Investment Road Test: Microequities Deep Value fund

PORTFOLIO POINT: The Microequities Deep Value fund offers sophisticated investors access to the small-cap sector with reasonable fees.

Investing in stocks directly can be a “bricks and mortar” experience – investing directly in companies that produce goods and services, and make real profits. The “problem” for retail investors is that this approach becomes more difficult when the companies are small and geographically remote, since it is harder (if not impossible) to understand and evaluate them.

Typically small companies are ignored by stockbrokers, who can’t generate enough brokerage revenue to justify analytical coverage of them. So they are ripe for investment through dedicated small-cap fund managers, especially where the manager isn’t shackled by the need to match its portfolio to the performance of broader sharemarket indices.

One such fund is the Deep Value fund offered by the Australian based small-cap manager Microequities Asset Management. The Deep Value fund started operation in 2009 and has generated good investment returns during that period: its total return since launch in March 2009 has been 106.27%. Looking back over the past 12 and 24 months shows returns that are more sober, with a 4.3% return over the past two years and a –2.95% return during calendar 2011.

That data suggests that the fund benefited from a large profit during its first few months of operation (when the fund size was relatively small), and so the more recent 12 and 24 month performance data is probably more relevant to consider. Compared to the general stockmarket returns during those periods, the Deep Value fund has beaten the general market by 8.64% over the past 24 months, and by 8.47% over the past 12 months.

Although the manager and its related entities have been in business since 2005 (and offer a range of other income-producing services), the Deep Value fund remains small, with about $20 million total funds under management. Potential investors should therefore consider the strength of the manager (as well as all of the other investment risks) prior to investing.

The Information Memorandum prepared for the Deep Value fund sets out its investment criteria:

• Companies with a well-established business model.
• Companies generally should be at least two years or longer EBITDA profitable.
• Companies with low manageable debt or no debt are preferred.
• High cash flow generating businesses.
• Companies with high earnings visibility and disclosure.
• Companies with a predictable future earnings stream.
• Companies in a growing sector.
• Companies that have a growth catalyst division, product or service.
• Companies with a highly competitive advantage or brand name.
• Companies with a stable management and track record for delivering value to shareholders.
• Companies where management has a significant stake.
• Companies with a reputable board of directors.

Aren’t these the aspects of a good company that the “bricks and mortar” approach would value? It’s also significant to note that the “usual” analytical tools of a “benchmark aware” fund manager are missing from this checklist; one of the typical reasons for the disappointment delivered by traditional managed funds is that stocks are often selected simply because they are provide “better” valuations than their peers. Since this comparative value is normally based on relative price/earnings multiples, it can mask the real worth of a company.

Many investors now see the pitfalls in buying stocks because they are “cheaper than they are worth,” just because a stock is trading below its “normal” price/earnings multiple doesn’t mean that it has real long-term merit. In the midst of the inferno raging in markets after the GFC, DIY investors are shunning the old way of playing the stockmarket; even a stock that appears to be cheap is not attractive to these investors who are now more focused on downside risk management.

By looking at the “real” qualities of a company, investment managers like Microcap Asset Management can try to deliver good earnings and capital growth over the medium term. The suggested term for investment into the Deep Value fund is for a period of three to five years, with a minimum investment amount of $50,000. Applications and redemptions can be made monthly. Given the relative illiquidity of stocks in the microcap sector, short term investing in this fund is not recommended.

One of the key concerns for small or micro-cap investors is the ability to withstand company-specific problems, and this is one of the main reasons to adopt a diversified portfolio approach to this space. Microcap Asset Management also adopts a range of risk management strategies that are well suited to this space: it doesn’t lend stocks nor does it short-sell them, and it is limited in the use of derivatives to risk management (but not trading or speculating). Monthly fund performance reports, available on the company’s website, disclose a portfolio that is widely diversified across a range of industry sectors, although software and IT investments account for over 40% of the overall fund.

The Deep Value fund is offered only through an information memorandum, meaning that it is only available to “sophisticated” investors (eg, with annual income of at least $250,000). The Deep Value fund is an unregistered managed investment scheme, with Microcap Asset Management acting as trustee and manager. It has appointed a Macquarie Bank owned entity to act as custodian of the fund’s investments.

Fees are not unreasonable for this type of fund. Annual management fees are 1.8% pa, with an additional 20% pa outperformance fee for returns above a threshold of 5% pa. There is also a high-water mark such that performance fees aren’t deducted until the fund performance has risen above the level on which any previous performance fees were paid. The Information Memorandum also discloses that the fund can charge an entry and exit fee of up to 2%, although these appear to be linked only to investment made through an intermediary (such as a broker or financial adviser).

Investing in good small or micro-cap companies is a proven way to generate great returns. Companies that fulfil the “bricks and mortar” criteria listed above can grow into behemoths. And don’t let the name belittle these types of companies – micro-cap stocks are defined as those with a market capitalisation below $250 million. Obviously the business nous and opportunity required to grow a company to that size, is something that can be of value to any investor smart enough to find the right type of company to invest in.

The score: 3 stars

0.5 Ease of understanding/transparency
0.5 Fees
0.5 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.