stark risk-off environment, there was also a size bias to equity market returns; while the FTSE 100 index made a positive 1.1% return, the mid-cap FTSE 250 lost 6.5% and the FTSE Small Cap (excluding investment trusts) returned -3.4%. The FTSE AIM All Share Index fared even worse, losing 10%. Nearly 90% of the Fund is invested in AIM stocks, leaving it exposed to the heavy sell-off.

Over the years, the Fund’s style profile has been a tailwind to performance but in January it represented a sizeable headwind to absolute returns, as investor sentiment shifted away from high forecast growth and small caps. However, in relative terms, the Fund found itself outperforming its IA sector peer group and the FTSE AIM All-Share comparator benchmark. The magnitude of the market rotation was amplified at the larger end of the small cap market, providing some relative insulation for the Fund, which focuses on the smallest companies (or “micro caps”) listed on the marketOver the years, the Fund’s style profile has been a tailwind to performance but in January it represented a sizeable headwind as investor sentiment shifted away from high forecast growth and small caps.

Many of the share price falls were unconnected to company newsflow. Solid State (-21%) lost a fifth of its value despite its only January investor update being details of a new order. Eckoh (-19%) and Inspiration Healthcare (-18%) fell a similar amount even though they issued no updates of note.

Microlise Group (-28%) included a note of caution in its outlook comments.  A trading update referred to 2021 revenue and earnings which were in line with market expectations but said that supply chain challenges were likely to last longer into 2022 than many anticipate.

Cake Box Holdings (-36%) also gave investors some cause for concern. The company confirmed some accounting discrepancies between its 2021 full year results and subsequent annual report, having suffered a heavy share price fall on the back of commentary from a retail investor blog. It clarified that there was no impact on 2021’s profits or balance sheet and stated that trading in recent weeks has continued to be strong and in line with expectations, and that the auditors had given the accounts a clean audit opinion.

In our experience, January often sees an automatic reversal of the trends that worked well the previous year. On this occasion, it’s very hard to predict whether these headwinds will persist or ease. Our investment process explicitly excludes any form of macroeconomic forecasting in favour of pursuing the bottom-up approach that has served us so well over the years.

While the equity market narrative around rising inflation and interest rates currently centres on the value versus growth debate, it may well develop to incorporate more nuanced factors, such as which companies possess the pricing power to maintain margins within an inflationary environment. One of the fundamental characteristics we look for in companies we invest in is a durable competitive advantage which confers a high degree of pricing power. A company with true pricing power can pass on some or all cost inflation rather than having to absorb it through a reduction in profit margins.

The evidence so far is that our companies are coping well in the current environment. Overall, we’ve found that trading updates across the portfolio continue to be positive, with expectations being met or exceeded. We have seen some caution in outlook statements, as companies continue to draw attention to global political and economic uncertainties which are out of their control, such as supply chain problems.

Over the long term, the consistent application of our investment process has yielded very good returns. Even if the market correction has further to go, we have high conviction in our stocks and every reason to believe they will continue to add value over the long run. 

During January, we took the opportunity to top up positions in a several of the Fund’s holdings in which we felt the sell-off had been most indiscriminate. We were also able to initiate three new positions: Arbuthnot Banking, Virgin Wines and The Property Franchise Group.

Arbuthnot Banking Group provides private and retail banking, financial planning, and investment management services to high-net-worth and corporate customers in the UK. It has eschewed the securitisation boom which is present in most of the industry and focused on traditional banking - taking deposits and making a margin on lending them out – meaning most of its income is recurring. Weakness in the share price over the last two years has seen its market cap reduce to a level, under £175m, which brings the company into the fund’s investible universe, enabling the commencement of a position.

Virgin Wines is a direct-to-consumer online wine retailer, which offers products to customers through two subscription schemes and a pay-as-you go offering. Relatively recently floated, the company possesses an asset-light business model which generates high returns, distribution strength, a well-known brand, substantial amounts of recurring revenue and increasing cohorts of loyal customers – all building to impressive intangible asset strength.

The Property Franchise Group is the UK’s largest property franchise business, with offices from Falmouth to Aberdeen, operating several well-known brands including Hunters as well as digital upstart Ewemove. This scale should give it a strong distribution advantage, with central costs shared across franchisees. It also manages a large portfolio of over 73,000 tenanted properties which provides a valuable base of recurring income and it is yet to fully exploit the opportunity in financial services, as has been done by several peers.

The Fund exited its position in Orchard Fund Group, which has struggled for growth through the pandemic and had become a relatively de-minimis position for the Fund. Charles Stanley also left the Fund due to the completion of its takeover by Raymond James. Finally, the Fund sold its holding in MJ Hudson with the managers seeing increasing risks to its balance sheet, which looks to have become stretched by recent acquisitions and a build up of deferred consideration payable.

Positive contributors included:

Arbuthnot Banking Group (+14%), Concurrent Technologies (+13%), Vianet (+12%), James Cropper (+8.8%) and Keystone Law Group (+4.2%).

Negative contributors included:

Cake Box Holdings (-36%), Microlise Group (-28%), Solid State (-21%), Eckoh (-19%) and Inspiration Healthcare (-18%).

Discrete years' performance** (%), to previous quarter-end:

*Source: Financial Express, as at 31.01.22, total return (net of fees and income reinvested), bid-to-bid, institutional class.

**Source: Financial Express, as at 31.12.21, total return (net of fees and income reinvested), bid-to-bid, institutional class.

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