Getting small cap companies, and in particular micro-cap companies, on to institutional radars can be like pushing water uphill. Many funds will have a minimum market cap requirement, and even where this is not an official policy, we often find that fund managers draw their own line in the sand.
The most often cited reasons are: fear of getting stuck in an illiquid holding, poor levels of corporate governance and disclosure, a perception reinforced by high profile corporate scandals, and materiality – no matter the size of investment, fund managers must perform a similar level of due diligence, consuming a significant amount of their much called upon time.
If the size of the company compared to the fund means that a meaningful investment cannot be made – at least without taking a disclosable stake, or even one that could trigger a mandatory offer to other shareholders – the fund manager may question the value of taking a meeting.
Small can be good
In terms of regulation and governance, we have certainly seen a move towards equality between small and large caps in recent years. The implementation of the Market Abuse Regulation in 2016 standardized rules on insider dealing and market manipulation across all exchanges including those dominated by small caps.
On AIM, the London Stock Exchange’s small growth market, there is a growing perception that the quality threshold for new admissions has increased in recent years. As of September this year all AIM companies are required to comply with a recognised corporate governance code.
In a fund universe dominated by trackers and passive investment strategies, the quest for alpha is certainly becoming more demanding. There is no longer such a thing as too big to fail: think Lehman Brothers and Enron, and more recently, Carillion and Conviviality.
Insolvency is not the only reason that large caps are not automatic safe harbours. In the last two years, shares in electronics retailer Dixons Carphone have more than halved, wiping some £2 bn from the market value, with the company suffering from weak demand, rising costs and a huge data breach.
Smaller companies are a huge part of the UK economy and the engines of innovation. This creates investment situations that can be less sensitive to macro conditions and offers investors the opportunity to enjoy the significant upside that comes from disruptive business models and technologies. Blue Prism, the expert in enterprise robotic process automation, is up circa 20x since its 2015 IPO, and Fever-Tree the specialist drink-mixer producer is up over 25x since its 2014 debut. Physiomics, an AIM quoted life sciences company, has seen its share price more than treble in the last year, having signed several new contracts including agreements with three major pharmaceutical clients. Physiomics has also added new institutional investors to its shareholder base.
Indeed the agility of smaller companies helps them to become trusted partners of larger enterprises, as is the case at Petards Group, which has an unbroken 18 year relationship with the Ministry of Defence. Its rail division is a trusted supplier of on-train software driven video and sensing systems to nearly all of the major suppliers of rolling stock to the UK Network, including Bombardier and Siemens.
In the small cap world, cornerstone investors can form long-term partnerships with investee companies, sometimes being instrumental in driving M&A strategies and even having representation at a board level.
The right audience
Attracting the right investor audience is not an exact science. Management teams with a strong track record in making money for institutions have a head start. However, in the early days of a company’s quoted life, retail investors can be an important source of liquidity, and tax efficient sources of funds such the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) can be valuable sources of capital.
In order to keep the momentum going, setting out corporate objectives and, if appropriate, market expectations of financial results are vital, as well as the delivery of news flow against that. Press coverage is an important means of getting noticed by retail investors, as is broker-facilitated access to the wealth management community.
Engagement with the wealth management community can bring on a longer-term grade of retail holder. Even as the company grows, retail can remain an important element of the share register. Individuals who are able to deal in smaller trade sizes can trade more freely than the institutional funds and form the backbone of the capital base.
Indeed, those with EIS or VCT only mandates are unable to buy in the market and will be restricted from purchasing shares outside of an IPO or secondary fundraising.
Regular and thoughtful investment research, combined with active marketing by the company’s broker, and willingness by management teams to engage regularly with investors, is the key to bringing on institutions.
The timeframe between an initial meeting and an initial investment can be significant, as investor trust needs to be earned, but can result in long and supportive relationships. The small-cap investor community has something of a herd mentality. Sometimes it takes the appearance of one well-known investor on the register to spark the interest of the wider market.
Rules of engagement
Dwindling trading commissions and the advent of Mifid II have made it harder for small caps to attract the attention of analysts and non-house sell side research is virtually non-existent. The responsibility of providing a balanced opinion now lies with the company’s retained brokers, and in some cases, small caps receive no coverage at all.
In the same way that investor trust is vital for companies to nurture, institutions also need to have confidence in a broker. Without that it can be very difficult to open doors for the potential large caps of tomorrow.
Of course, it’s important to put your best foot forward when looking to raise capital. But it is equally, if not more, important to update investors and introduce the story to potential new participants on a regular basis. Especially when there is no deal on the table. Equally this can help to maintain market interest during periods where material news flow is quiet.
Honesty is best
Nothing goes up in a linear fashion. With that in mind, bad news needs to be communicated in as open a nature as possible: delivered in as timely a fashion as positive news. Should a company have any inkling that things are not going to plan, it should bring it to the market’s attention at the earliest possible moment.
It’s better to be over cautious and surprise to the upside, rather than try and ride out the storm until the last moment and catch the market off guard. The city has a long memory and the mis-management of expectations can take years to recover from.
It’s vital to have long-term followers who understand the dynamics of your business and investment merits. This is the only way to create buying interest in the market, which can help shares respond to good news and limit the downside when sellers enter the market.
Derren Nathan is head of research at London-based broker Hybridan