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Small cap picks in a rocky environment

If you can ignore the noise, you’ll do well in the next 3 to 5 years buying these companies – Charl Botha.
Master Drilling recently unveiled horizontal boring technology at the Mining Indaba.

WARREN THOMPSON: Welcome to this week’s edition of Click an Advisor, joining me on the show today is Charl Botha, he is from Futurewealth Portfolio Management and, as opposed to being an advisor, he is actually more of a portfolio manager. Good to have you with us, Charl.

CHARL BOTHA: Thanks, Warren, thanks for having me.

WARREN THOMPSON: Just tell us a little bit about your business, you are actually running what we call segregated accounts for small caps, investing in small caps, is that right?

CHARL BOTHA: Yes that’s right. I don’t have my own financial license, so I’m actually on the FSP license of a company called Lentus Asset Management and they do all my back office and so on. So I get time to read and research shares and I design the Futurewealth portfolio, which gets replicated for each person who joins the portfolio.

WARREN THOMPSON: Okay, so tell us a little bit about some of the metrics around what you invest in, you’re investing in small caps, give us an [idea] of the size and amount of the stocks that you run in this model portfolio, the size in terms of the market cap of the companies involved.

CHARL BOTHA: First of all, I am size and style agnostic but most of the stocks in the portfolio are small cap, what you would traditionally call small cap. The reason for that is mathematical, I see that small companies can grow faster and become bigger than the equivalent big caps and also there is much more room for growth for them to become ten-baggers or five-baggers. So the market caps that you would see in my fund range from about R300 million to R4 billion but I also have Steinhoff in the portfolio, which is obviously a very large cap.

WARREN THOMPSON: What is the criteria for including a stock in your model portfolio?

CHARL BOTHA: The first thing I look at is I want to see topline growth, so I want to see people demanding the services or goods of this company, and topline growth that’s faster than inflation, in other words real growth faster than the economy.

WARREN THOMPSON: So their revenue has got to grow faster than our inflation?

CHARL BOTHA: Yes plus our real growth. So our real growth is quite low now but let’s say South Africa’s potential GDP is around 2% or 3%, add inflation of 6% to that – I’m looking for a company that can grow revenues faster than 10%. Also, it doesn’t help to just grow revenues and using massive amounts of assets to do that, I’m looking at how efficiently or effectively the company can use its assets. So return on capital, which you can define in various ways but let’s say return on equity or return on capital employed or return on invested capital, those types of things. So those are the two most important metrics I use. Then I also like to look at the stability of the margins and then I try to understand how the company makes money, which is very important.

Futurewealth’s model portfolio  

WARREN THOMPSON: How many businesses are in your model portfolio at the moment, how many different stocks?

CHARL BOTHA: At the moment I only have eight, so my take on portfolio management is, like Warren Buffett says, I don’t want a zoo, I don’t have time to understand 70 or 80 businesses. So I’ve got fewer businesses, which I try to follow more closely, so more concentrated bets.

WARREN THOMPSON: How are they distributed in the portfolio? Do they come in at a fairly standard size or do they come in small and you build them up in terms of the percentage size in the portfolio?

CHARL BOTHA: Yes, so if something can’t be around 4% in my portfolio I don’t include it. It must at least be a 4% bet for me. If I really, really like something and I’m really sure about the metrics and the price I pay it could go as high as even 20%, which is quite abnormal in the professional money management business but that’s the way I go about it.

WARREN THOMPSON: Is anyone at 20% or greater at the moment?

CHARL BOTHA: Yes, Rolfes Chemicals and Master Drilling, two companies I have written about on Moneyweb, these are two businesses that I think still have a lot of legs. I like the management and I like the metrics.

The funny thing is a lot of people say to me that small caps are quite risky, so why don’t you invest in the so-called blue chips or Top 40 shares and I would say the following, I think Rolfes, for instance, is a lot less risky than something like Kumba or Anglo Plats because they have single commodities and are exposed to the vagaries of these international commodity prices, whereas Rolfes has got four different businesses and hundreds of different clients in different sectors of the chemical market.

Rolfes is a speciality chemicals company, so they’ve got food chemicals, industrial chemicals, agricultural chemicals and water chemicals. For each one of those they don’t only sell in South Africa, they also sell in Africa, the United States, Europe and none of these guys make up a significant percentage of the revenue. For instance, if one big client drops out that’s not a problem, whereas with Kumba if some people in China slow down on steel we’ve seen what happens.

WARREN THOMPSON: You’re thinking about risk in quite a different way…

CHARL BOTHA: Yes.

WARREN THOMPSON: If I’ve understood you correctly, you’ve made reference to the margin, making sure that margins in a business stay stable, as well as growth. So for that reason when I asked you off-air if you’re more a value investor or a growth investor, for those people who have read Peter Lynch’s books, you’re using quite a different set of metrics or an opposing set of metrics, one would say, when you try and pigeonhole the style of the investing.

PEG ratio defined

CHARL BOTHA: It’s very interesting that you mention Peter Lynch because I’ve learnt a lot from him and I really recommend his books to all our listeners. I don’t like pigeonholing from above, so to speak, so what I would say is try and buy a growth company at a value price, so that’s the Holy Grail for me. If I can get a company that grows double digits and I can buy it on a single PE – one must be careful if you’re using one metric – but that’s just an example. So if I can do that then I’m very happy.

I don’t just want to buy something that’s not going anywhere for a very good price, I want to buy something that grows at a good price.

WARREN THOMPSON: If I remember correctly, Peter Lynch uses something called the PEG ratio, perhaps you can explain that for investors, for the uninitiated, what the PEG ratio is because it’s quite a nice way and quite a quick rule of thumb to see whether it would fit what you’re talking about with companies that are growing faster than what their price indicates.

CHARL BOTHA: The PEG ratio is quite simple, so you take the PE, the price-earnings ratio, so let’s say the PE of a business is ten and you’ll see that in the newspaper or on Moneyweb and so on, and then you take the growth rate in earnings, the bottom line earnings, so profit after tax, and that will be a certain growth rate. So I like taking it over a five-year period so that evens out the cycles of the business and then if you take the PE on top, the numerator, and you divide the growth rate, the denominator, so let’s say it grows at 10%, the PE is at 10%, so that will give you a PEG of 1%. So if you find a business at less than 1% that’s a good thing.

WARREN THOMPSON: So let’s just do this as a very simple calculation, there’s a share price, a company earned earnings/share of R1 in the last financial year, the share price is at R10, so the PE ratio is R10, so we put that ten divided by what you think will be the…do you look back at what the historical…

CHARL BOTHA: So I look back first of all because that will give you a baseline, otherwise you are just plucking numbers from the air. So then I would say this business has managed over the past five years to grow at an average of, let’s say, 10% and then this year maybe I’ve spoken to management or I’ve read somewhere and I see it’s looking very good for this year, maybe they’re going to grow by 20%. So then you’ve got the 10% divided by the 20%, which is 0.5%, which is excellent. So anything under 1% is excellent.

I just want to mention one caveat with the PEG ratio and this is more technical but I think it’s very important, the PEG ratio is very good for this type of low price paid and good growth to find these companies but you must just check one other thing, you must check the level of return on capital. So the PEG ratio doesn’t take that into account. So the rule of thumb is ROEs above 15%, return on capital employed above 10%, rule of thumb that should be great, just check that.

WARREN THOMPSON: So you use that return on capital because obviously a business that injects more debt into its capital structure could grow faster but its returns on its capital might be lower because a return on capital assumes that you’re looking at something like a profit divided by the total capital employed in the business, which would include the equity and the debt.

CHARL BOTHA: Yes, you are right. So return on equity only includes the equity part, our part as shareholders and return on capital employed or return on invested capital is more what you’d call the weighted capital. So you’ll see if you read a technical article and in some of my articles I use something called the WAC, which is the weighted average cost of capital, so it very simply is just a mixture of the capital you use, the cost of that.

Investing in small caps: Challenges

WARREN THOMPSON: Just coming back, let’s just talk about the challenges of investing in small caps, there are a couple that are very obvious, like liquidity, being able to buy and sell the shares in the volume that you need them. Just take us through a couple of the challenges that you’ve identified when you invest in small caps in particular.

CHARL BOTHA: I’m fortunate or unfortunate; I know my fund is not that big, so I can move in and out of the shares I’m looking at quite comfortably. I think someone like Keith McLachlan would have a bit more of a problem with that because his fund is bigger. So that’s definitely a problem because if you wanted to buy a significant stake in one of these companies you can drive up the price if you are impatient.

What I’ve found with small caps, and this is just anecdotal, small caps tend to move around news flow events, so there might be many months where nothing happens to the share price and retail investors can maybe get a little bit impatient and sell out because it’s not exciting enough. So small caps move around news flow events, one must be patient… you need patience in shares but you need even more patience in small caps.

WARREN THOMPSON: When you say news flow what exactly are you referring to there?

CHARL BOTHA: That will be interim results, six-monthly results or 12-monthly results, trading statements. Also, let’s say, new technology that the business has developed, for instance like Master Drilling recently unveiling horizontal boring technology at the Mining Indaba, which is a big deal since they have only been able to drill vertically for clients up to this stage, so horizontal technology is a big deal for them.

WARREN THOMPSON: That’s a very interesting company as well because another thing and it’s becoming more and more of a legacy idea around small caps is that they are usually very domestically focused, in other words they have a big exposure to the South African economy and very little revenue and profits coming from offshore, how do you see that at the moment?

CHARL BOTHA: Yes that’s a good point you raise and you’ll be surprised how much money these smaller companies make overseas. For instance, Master Drilling’s financial reporting is actually done in dollars because most of their money is made in dollars, their contracts are in dollars. So they are very big in South America, they’re very big in the rest of Africa, they’re also moving into the United States and Mexico. They’ve got a presence in South Africa, it’s not insignificant but it’s smaller than their foreign exposure. The same with another company I like, Santova, Consolidated Infrastructure Group, recently I think it’s 60% revenue outside South Africa.

WARREN THOMPSON: That much?

CHARL BOTHA: Yes. You think of the classic rand hedges that everyone talks about, British American Tobacco, SABMiller but you actually get rand hedges in the smaller companies as well, so people mustn’t forget that.

Governance in small caps

WARREN THOMPSON: Just take us through a little bit about the governance, obviously the fact that many companies are small cap would suggest that there might be the presence of the entrepreneur or the founder in that business, when these entrepreneurs start undertaking to move their company to a public format where they list on the JSE, for instance, how do they undertake governance because it’s quite a different animal when you’re an entrepreneur running your private business you are basically like a dictator, you make all the decisions, you do what you want. When you become a public company it imposes responsibilities and standards and conditions on them around how the board is formulated and how the business is governed. How are these small businesses doing in that respect?

CHARL BOTHA: It’s a good point you raise and as investors we stand outside the company, so I’m not in a board meeting and things like that, so one obviously has an informational disadvantage but what I try and do is I want to see how the board is composed. So, for instance, an ex-businessman and people who are respected in the industry, I like to see that the board is not just a bunch of well-known names but that the entrepreneur or their family has actually picked the board well, so people who can help them to professionalise the business.

I’ll give you an example, in 2015 Rolfes bought a food chemicals company called Bragan and Bragan has been a real game changer to them. They bought Bragan from Craig and Julie Taylor for R213 million and Craig and his wife stayed on. The CEO of Rolfes, Lizette Lynch, told me that the company was great but they had to professionalise some of the reporting systems and some of the structures within the business to be able to be able to take it to the next level. There’s nothing wrong with the business but just to bring it into a listed environment and to grow it, they needed to add one or two managers and they needed to up their reporting.

So the composition of the board and to trace the history of the company a little bit, just see who the guys are and speak to people in the industry that’s what I do.

WARREN THOMPSON: Basically it’s businesses where the operator doesn’t have any big financial incentives, so there’s no skin in the game.

CHARL BOTHA: Yes, there’s no skin in the game. It’s a difficult question to answer because I’ve done it a lot and I know when I see it but it’s difficult to describe to you exactly what I see. Maybe the way he writes the reports, the sort of information he adds, the sort of style he speaks with when he’s doing interviews, the things you hear about him from other people and from that you try and create a mosaic of the management team.

Obviously you can be wrong and that’s why you can make mistakes with people and I recently did make a mistake with a company that’s been in the news regarding the grants payments, so you do make mistakes. But you try as best you can to build a circumstantial evidence case for these guys are good managers, they take care of shareholders and these guys aren’t, and so on.

Consolidated Infrastructure Group

WARREN THOMPSON: You’ve mentioned Master Drilling, they’ve done that horizontal raised boring, Consolidated Infrastructure Group, tell us a little bit about that business, the last I had heard they had bought a business in Angola, an oil services business, I think they were servicing the oilrigs off the coast of Luanda, what attracts you to CIG at the moment?

CHARL BOTHA: I am quite active on Twitter and there’s Keith McLachlan and Anthony Clark, listeners will know them well, I follow them and we speak quite a bit on Twitter and they have liked this company for quite a while. As people know, Anthony has always got his top five every year and he’s included Consolidated Infrastructure Group in the top five for quite a while. I was a little bit sceptical of it because it’s a projects-based business and because you’re a projects-based business you’ve got lumpy revenue and lumpy earnings.

In Africa, as we all know, getting paid is one of the bigger risks you have. Even though the business had great metrics (on my revenue metric it did very well) it requires quite a bit of cash flow to finance these projects. I took a more in-depth look, especially after they bought a business called Conlog last year. So you were talking about AES, the oil services business, it’s a fantastic business; they service all the oil majors, the waste products from the oil drilling business. But coming back to Conlog, it’s a different sort of business from the rest of their portfolio, Conlog is a much more capital-light, non-projects-based business, so it’s highly cash generative. That changed the profile of the bigger group for me and de-risked the business quite a bit and I recently wrote an article on Moneyweb about that. I think that’s a fantastic business with a lot of topline opportunity for growth, given Africa’s lag in power and other infrastructure spend.

WARREN THOMPSON: One last question, we’ve obviously had a very rocky two weeks in South Africa from a political side of things, how have small caps behaved in that period and how do you see the valuations on some of these companies on the JSE, has the market presented you with more buying opportunities or less since Pravin Gordhan was recalled from London?

CHARL BOTHA: I’m like a kid in a candy store at the moment, there are lots of opportunities now. The valuations on some of the stocks I’ve mentioned, Rolfes, Santova, Adapt IT we haven’t spoken about, Consolidated Infrastructure Group, if you can ignore the noise around the political sphere and so on I think you will do very well in the next three to five years buying these companies.

WARREN THOMPSON: That was Charl Botha, portfolio manager with Futurewealth Portfolio Management.

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“opposed to being an advisor, he is actually more of a portfolio manager” – then be a portfolio manager. I am not questioning his skill set, but you can’t wear both hats whilst sitting in front of a client.

The following companies were/are all small caps Tiger Wheels, Alert Steel, Wearne, Nando’s, Taste, Nutrition, Conlog, Venter Trailers, and a host of others too many to mention. The reality is no matter how you cut, slice and dice your numbers at the end of the day it is the management that ultimately counts. If they are the get rich quick crowd, or the smoke and mirrors brigade, then matter thee amount of financial dissecting these whizz bangs do they will be wrong. To my mind there is a simple routine to follow – who are the directors, what’s their history, have they been successful elsewhere, are they connected (not the Zuma783 type connections) what’s their level of education, and is their company in a niche segment and who are their peer and what have their performances been like latterly. When seeking advice suss out many advisors and then visit a witch doctor

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