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The cheapest equity sector in the world

The only catch? Risk.
In the Alpha Wealth Prime Small & Mid Cap (AWSM) fund’s May newsletter (read a full copy here), I unpack some basic global equity market valuations and arrive at the conclusion that the South African small cap sector is among the cheapest of all equity sectors out there, including the other small cap equity sectors.

My methodology is simple: I use all major indices pulled from Bloomberg and specifically include other major small cap indices to control for the “size discount”. Then I go and use a range of valuation relative metrics so that we can control for geographic, tax, accounting, gearing and other variables that make indices difficult to compare.

And, except for the Italian Index (FTSE MIB), which is trading cheaply for a very good reason (I wouldn’t want to own it!), South African small and mid caps are the cheapest equity sector in the world. And this is true based on pretty much any measure.

The three major measures:

There’s a chance that South African small caps are always cheaper than these other indices. Could it be that our risks justify our valuations at such discounted levels?

To control for this risk, I have indexed and plotted the JSE Small Cap Index’s Price-to-Book (PB) ratio against that of the MSCI World Index and the FTSE Global Small Cap Index’s PBs. The former is to check against all equity markets while the latter is to check against the “size discount”.

Once again, our South African small cap market appears deeply discounted. While the rest of the world has been getting more expensive over the last two or three years, we have been getting progressively cheaper.

In fact, South African small caps are almost as cheap as they were during the credit crisis. Unlike during the credit crisis, though, everything else is now quite expensive. Hence, South African small caps are pretty much the cheapest equity sector in the world right now.

Keith McLachlan is a small- and mid-cap fund manager.

This article was originally published on smallcaps.co.za here

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Analysis aside , reality is that any small cap business in SA is very risky , because our market is small and big business simply swamp small companies , by diversifying into any new development opportunity that arises . Economy of scale is essential to be able to survive setbacks , and small cap companies , simply do not have access to enough capital to effectively compete ,with conglomerates . We need more intervention from our competition authorities , to ensure greater competition , by preventing a handfull of large cap companies controlling nearly all business sectors .

More intervention from the Competition Authorities? You mean that bullying, grossly overstaffed communist-collective 1950’s ideological swamp exclusively populated by deployed cadres who have no understanding of math, statistics or basic commercial principles? Perhaps you should reconsider your proposed solution to an admittedly real problem.

Competition “authorities” in SA is just a tax collection agency with little value that does a great deal of damage.

Just a multiple of earnings – this doesn’t mean the share prices are moving up/down or sideways, just that you pay little for the earnings you’re getting. I would guess their earnings have been going backwards hence the multiples are reducing? Even so, it means the multiples are moving faster than the earnings and there is possibly value there.

A stock is only cheap(in the eyes of equity investors) if these multiples are comparatively low but its Return on Equity exceeds its cost of equity i.e. it is generating excess returns. These prices may in fact truly reflect the state of the sector. You are drawing a conclusion based on incomplete analysis.

I agree. Cheap does not mean value.

indeed! Value exists only if there is mispricing and EOH is very very badly mispriced at the moment. single digit PE, double digit Revenue growth and double digit RoE.

cheap can get cheaper . small business faces many challenges becuse this govt seems to continually invent more red tape and when they are the client they do’nt pay.
small bus. should stay away from govt. contracts

By the way Keith, is it just a coincidence that you work for smallcaps.co.za and this also happens to be the sector you advocate for people to invest in because it is cheap?

yes – but the article was probably published there and then replicated for Moneyweb. Can’t begrudge someone their opinion because they work there / talking their own book.

It would be interesting to see this analysis but looking at a few common industry sectors. So how does a small-mid JSE pharma company compare, etc

If there is one true once-in-a-lifetime opportunity here, it is Finbond. The Finbond is another Capitec. It is merely a matter of time.

Sure thing eh?

Looks more like a Steinhoff to me.

more like an African bank

Keith – great article EXCEPT – you cannot decide something is cheap without looking at their growth over time.
For instance in the bottom graph – you need the Book growth over that time period for all those indices. If SA companies book or earnings or sales growth has been negative for the past 10 years and other indices are positive – well that would explain a lot – would it not ?

Whilst money flows freely to the disadvantaged made from our taxes through IDC leaving others prejudiced.

There is also the issue of trust and reliability. Unions and strikes are not helping either and the damage to private property. So until the government says enough is enough and gets on with making South Africa a better place for all, the hand outs will continue at the expense of growth and happy workers who cannot find jobs because of over regulation. How does one deal with an employee who kicks you in the butt demands more money and then expects the employer to control his staff.

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