Small-cap tips: how to invest during a recession

Victoria Stevens, co-manager of the Liontrust UK Smaller Companies fund, has some advice for anyone wanting to invest in individual small-caps in current market conditions. She also talks to interactive investor’s Lee Wild about which small-caps to buy and how they will cope with a deep recession.

Filmed 28 May 2020

Lee Wild, head of equity strategy, interactive investor:  Within the Liontrust UK Smaller Companies Fund portfolio, are there are any companies that you’ve decided don’t fit any more? Have you sold any down during the pandemic? I ask because I see Hilton Food Group (LSE:HFG) and Team17 (LSE:TM17), they’ve dropped out of the Top Ten. But also just wondering whether that’s only down to share price movement and nothing else.    

Victoria Stevens, co-manager of the Liontrust UK Smaller Companies fund: So naturally there have been companies within the portfolio that have underperformed, not all of them have held up well. Some have been hit harder than others and that has been particularly the case, it won’t surprise you to learn, where they’ve been more exposed to the very frontline impacts of the virus and the lockdown. 

So a couple of examples for you would be Accesso (LSE:ACSO) which sells ticketing and guest management software to leisure attractions and theme parks. Of course, many of those attractions have remained closed for many weeks now. 

And we also hold a company called Quixant (LSE:QXT), for example, which produces computer platforms that drive high end slot machines which are sold into casinos, and again, casinos have been closed for many weeks now. So both of those have been examples of stocks that have suffered more. 

But specifically to your question, we haven’t sold down any holdings completely where companies are experiencing short-term difficulties. And what we’ve really been focusing on with those companies is their ability to trade through and survive this downturn, and hopefully emerge on the other side to take advantage of that upturn when it does come.

And for us, if we hark back to the way that we invest in our investment process, you know, the strong barriers to competition, the attractive market position, the history of higher returns for our businesses, should hopefully stand them in quite good stead if any of our companies do need to go to the stock market to raise fresh financing. 

And we also believe that such companies should hopefully be well placed when the dust settles to start to take share even quicker from weaker competitors who perhaps have suffered more, or even sadly fallen by the wayside during the most difficult times that we’re experiencing at the moment. 

You mentioned two stocks specifically, Hilton Food Group which is a specialist meat packing business which supplies supermarkets such as Tesco (LSE:TSCO) in the UK, and also Team17, which is a video gaming business, and both of those two companies, we’re still very happy holders of. Both of them, if anything, have been beneficiaries of the current scenario and the lockdown and people staying at home more. 

Lee Wild:  Some stocks within the portfolio will have greater potential than others perhaps, each will be on its own trajectory. Are there any though that you secretly think, this is a potential ten-bagger, this could go further than the rest? 

Victoria Stevens: Well as I’ve been describing, the way that my team invests is less to do with looking for those very racy, short-term, blue sky, upside type scenarios. It’s much more to do with picking what we think are really great businesses which can just quietly compound out their growth over the very long term. 

And we of course believe strongly that many of our businesses have the potential to grow to be multiple times the size that they are today. And I could mention any number in the portfolio, but a couple of examples would be Ideagen (LSE:IDEA) which is providing risk and compliance software to the so-called high consequence industries such as engineering or pharmaceuticals or global data, which is a business that is really building a powerhouse in the area of premium business information and analytics to businesses. 

So there are many examples of businesses that we think have very, very strong growth potential over many years to come. But it is exactly that, you know, our companies are more likely to be steady, reliable, growth compounders over many years as oppose to the higher octane, more risky small-cap where, you know, yes, you could see extreme upsides within a very short period of time but also potentially you could see a very extreme downside as well. 

Lee Wild:  In the near term, I just wonder whether you’re worried about conditions for the small-cap sector during what I guess could be a deep recession for at least the second and perhaps third quarter, who knows beyond that. Just trying to get a feel for how you’re approaching this period. 

Victoria Stevens: I mean I agree with you, I think for many companies they are really likely to find life quite tough for a while yet, and that is particularly going to be the case of course once the lifeline of government support is withdrawn. You know, I think that these are going to be very testing times for companies on multiple fronts, they’re facing any number of challenges. 

There will be decisions as to whether or not to lay off large numbers of staff, all the way through to ironically, you know, in terms of a positive impact, but also throwing up a challenge, is the need to very carefully manage working capital as businesses start to reopen. As a team, facing those kind of challenges among our business, what we will very much focus on is our companies’ financial strengths, their balance sheet strength. 

And it’s worth mentioning that as we went into the crisis, we had a portfolio of business that had very strong balance sheets, so around two-thirds of the companies in the Liontrust UK Smaller Companies Fund had net cash on the balance sheet as we came into the sell-off. 

And it also did have net debt, you know, usually, typically we’re looking at really quite minimal levels of net debt. And a lot of that is down to the owner manager culture that I mentioned earlier, where those managers of these businesses that are holding big equity stakes, are obviously less willing to put their own capital at risk by levering up the company substantially. 

And we found that that balance sheet conservatism has stood our companies in very good stead over the past couple of months. So far we’ve seen relatively few of our companies coming to tap the market for fresh finance but we are aware of course that, as I’ve said, the challenges are just beginning. So we’ve repeatedly said that if our businesses require it, you know, we will be there to stand behind them and to support them. 

Lee Wild:  At times like this, I can see investors look to the past for indications as to what might happen in the future. Now, certainly in the US, people are talking about small-caps which are there, which have outperformed large caps, coming out of nine of the last ten economic downturns. I’m just wondering is the same true in the UK small cap space? 

Victoria Stevens:  So it is true to say that after the past couple of major downturns, notably the dotcom boom and bust of the early 2000s, and then the financial crisis of 2008/9, in the UK as well as the US, small caps did outperform in the immediate aftermath, so that is true. 

But what I would say is that we are living currently through a period of unprecedented macro economic uncertainty and it really is impossible to predict just how long or how deep this downturn is going to end up being. 

Or, on the other side, how fast the recovery will be, and it could very well prove to be the case that this time round it might be larger companies who have got more diversified businesses generally, and have better access to capital that might be better able to withstand the particular challenges of the current crisis and, therefore, then might recover quicker in the aftermath.  

I think from my team’s point of view, you know, we wholeheartedly believe that small-caps are well positioned to be able to be very nimble and agile and flexible when it comes to responding and adapting to what will inevitably be quite a changed world post coronavirus. But I also think that in terms of the timing of that and trying to accurately and constantly predict market moves going forward, that is very difficult indeed with so many variables. 

So what we will very much encourage investors to focus on is what they do know about and that is individual company fundamentals. 

Lee Wild:  Victoria, what advice would you give a retail investor looking to invest in individual small-caps in current market conditions? I mean very, very tricky at the best of times, but sort of have you got any tips for investors right now? 

Victoria Stevens:  So I was recently sent a memo from quite a well known investor called Howard Marks at Oaktree Capital Management and he, in this memo, was suggesting that the best way to deal with the uncertainty of the current environment was, and I quote, “A calm, open mind and an objective process”, and really I couldn’t agree more with that advice. 

Because it’s all too easy in the world of small-cap to be tempted by the latest fad, which is often accompanied by, you know, a very compelling story in small-cap, but too often you can find that that is associated with an inflating bubble and when that bubble pops, it can leave investors with some quite nasty losses. 

So, I think my advice would be take the time to really understand what it is that you’re looking for in an investment and really try and define that. Write it down if need be and really try and stick to it because I think that way investors are much better able to make an objective judgement on the investment opportunity in front of them and make a calm and objective assessment of risk versus reward.