why sa’s small-cap stocks are back in favour

12 July 2018

By: Marcia Klein   Source: fin24

In a market that perpetually favours the Top 40, reports showing that South African small-cap stocks are the cheapest in the world may prompt more interest in small and mid-cap counters.

But cheap doesn’t necessarily mean good value – especially if the share stays cheap. Nor does it mean that cheap shares will necessarily move to fair or full value.

With one exception (being Italy), South African small and mid caps are the cheapest equity sector in the world, according to Alpha Wealth.

Alpha Wealth’s equity analyst and small-cap specialist Keith McLachlan recently produced research showing that the South African small-cap market is not only deeply discounted, but while the rest of the world has been getting more expensive over the last two or three years, local small caps have been getting progressively cheaper.

Westbrooke Alternative Asset Management research, which looked at 130 companies with a market cap between R100m and R10bn, showed that all are trading at a discount relative to historical valuations, particularly operating companies with a market cap below R2bn (whose price-to-equity ratios have de-rated by 10% to 7.9 since March 2017) and investment holding companies (which are trading at a 33% discount to net asset value [NAV]).

The valuations of corporate and private equity merger and acquisition transactions, on the other hand, have been at a significant premium to current listed valuations, it says.

Jarred Winer, fund manager of the Westbrooke Special Opportunities Fund, says the potential for an increase in earnings across small-mid-cap operating companies is strong, “with significant operational leverage driven by revenue growth and a reduction in operational expenses over the last few years.

These companies have significant balance sheet capacity for corporate activity and corporates also have significant cash on hand to resume capital expenditure and acquisition activity.”

Whether cheapness is a reason to invest, however, is up for debate.

Unlike the internationally-inclined large-cap stocks on the JSE, small caps track the local economy, which has been poor and is not showing signs of significant improvement.

Small caps struggle to get institutional and individual investment interest. They are just too small for institutions, and individual investors are concerned about risk and generally not that aware of the myriad companies, what they do and how they fare.

This makes investment decisions difficult and risky.

Small caps are rarely recommended, as few analysts cover them, although those that do always point out that this is where a knowledgeable investor can steal a march on the rest who tend to ignore smaller stocks.

Many of these companies, as the research shows, are cheap and some may be the rising stars of the future. Many large successful companies start from nothing.

Offsetting the allure of buying cheap, currently, is investor concern that small caps may not be reliable or as keenly watched and governed as larger companies.

This concern has been reinforced by huge volatility in some small and mid-cap shares following the Steinhoff disaster, like EOH and Resilient, as panic spreads.

It must be mentioned, however, that Steinhoff itself was a large company that still managed to escape the stringent oversight it supposedly had.

Why the discount?

Most small-cap stocks are directly linked to the performance of the SA economy, which has been characterised by a lack of business and consumer confidence, high unemployment, lack of foreign direct and government investment, and poor sentiment, says Unum Capital trading desk analyst Lester Davids.

“With these factors weighing heavily, small-cap shares have become cheap relative to the market as their earnings become less predictable in an uncertain environment.”

Investor concern is exacerbated by worries about issues that have come to light at certain companies such as EOH, Invicta and the property sector, including companies like Resilient, Greenbay and Fortress, he says.

Additionally, fund managers aren’t interested because any uptick in the share price of smaller companies would fail to “move the needle” in the context of a large portfolio.

However, he says a number of small caps have more than discounted the negative factors “and any one piece of good news could lift the share and spark renewed investor interest”.

“A share being cheap should in most cases not be the only reason to invest, but rather one should also consider the quality of the earnings, assets and most important in the small-cap space: management.”

Mergence Investment Managers portfolio manager Peter Takaendesa says the small-cap index has lagged the overall JSE All Share Index over the past 12 months, “but there is no reason to rush into that universe given the weaker current domestic economic environment, and some companies in that universe are likely to find it difficult to survive if the current economic environment lasts another 12 to 18 months.”

Investors need to do their homework properly “to identify small companies with strong balance sheets, strong market positions, solid management teams and trading at reasonable valuations”, he says.

Given the number of apparently cheap small-cap opportunities available, Mergence recommends “looking for opportunities where there is a clear path to value unlock”.

McLachlan says that given the fact that South African fundamentals are now on a positive trajectory, or have at least bottomed, “the fact that small caps in South Africa are cheap is definitely relevant”.

“On a balance of probabilities, anywhere and anytime that you have cheap equity with improving fundamentals, your chances of making material returns in the future start to become particularly high.”

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