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River and Mercantile Micro Cap reports on difficult year

River and Mercantile Micro Cap to return more cash

River and Mercantile Micro Cap reports on difficult year – the NAV total return of the River and Mercantile Micro Cap’s portfolio over the year ended 30 September 2019 was (17.48%), which compares with the total return of (7.34%) posted by its benchmark index. The share price fell from 211p to 157p as the discount widened from 7.9% to 17.0%. As the fund shrank, its ongoing charges ratio rose from 1.25% to 1.30%. The board has decided that raising cash to buy back shares at this time would be unhelpful given the adverse sentiment towards micro caps. It points to the trust’s record of handing back cash in the good times and asks investors to be patient now.

Extract from the manager’s report

We ran a high conviction position of approximately 5% in Keystone Law through the year which, combined with the 18% gain in the shares, delivered a strong contribution. It remains an attractive, high scoring PVT investment case capable of delivering high growth and improving return on capital (increasing Quality credentials).

The Company’s precious metal exposure made a strong contribution with both Shanta Gold and Serabi Gold recovering from depressed levels with the former gaining 76% and the latter 63%.

Alpha FX (AFX) offers unique and disruptive FX services to corporates trading internationally and purchasing currency for commercial purposes. Its business model is highly scalable, and it generates operating margins in excess of 40%. It focuses on FX advisory services paid through execution that puts in place rolling hedging programmes rather than intermittent ad-hoc FX trades with cliff-edge effects driven by directional bets. Realised and continuing rapid market share gains from the established banks that dominate the market underpin strong Growth potential. Management incentives are strong with the founder-CEO and management holding a significant proportion of the group’s shares. Earnings delivery has been well above market expectations which, partially offset by modest multiple contraction, has driven strong share price performance (+19%).

Tax Systems is a great example of what happens when public markets fail to recognise the potential of businesses. Having listed at 67p in July 2016, the business was taken private in 2019 via a private equity backed management buyout at 115p. An attractive return from IPO and a valuable 12.5% gain in the period but I expect the management team recognised potential well ahead of that valuation.

Justifying our ownership of the negative contributors, many of which we still own, is important as we believe the way we challenge ourselves when we are wrong is more important than explaining what we have got right.

The extent of the declines in some of the holdings over the twelve month period, whilst disappointing, does convey the risk and illiquidity aversion that has been apparent over the period. For example, MaxCyte, a business which enables some of the leading cell therapy companies, fell 49% despite delivering good growth and announcing several commercial licenses. In our opinion, the progress that has been made by this company in the last two years is far from being reflected in the share price. Boku is another good example; the core business has delivered good growth and is delivering ahead of IPO expectations but the shares lost 42% over the period as the market was concerned over the potential of the acquired Identity business.

SDX Energy, the Egyptian and Moroccan oil and gas producer, did disappoint on progress with the two key growth assets (South Disouq and Morocco). The potential from these two opportunities not only remains attractive but risk-adjusted returns also remain unchanged from previous expectations, just later. The 57% fall leaves the shares trading on a 50% discount to book value, despite the strong recovery of more than 50% from the lows in August on the back of delivery by the interim CEO and several insider purchases. The other oil E&P business, Lekoil, also performed poorly, losing 73% as its purchase of an additional stake in one of its prospects from Afren was challenged with the court ruling that it required consent from the Nigerian government which was not forthcoming. Having signed a memorandum of understanding with Schlumberger for financing of its core production asset, it is looking for industry partners to finance appraisal and development activities at the larger prospect, Ogo. Whilst the investment clearly remains high risk, the company trades at a substantial discount to its discovered resources NAV and therefore presents asset backed strategic value.

RA International, the remote locations support services business, was, unfortunately, guilty of setting overly ambitious IPO expectations which were missed, leaving the shares trading at a 30% discount to their June 2018 IPO price. When we consider Growth PVT investment cases, we are looking for businesses that have delivered attractive growth but are forecast to continue doing so at an attractive Valuation and with supportive Timing. RA International has compounded revenue growth of 30% over the three years to December 2018, leaving consensus sell side forecast of 10% per annum achievable. It has a cheap valuation, with a PE ratio of 6x December 2019 consensus earnings which fails to recognise that almost a third of the market cap is held in cash (GBP22m as at the interims); a substantial discount to the market and peers. If the company can start to deliver on expectations then the third and final leg, Timing, will be in place. The substantial contracted revenue backlog certainly suggests the company has a strong market position.

Tremor International (formerly Taptica), a global leader in digital advertising, has made a strategic shift, aided by two transformational acquisitions (Tremor Video in 2017 and RhythmOne in 2019), to focus on video, data and connected TV (CTV) where there is strong Growth potential given increasing consumption of content through CTV platforms and streaming media. Tremor was the worst contributor during the period, falling 64% primarily on the back of valuation multiple contraction and, to a lesser extent, negative earnings revisions. Mobile advertising underperformance was a key driver of earnings downgrades during the period as the business declined faster than expected; the division now represents less than 30% of sales. Tremor is cash generative with a current net cash position equivalent to over 30% of the group’s market capitalisation and a prospective free cash flow yield of around 20%.

ULS Technology’s core business connects homebuyers with legal professionals, providing economic benefits to all three parties involved; the consumer, the legal professional and the intermediary (ULS). Supply of such legal services is highly fragmented and we expected the structural growth opportunity to provide some degree of immunity from cyclical trends in residential housing transaction volumes. However, increasing competition coupled with adverse cyclical trends has led to material earnings downgrades compounded by a derating, driving the shares down 60% over the period. Returns remain attractive and we believe a recently launched service, DigitalMove, that significantly streamlines the home moving process by bringing all parties in the transaction together in a fast, convenient and secure environment, will improve the company’s market position. This new service differentiates ULS from the competition and should enable it to reaccelerate growth.

Allergy Therapeutics is a specialty pharmaceutical company focused on the research and development of allergy vaccines that deal with the underlying cause and not just the symptoms of allergies. The vaccine, an ultra-short course injection, offers convenience with far fewer injections than the market average, supporting increased adherence, and is the foundation of the group’s well-established commercial position in Europe. As part of the process to move the group’s vaccine platform to full registration under a new regulatory framework, the company underwent an important phase three trial which, unfortunately, had a negative outcome, causing the shares to decline 48%. The data was inconclusive, in a large part due to the challenges in measuring the efficacy of vaccines when compared to placebos for allergies. Whilst disappointing, we do not believe it is as severe as the market fears, particularly as the regulator is likely to be reluctant in removing a product from the market that has resulted in improved clinical outcomes for allergy sufferers. What remains is a business that has delivered many years of attractive Growth with significant optionality on new markets (US) and vaccines (peanut) and at a depressed valuation.

RedT Energy is a developer of liquid energy storage machines, equivalent to pumped hydro in a box given its long-life and heavy cycling attributes. It enables arbitrage opportunities from energy storage and enhances the efficacy of renewable investments. We expected this to underpin strong Growth potential, however the roll-out of the group’s energy storage technology was much slower than expected, primarily due to adverse developments in the UK and German energy markets. As a result, unit production and sales did not reach a level at which the business could become cash generative, resulting in additional capital being raised in October 2018. We supported the capital raise in order to fund short-term working capital to progress delivery of the order pipeline. The group had begun searching for strategic partners to support and finance continued growth of the business however, this did not materialise within the timeframe dictated by the group’s financial position. A strategic review was launched in March 2019, resulting in cost cutting and another capital raise which we declined to participate in as we could not see a likely path to realising Growth potential in the near-term. We exited our small remaining position in July 2019. Unfortunately, with the shares down 89%, this is an example of the challenges of investing in poorly funded, early stage, loss making growth companies. Very little exposure to this type of investment remains in the portfolio.”

RMMC : River and Mercantile Micro Cap reports on difficult year

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