According to George Ensor the fund manager of River and Mercantile UK Micro-Cap Investment Company, UK smaller company stocks are “fantastically cheap” and on a cyclical low.
“Unprecedented” outflows from UK smaller company funds over the past two years could become a catalyst when investor sentiment improves, Ensor said. To me, that means small-cap shares, trusts and funds look set to do well in the coming months and years.
The fund’s top holding
One way of playing the theme is via small-cap vehicles like the UK fund Ensor manages. But my preference is to research small-cap companies and pick individual stocks to hold.
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However, scanning the holdings of small-cap investment funds can be a good jumping-off point. River and Mercantile UK Micro-cap Investment Company lists its top holding as Keystone Law (LSE: KEYS), which accounted for 5.6% of the fund’s assets at the end of 2023.
It’s a full-service, “tech-enabled and challenger” law company with a compound annual growth rate (CAGR) for normalised earnings near 20%. I’m impressed by the way the firm even increased its earnings every year through the pandemic.
There’s a robust balance sheet here, which shows a net cash position rather than net debt. But as well as the prospect of further earnings growth ahead, there’s also a dividend for shareholders to collect.
With the share price in the ballpark of 547p, the forward-looking yield for 2024 is a just above a decent 3.7%. That suggests Keystone Law has potential to make a good investment for total returns if operations go well.
Meanwhile, the stock is well down from its highs of 2022, although it’s been trending up again since last summer.
In September 2023 with the half-year results report, the company issued a positive outlook statement.
Strong client demand
Activity levels and client demand had been strong. Meanwhile, recruitment market conditions had been favourable. Key to the firm’s growth prospects is the way it aims to attract high-calibre talent. However, the company did concede that economic uncertainty “continues to weigh on candidate flow”.
One of the biggest risks with a business like this is that service delivery relies on qualified and talented people. The assets of the business – its people – could leave at any time. So it’s understandable the directors put so much emphasis on recruitment.
Looking ahead, City analysts have pencilled in a modest advance in earnings for this year of just over 4%. Set against that expectation, the anticipated earnings multiple is running at just over 20.
That’s a fair valuation when considered alongside the multi-year CAGR for earnings. But the rating compares to the FTSE AIM All Share index multiple at just under 12.
So there’s some risk in the valuation for shareholders. If Keystone Law misses its earnings estimates in future, that rating could contract, taking the share price lower.
Nevertheless, I can see why Ensor likes the stock for his fund. I’m now keen to dig in with further research with a view to buying some of the shares for a long-term hold.
