Investing in small and micro-caps – case studies

Over the 20-year history of the Quaero Capital Funds (Lux) – Argonaut fund (the Fund), we have adhered to our investment philosophy and fundamentals/value approach of investing in good companies at great prices. Our investment process is based on primary research, which is necessary for investment in smaller companies that communicate less and have limited coverage by brokers. Over the years, we develop an intimate knowledge of the companies we invest in.

Constructive Engagement – an opportunity to transform companies and create value

Ever since the launch of the Fund, we have maintained a close relationship with the top management of companies who often seek our advice on how to better communicate with the stock market and investment community. What has changed/evolved over the years as the Fund grew larger is that we now often own 5 to 10% of a company, giving us an even greater say in the business. The friendly engagement with the management – that we call ‘Encouraging Best Practice’ – has given the Fund an extra driver for value creation.

Two examples of our constructive engagement:

We have led continued discussions with the management of French industrial mini-conglomerate Groupe Gorgé about streamlining their business and focusing on the core business in which they are a global leader, generating high margins and solid long-term growth. After asset sales, spin-offs, and acquisitions, this has led to a change of name to Exail Technologies, with a strong position in the niche area of submarine drone technology for the neutralization of underwater mines, with vertical integration in the production of inertial navigation systems. The company is now well-positioned to gain very large contracts in Australia, Europe, and for navies that will be charged with cleaning the Black Sea of drifting mines. Margins are high, and growth is assured by the full order book (several years of sales).

For more than two years now, we have been encouraging two Swiss companies (Starrag and Tornos) making high-precision machine tools to seek synergies and critical mass through a merger. The logic was that in these machine tools businesses, very high margins are made in the aftersales services and maintenance activities. However, these niche operators sell their machines all around the world and are too small to have service centres everywhere. Combined, they would have service centres able to cover a greater proportion of the large markets across the globe. Furthermore, we felt that, from a stock market perspective, two micro-caps would become one small cap and would attract more attention from investors. In our discussions with management, we felt that, even if they were not immediately receptive, they also saw the logic. Further meetings and encouragements ensued, and in May of last year, there was the announcement that the two companies were exploring a merger. The merger became effective in December, with the corporate presentation calling it ‘a perfect match’ with complementary product ranges (turning and milling machines of various sizes), client industries (aerospace, medtech, watchmaking…), and geographies, generating substantial growth and margin synergies. We believe the new StarragTornos Group is now much more attractive than its constituent parts.

Valuation discounts at the bottom end of the market

It was not so long ago that smaller companies traded at premiums to larger companies because of their higher growth profile. Listed smaller companies also traded at valuations at a premium to their peers that were bought by Private Equity. As the small and micro-cap market has been out of favour, discounts and mis-pricings abound.

Two examples to watch closely…

When we invested in Dutch construction company Heijmans, the company was making losses on its infrastructure business (due to a poor bidding process), its balance sheet was in need of repair, and the market feared a dilutive issue of shares ahead. We encouraged management to look for alternative sources of capital, and they sold their profitable subsidiaries in Germany and Belgium to focus on the company’s domestic market where it has entrenched positions. The company has now been fully turned around to a strong level of profitability, and the balance sheet has been so fully repaired that management was able to make a large strategic acquisition in their core business in Holland last year while continuing to pay out 40% of profits in dividends. Clearly,  the market has still not seen this as the shares are trading on a PE ratio of 5x and a recurring dividend yield of 8%.

We do not tend to invest in IPOs as they are usually pitched to the market at high valuations by Private Equity owners taking profits. These IPOs tend to come just after a few years of good profitability and growth, and then brokers are encouraged to extend a blue-sky scenario for many years ahead. However, we do look at ‘failed-IPOs’ where high expectations were not reached, and shares fell sharply. If balance sheets are strong, the business model sound, and shares are down 60/70%, these low-expectation shares can make a good investment. German online eyewear retailer Mister Spex came to the market amongst great enthusiasm in 2021 when lockdown online sales were strong, and the company had an ambitious plan to roll out physical stores across Europe. At the time investors did not seem to be worried about the fact that the company had been losing money for 10 years. Venture Capital was still in fashion, and growth was more important than profitability. However, the tide turned, the company disappointed, and investors became less forgiving of a start-up mentality involving a heavy loss-making ramp-up period while the company invested to gain market share in high street stores to reflect its market share online. We started investing when the share had already fallen by 80%. We were attracted by two things: 1) the company had raised cash at the IPO which now covered the entire (reduced) market capitalization. The operating business was, therefore, going for free. This could only be justified if the business was going to continue losing money and consume all the cash. 2) A meeting with the CEO in Germany made us understand that he was going to completely change the strategy with a focus on stemming the ‘cash-burn’ and then getting to cash flow breakeven by the end of 2024. The management estimates the net cash on the balance at the end of last year will have been circa EUR 105m, which is exactly the current market capitalization. If the company reaches cash flow positive by the end of this year, we will have bought the operating business for free!