May 2017 was tough. Since President Jacob Zuma’s Cabinet reshuffle about two months ago, sentiment in the JSE small cap sector has been very gloomy indeed.
Across the board, the shares of smaller- and medium-sized companies have been sold down aggressively, including those in the Futurewealth portfolio. The question is, has this selling being justified?
On the one hand, the answer is yes. The president’s actions have surely dented the confidence of the body politic in SA, who cannot but think that his motives are not quite aligned with what is best for SA – especially from an economic perspective. Confidence is an extremely important enabling factor in an economy, as it is an essential element in economic agents’ motivation to spend money – whether investing or consuming. It is the aggregate of these spending decisions that makes the economic wheel turn faster, slower, or even in reverse. Although confidence is very difficult to model or measure accurately, recent surveys done by the Bureau for Economic Research (BER – Stellenbosch) suggest that South Africans’ perceptions of the state of the economy have been brighter in days past.
On the other hand, the general sell-off in smaller- and medium-sized shares is definitely not justified. Even though it might not be the best of times in our country at present, it certainly isn’t factually the case that SA has gone to the dogs (not yet at least). We are not going backwards at present, although it must be said that it appears that we are going forward at a slower and slower pace, given the seemingly weekly downgrades in the economies’ expected growth rate.
Generally in bad economic times such as these, there are often very specific opportunities for those courageous souls who know their true values from their prices. People often wrongly attribute what is happening on average to the particular case they happen to be considering, and this is what I think has happened, and is happening, to many of the shares that are in the small cap space. The seemingly miserable average state of the macro economy, has resulted in many investors selling specific shares that they shouldn’t have.
Think of it this way: even though the broader economy, consisting of all of us (consumers, firms, and government) might not be as healthy in aggregate as what we would like it to be, it surely does not imply that it is going badly with each and every particular company, consumer, or sector of government (I think the fallacy of composition might actually apply to government!).
For example, on average a class might score very poorly on a maths test, but that does not mean that it wasn’t possible (and very probable) that a couple of kids did very well on the test. In the same way, I think that some companies – Santova, Rolfes, Master Drilling, and Consolidated Infrastructure Group (CIL) among others – may do well notwithstanding the general malaise of the general South African economy.
In conclusion, don’t worry if the economy is going to a bad place on average; specific companies should still do very well. The companies that I expect to do well are those that are not expensive (low PE/low debt/good CF/good returns on capital) and have an economically-diversified business (lots of different clients in different geographies preferably and a diversified product basket).
Small caps are only dangerous if you need cash quickly or if their tendency to move sharply (up and down) induces you to buy or sell just because of X, where X is any reason not having to do with the actual underlying business and its valuation (how it makes money and what you are paying for that income stream).
There are small- and medium-sized businesses on the JSE that will most certainly have to scrape the bottom of the barrel to make decent returns, if at all, in a low- or no-growth macro economic environment. However, I am confident that those who do their homework will do well to invest in firms such as Master Drilling (MDI), Afrimat (AFT), AdaptIT (ADI), CIL, Santova (SNV), and Rolfes (RLF) at current levels. These are some of the primary holdings in the Futurewealth portfolio. Drop me an email if you want to know more.
As an interesting and very important side note, many small caps earn a material portion of the money that they do in foreign geographies. For example, three of the companies that I mentioned, CIL, Master Drilling , and Santova, generate more than half of their after-tax profits in a combination of US dollars, euros, and pounds – hardly the sort of currency exposure that South African investors normally shy away from.