An investor looking at the JSE today is really looking at two distinct markets. There are the large-cap stocks, which are generally multinational companies that earn the majority of their revenues outside of the country, and the mid and small caps that are predominantly dependent on the South African economy.
In recent years the performance of these two groups has diverged materially. The large caps, led by Naspers, have risen to levels where valuations in many instances look stretched. The mid and small caps, however, look heavily undervalued.
A look at the performance of the Top 40, Mid Cap and Small Cap indices over the past five years illustrates the differences in their fortunes:
Source: Sanlam Investment Management
“The difference between the Top 40 and the Mid Cap index might not seem that huge over five years, but if you compound that 1.5% it becomes material,” says Vanessa van Vuuren, manager of the Sanlam Investment Management (SIM) Small Cap Fund. “Over the last year, and the year to date, it is very accentuated.”
It’s also important to note that, historically, the Mid Cap index has out-performed the Top 40 over meaningful time periods. A reversal of that long term trend is therefore significant.
The weak environment
The primary reason for this divergence is the state of the South African economy. The country’s GDP growth has been below 2.5% since 2014, and has not climbed higher than 1.5% since mid-2015.
“Small caps out-perform during periods of strong domestic GDP growth,” explains Adrian Clayton, the chief investment officer at Northstar Asset Management. “Large caps on the other hand do significantly better when South African GDP growth is stalling, the rand is weakening, and interest rates are rising.”
The environment over the last few years has very much been the latter. In 2017, Clayton points out, small and mid caps delivered their largest under-performance relative to large caps in 16 years.
When looking at the index performance, it’s also important to consider the constituent companies. As Van Vuuren points out, the deep collapse of the resource cycle in 2015 is reflected in those numbers.
“A lot of resource shares fell out of Top 40 in that period and that has also been a drag on the relative performance,” she says. “This year, platinum and gold stocks have collapsed, and that is also having an influence.”
A third major impact, felt predominantly in the mid-cap sector this year, has been that there are some major under-performers with company-specific issues in this universe. Steinhoff, EOH, Resilient, Fortress and Greenbay are all mid caps.
What should be obvious from all of this is that the FTSE/JSE All Share Index (Alsi), is no longer telling us a complete story. Certainly over the last year it does not capture this tale of two markets.
“Large caps account for almost 85% of the total market weighting, as against mid caps at 10% and small caps, a little over 5%,” Clayton explains. “Naspers is 19.4% of the market, effectively four times the size of the small-cap index, which comprises 68 companies.”
Extending this further, the 10 largest companies on the JSE account for 58% of its market cap. The smallest 10 in the Alsi make up just 0.15%.
“This only tells one that large caps dominate the performance of the Alsi,” says Clayton. “It says nothing about generating returns for investors. The distorted sizes of stocks on the JSE is an enormous opportunity for investors and active managers. The JSE has a valuation distortion.”
The scale of the discount
Westbrooke Alternative Asset Management recently conducted extensive research on just how big this distortion has become. The company analysed 130 small- and mid-cap stocks with market caps of between R100 million and R10 billion, excluding only resource counters.
What it found is that this universe is trading at a discount to historical valuations. This was most pronounced among the smallest companies.
“The companies offering the most value are select operating companies below R2 billion in market cap,” says Jarred Winer, manager of the Westbrooke Capital Management Special Opportunities Fund. “Those have suffered from the most significant de-rating.”
Westbrooke found that the price-to-earnings multiples of this group has de-rated by 10% to 7.9 times since March 2017. This is also a 22% discount to the five-year average of 10.1 times. Measured on an enterprise-value-to-Ebitda basis, these companies are currently valued at a 16% discount to their five-year average at a 4.4 times multiple.
“This is a significant discount to the valuation multiples of comparable private equity transactions,” notes Winer.
Source: Westbrooke WSO Research Project (WSO refers to the Wall Street Oasis online community)
Investment holding companies below R10 billion also offer a compelling discounted opportunity. Westbrooke’s analysis shows that this group is currently trading at a 33% discount to intrinsic net asset value (NAV). Four years ago, the average discount was 10%, while in 2014 the universe traded at a premium to intrinsic NAV.
Unlocking the value
The obvious question this poses for investors is how does this value unlock? Clayton believes the first necessary condition is that government successfully address corruption.
“Unless we sort out corruption, which is crucial to revitalising the economy, the cost of funding will be higher than it should be in South Africa as a whole,” he says. “High funding costs are negative for small companies. Corruption also displaces investments that are supposed to be directed at specific outcomes, which prevents the private sector from winning work. This is all a negative spiral for a budding ‘junior’ economy.”
Critically, this must be accompanied by renewed economic growth.
“What will lead to a re-rating and flows back into the sector is economic growth and improved sentiment,” says Winer. “Along with that, we have seen the start of corporate activity in the sector. The discounted valuations should lead to increasing corporate activity in the medium term, which will lead to the wider market taking notice of the small- to mid-cap sector.”
Encouragingly, Van Vuuren believes the signs of this happening are already there.
“All the right things are being put in place,” she says. “Government is starting to root out corruption, it is fixing state-owned enterprises, and President Ramaphosa has gotten rid of some under-performing ministers. These are all the right steps for our complex of stocks to be better positioned over the next three to five years. I think we are at a sort of cusp.”
Source: Westbrooke WSO Research Project
Caption: The chart illustrates the average percentage change in earnings before interest and taxes (Ebit) for changes in revenue. It indicates that in addition to the valuation multiples, earnings could be poised for a significant uptick in an improving operating environment where revenue growth resumes.
However, investors should not expect a turnaround in this sector to be quick.
“You have to have a stomach for volatility,” Van Vuuren warns. “It will be a rocky road before you see tangible changes on the ground within these companies and in the political framework.”
Investors also have to be aware that we are already very late in the current market cycle, and there probably isn’t much life left in the current bull market. If there was to be a major market correction, small and mid caps would, as always, be the hardest hit.
“Large-cap stocks are not cheap,” says Van Vuuren. “If we experienced a broad-based sell-off, exacerbated by emerging market outflows, that contagion would spread.
“While not necessarily justified, given their attractive relative valuations at this point, small and mid caps would be affected indiscriminately in a big run on our market,” she adds. “We would, however, just see that as an additional chance to pick up better quality small- and mid-cap stocks. It could be a one-in-10-year opportunity if that happens, but you would have to take the pain beforehand.”
For Winer, the opportunity for investors is compelling.
“Select small- to mid-caps stocks are offering an asymmetric return profile, because they have come down to really discounted levels,” he says. “If you get any pick-up in the economy and sentiment, you will benefit from a re-rating of the valuation multiple closer to where they have been in the past, and you will also benefit from a pick-up in earnings. You will win on both sides with, with limited downside from current valuation levels.”