Contrarian value investing can be likened to sifting through a field of pebbles hoping to find that discarded nugget of gold. Sometimes you spend a long time looking and come up empty-handed, and sometimes the nuggets are plentiful. However, you can secure the richest pickings and save yourself all that effort if you find the goose that lays the golden egg.
Within equity markets, the golden goose is the stock that keeps on giving to the investor. This refers to investments that compound investor returns over long periods of time, making a significant contribution to portfolio returns. Often, golden geese are much more prevalent among the neglected, smaller listed companies than among the popular, blue chip large caps as there are structural reasons that these businesses are overlooked and mispriced by many market participants.
Opportunity exists outside of the Top 40
A well-diversified portfolio should invest across the size spectrum and not primarily in either small or mid caps or only the Top 40. There are several reasons why, including the fact that carefully selected smaller companies can provide a structural advantage to an equity portfolio.
A small group of names dominate the JSE indices and a handful of managers are responsible for the lion’s share of the South African asset management industry’s assets. As a result, the average South African equity portfolio is very heavily weighted to a small number of mega-cap shares. It is very difficult for a large manager to extract value for their clients by investing outside of the Top 40, because their funds are too big. For example, a manager that has R200 billion invested in South African equities can only invest in 26 companies on the JSE, assuming that they want the stock to make up 2% of their portfolio and would prefer to own no more than 10% of the company – and this is before allowing for the free float in a share. As a result, the true investment universe under these criteria is even smaller.
The focus on large companies makes the mispricing of smaller companies more likely. The absence of size constraints when coupled with an ability to select investments from outside the Top 40 presents a significant competitive advantage for domestic equity managers.
Due to the overwhelming focus on large caps on the JSE, there is also very little research on smaller companies and many are neglected. In this environment, mispricing is more likely.
Smaller companies can offer significant compounding benefits
The real advantage that smaller companies can bring to a portfolio is that they can compound at high rates for long periods of time. The business may be operating in a fast-growing industry or could be enjoying rapid growth in market share, or both. Large-cap names are typically more mature businesses, often competing in more mature industries. As a result, medium-term growth rates will be more muted.
One feature of investments in smaller businesses is that they are less liquid. Share prices can therefore be prone to swings in investor sentiment between fear and greed. At times, liquidity can just about disappear, as it did in 2008.
This perception of risk is exacerbated by the fact that most smaller businesses on the JSE are heavily exposed to the domestic economy, which is susceptible to global economic sentiment, domestic politics and movements in the rand. The attraction for long-term investors is that this perception of risk results in material mispricing from time to time, which can be exploited.
For these reasons, it can be more difficult to get in and out of smaller stocks and they can be prone to large price moves. This is why you need to do your homework; perform a detailed assessment of the inherent quality of the business, and patiently wait for mispricing to be corrected and compounding to work its magic.
The quality of management is very important when investing in less liquid stocks. A smart investor only invests in businesses with strong management teams that have a track record of looking after minority shareholders.
Divergences in stock valuations present risk and opportunity
For some time, the stock market has been characterised by a significant difference in valuation between stocks that are perceived to be of a high quality and stocks that are more cyclical in nature. In the case of the former, investors are focusing on a positive narrative and are extrapolating past experience, paying very little attention to the price paid.
For example, there is currently strong demand for private education groups and food producers. Investors will be hoping that the companies deliver on the very lofty expectations that are built into their share prices.
This leaves the out-of-favour domestic companies off their radar. These companies are exposed to the tougher parts of the economy and have a greater chance of being mispriced. Examples include Super Group, Tongaat and Hudaco. Buying good businesses cheaply when earnings are depressed can be a great recipe for excellent long-term returns.
Shaun le Roux is fund manager at PSG Asset Management.
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