Finding the value in small caps

It takes time, say the fund managers.

Small cap companies hold a particular fascination for investors. On the one hand there is research (quoted here) that suggests that small caps tend to outperform large companies. On the other there is the argument that the sector is inherently risky and the chances of major losses are greater than normal.

There is an element of truth in both those statements.

“If you look at risk as a standard deviation around a mean, then small caps would be defined as less risky,” says Alistair Lea who runs Coronation’s Smaller Companies Fund with Siphamandla Shozi. “However, if your definition of risk is the chance that one of the companies may go bust, then yes it’s more risky.”

The reason investors pay up for blue chips is the relative security they offer. If you put your money in a blue chip and return to it in 10 years, the company will most probably be around. Investments in small caps require much more work. “If you do not track companies, do your homework and actively manage your investments, you may find that their fortunes have changed without you noticing. Investors need to be aware of the risk of permanent capital loss,” says Keith McLachlan, who runs the AlphaWealth Prime Small & Mid Cap Fund.

“Smaller companies tend to have less access to capital, and more susceptibility to liquidity challenges, hence the risk of business failure is greater.”

For this reason the sector can pose more risk for the average retail investor – the risk of picking an Ellies, which has fallen from R9.90 to 70c, or Chemspec, which is in liquidation, is far greater.

In South Africa the small cap universe is dominated by industrials – companies that are operating at the coal face of the weak economy. Inevitably this is taking its toll, but there are many companies in the index that are surprisingly resilient.

It may be difficult for a company like SAB or Shoprite to grow market share but a small company that is well diversified or in a clever niche can be more nimble and can prosper in a stagnant economy, says Lea. For instance AdvTech occupies a great niche in the education space, while Consolidated Infrastructure Ltd, which is heavily exposed to the mining and construction industries, has expanded horizontally and geographically and is more defensive as a result.

Two relatively recent acquisitions in the Coronation Small Cap Fund include Holdsport and Grand Parade. The former is the holding company for niche retailers Sportsmans Warehouse and Outdoor Warehouse. “This is an incredibly well managed and solid company,” says Lea. “South Africans love to shop and despite the economy this company is performing well.”

Grand Parade’s share price has not moved in the last few months, but Lea is happy to be patient. “We did very well out of Famous Brands and like the sector. We think their investment in Burger King will be worth a lot of money in five years. In addition they own a 10% stake in Spur, which we also like.”

Yet he is not as excited about Taste Holdings. “They have invested in big brands like Dominos and Starbucks, but we think they will have to pay lot of school fees to get everything up and running and the share is currently overvalued.”

McLachlan believes that many stocks on the small cap index are in fact quite high quality companies. “There is evidence of survivor bias, which careful stock selection can profit out of. Examples of these are the companies that preserved capital ahead of the credit crisis, enhanced their efficiencies and kept their operations lean,” he says. “Post the crisis they have used their capital to make smart acquisitions and grew their businesses while others were struggling.”

A poster child to surviving the crisis and growing beyond it is Afrimat, an open pit mining company that supplies industrial and construction materials. “All credit to management. They have conserved capital allowing them to identify new opportunities at good multiples and move decisively on them,” he says.

Many of these survivors — and their latter strategies — are contributing to an emerging trend on the index. Five to ten years ago the small cap sector was dominated by companies that were wholly exposed to the domestic economy. This is changing as companies expand beyond South Africa’s borders. “This means there is a group of smaller companies that are slowly but surely decoupling from the economy.” An example is Santova, a non-asset based supply chain manager that now earns over half its profits from outside of South Africa, with more likely to come down the line, he says.

Interesting as that may be, these companies are not necessarily cheap. Since 2005 the forward PE for the Coronation Small Cap Fund has been between 6x and 12x. “Today we are on 12x, which is expensive territory. Couple that with a poor economic environment and one cannot see good earnings coming out of South African industrial companies,” says Lea.

This means to generate return it is necessary to take selective risk. “In this expensive market, you need to take selective risk in order to generate returns. While we hold solid performers like Capevin, AdvTech and Truworths we also have a risk budget in the portfolio for stocks such as Bell, Aveng and Murray and Roberts.”

Which just goes to show, in the small cap sector you don’t back the index. It’s a stock pickers market.

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