Some 20 years ago, there were close to 750 companies listed on the JSE and the investment universe was growing as an increasing number of businesses looked to access capital markets to fund growth.
This universe has shrunk for a number of reasons including the growth in private equity and a stagnating economy.
Taking into account listed companies that are actually investible by fund managers, the universe is, in fact, no more than about 130 companies, while large asset managers are essentially constrained to investing in the top 40.
One of the advantages smaller, more nimble fund managers like Denker Capital have is a bigger investible universe and the ability to take sizeable stakes in smaller-cap companies, says Denker SCI Equity Fund portfolio manager Ricco Friedrich.
“We have access to great smaller cap companies that perhaps have better growth prospects not necessarily tied to the fortunes of what is happening from overall economic perspectives.”
Portfolio manager Claude van Cuyck says that to find an edge in a highly competitive market, you need to look at where your potential strengths lie, for example, in the small- and mid-cap space, which is not a focus area of larger peers.
“We like to identify high quality companies and employ concentrated stock-picking to buy at discount to net intrinsic value. It is hard for our competition to replicate these holdings.”
While small-cap companies account for about 4.5% of the JSE’s market cap, small-caps comprise 17% of Denker’s SA Equities portfolio, which has, among its top 10 holdings, companies like Combined Motor Holdings (CMH), Altron and Italtile.
The small cap space has tended to outperform the market historically, but not over the past few years because of the challenges in the South African economy. This is also reflected in the fund’s performance, although it did manage to ‘miss a lot of falling knives’ including EOH, MTN and most of the construction stocks, while it benefitted from the unlock of value in Altron, Adcorp and Stefanutti Stocks – the only construction company showing significant positive returns in 2018.
Friedrich says South Africa’s problems “have had a significant negative impact on SA Inc, which has a disproportionate small- and mid-cap prevalence, so this premium has not prevailed. This means there is a greater proportion of mispriced opportunities than in big-cap dual-listed companies.”
Friedrich, who previously managed a small-cap fund, says as large managers don’t allocate resources to small and mid-cap companies, these are under-researched – “and where we tend to find great mispricing opportunities and where we can get to know and understand these businesses inside out”.
One example is CMH, which has been around for decades. It has a great management team, long-serving management and a track record for allocating capital, but is off the radar of big asset managers. “It generates a great return on equity and high levels of cash conversion, and has an astute management team in terms of capital allocation and has grown earnings significantly,” says Friedrich.
“If you are a big business, you are essentially the market, but great smaller businesses are able to significantly outperform the market in good as well as tough times.”
The small-cap space has attracted the attention of investors looking for turnaround opportunities. “We are not fans of investment in turnarounds as there seldom is a turnaround. We are not deep value investors simply buying because a company is trading at half its net asset value or four or five earnings multiples – we want to understand the fundamentals of the business,” says Friedrich. “If value or cheapness is the only reason, it is probably the wrong reason.”
There are, however, exceptions where a catalyst for a turnaround has already been identified, and Denker has engaged with Value Capital Partners, founded by Antony Ball and Sam Sithole, formerly of Brait, who bring their skills set and engage with companies to bring about change. “Where we have seen that change, we are happy to be part of unlocking the value. Simply to buy a company because it looks ridiculously cheap is not sufficient as often the odds are stacked against you.”
Nimble investment management does not necessarily mean the ability to constantly buy and sell. In fact, Denker has a long-term approach and hardly trades at all. “Nimbleness means that, if we identify an opportunity, we are able to build up a decent position quickly.
“We tend to limit the number of positions in our portfolio to about 35, and we don’t have a long tail of positions under 1%. Our minimum is 1% and the structure of our portfolio, as a result of our size and agility, looks different to those of other asset managers.”
Liquidity is a challenge, and if things go badly for a company, there is often no chance of getting out. “We understand liquidity is not a constant,” says Friedrich. “When the going is good, there is liquidity, but good luck trying to sell when things go bad. The reality is not every investment turns out well and sometimes the best thing is to sell.”
The past few years have been tough and SA Inc has been under pressure for good reason. “The political backdrop has not been supportive of South African companies,” says Van Cuyck. “Whether this will last forever is unlikely and a lot of negative news is already priced in. We are starting to see a lot more opportunities from a long term perspective in this market.
“It will only require small incremental changes to sentiment to see a significant change in returns purely because of relative valuations and because negative news is priced in.”
While small caps have recently showed negative returns, some, including those in the Denker portfolio, have generated exceptionally positive returns. “This includes Altron, a specific opportunity we identified, and where we engaged with management and Venture Capital Partners in an active approach to unlocking value.”
“But we have a distinctive investment approach which suits investors with a long term mindset, especially through tough cycles, where often opportunities present themselves.”
Brought to you by Denker Capital.