The small-cap sector, a really tough place to pick winners

‘Capitec is a good example of an excellent investment – bought for all the right reasons, held for the right reasons, and then sold because of a technicality’: Keith McLachlan of Integral Asset Management.

RYK VAN NIEKERK: Welcome to this week’s addition of the Be a Better Investor podcast. It’s the podcast where I pick the brains of some of the top professional investors in the country and we delve into their own personal investment approaches. We talk about the research process they follow to identify potential investments, we look at their best and worst investments ever, we peek into their own personal portfolios – the idea is to find those golden nuggets from their perspectives and experiences to assist amateur retail investors to become better investors.

My guest today is Keith McLachlan. Now, officially he is the investment officer at Integral Asset Management, but he also wears and has worn several other well-known hats. The most definitive one is probably his status as one of the best small-cap analysts in the country. He has run and managed several small-cap funds. He also has a blog, smallcaps.co.za, where he writes about small caps and he shares his views about the prospects of many companies. All his views thereof are listed in Joburg, as well as in the rest of the world.

Keith, welcome to the show. I really appreciate your time. Let’s just start off – where did your fascination with small caps come from?

KEITH McLACHLAN: That has to go back some time. I’ve always been interested in the stock market. I started investing in the first year of varsity with my scholarship money, but that’s a whole other story.

Through the process of making and losing money when studying finance and ultimately becoming a CA and the like, I realised that I both enjoyed and was good at fundamentally researching companies, and ultimately, coming through that process, hand-picking stocks to invest in.

Now a natural progression then is to drift to the part of the market that rewards that the most, and the part of the market where primary research is the least done. The most amount of alpha that can be generated is in the small and mid-cap space, thus it became a natural progression to move in that direction and generate the maximum amount of return in my time as a researcher, and ultimately hopefully generate the maximum return as an investor.

RYK VAN NIEKERK: Yeah, that’s the theory, but the small-cap sector has really lagged for probably a decade now. It’s been a really a tough sector to go and pick the winners. So take us through your process. How do you look at small caps and how do you separate the winners from the losers?

KEITH McLACHLAN: Actually, the way you look at small caps is the way I think you should look at any company, so this answer works for large caps as well. But intrinsically, as an investor, I think we should buy good companies and try to pay good prices for them. Now that’s a bit of a vague expression, because what is a good company and what is a good price?

What makes a good company isn’t rocket science; it’s all the classic attributes of quality.

You want a highly profitable business with good barriers to entry to the industry, good competitive advantage against its peers, hopefully differentiating itself in such a way that it almost has no direct competitors, a large investible market, highly profitable, [with] great returns on capital, great margins, and being well managed by a good management team that is aligned with shareholders, and so on.

None of these things I’m saying should rock the boat. They’re all pretty logic[al] and, honestly, quite boring but fundamentally important.

What gets a little bit more esoteric is when we consider what a good price is.

Now I think value without quality is a trap, but quality without growth is an illusion.

What I mean by that is looking at a company and going ‘Gosh, that’s a very low price-earnings [ratio]’ isn’t good enough – or a ‘low price-to-book [ratio]’ or a ‘low valuation’ – that isn’t good enough to necessarily buy that [stock]. You’ve got to make sure that the underlyings have to hang around, that the underlyings can survive and be good. So you need that underpin of quality.

What I think is that growth is one of the attributes of a quality business. Without growth it’s not actually quality. Why isn’t it growing? There’s a problem there. And therefore you’ve got to find a combination of all these attributes. That starts to become a very defendable investment into a company, irrespective of whether it’s large or small.

RYK VAN NIEKERK: It’s interesting that most professional investors I talk to have a similar approach, a really fundamental financial analysis, and then maybe a macro analysis of where this company is going – are the arrows pointing upwards, is there growth on the horizon?

But in your funds, typically, what is your hit ratio?

How many companies actually achieve the potential you see when you buy the share? How many winners do you pick in relation to the total number of shares in the portfolio?

KEITH McLACHLAN: It honestly depends which portfolios and mandates you are looking at because we, for example, have some much more defensive broader and well-diversified ones. Then we have far more concentrated ones. I run, for example, a small and mid-cap mandate as well, and we run some large caps offshore.

Ryk, it’s a good question, but that’s a hard question to answer because at Integral Asset Management, as in my PA account [personal account], in my personal capacity, we are running portfolios that are crafted for different investors.

What I would say is that if you are looking on the lower end of the market and the riskier portfolios, what you are doing is you are looking at a flatter normal distribution curve in terms of returns. What I mean by that is that you tend to have ‘fat tails’. So your winners will be huge winners, your losers will be terrible, and a little bit of the portfolio will just basically track the market.

Now luckily, with your losers, you hope to identify them quickly and get out.

Because you don’t use gearing you don’t lose a hundred percent there, or more than a hundred percent, and hopefully you get out long before you’ve lost anywhere near to a hundred percent.

But your winners you can let run. And by that you cannot just offset your losers, but you can create alpha on those. That’s really where you get your multi-baggers that generate huge returns.

Now, the more defensive the portfolio, and the more diversified, the smaller those fat tails will be and the closer in the clustering into the normal distribution curve, you’ll tend to have the higher, the bolt-shaped curve.

That’s a long way of answering that it depends on the portfolio. I do think that in investing – not just stock picking, but managing portfolios – everyone focuses on the returns; not enough people focus on the risk. This is actually ultimately a risk-management process.

So I’m less concerned on the winner-to-loser ratio irrespective of the mandate and the portfolio, and more concerned on the risk-adjusted return and the ultimate total return-generating at a portfolio level. And there I’m quite comfortable we’ll consistently do well.

RYK VAN NIEKERK: That’s a good point. Let’s talk about your investment career. You said earlier you bought your first share when you were at varsity. Tell us what the very first share you bought was, and why you bought it.

KEITH McLACHLAN: [Laughing] This is a terribly embarrassing question. First year of varsity, knowing nothing, and I’ve always been a strong proponent of learning by doing – by all means read and research and understand what you’re doing to the best of your ability – but some lessons can only be learned through experience.

So when I started at varsity, in the first year I was quite lucky. We had a dean’s scholarship, which is really a discretionary payment; it’s supposed to cover your studies. But my father was a professor at varsity, so I was doubly blessed by not having to pay tuition and student fees.

So I took half of that scholarship and I put it into the stock market with the view to let[ting] me figure out how the stock market thing works. And then in the background I was obviously studying and going on with my life.

The first share I bought was a company called Zaptronics.

RYK VAN NIEKERK: I remember that.

KEITH McLACHLAN: It [was not] listed. It is a terrible stock, and my rationale, because even though it sounds fancy to be trading your scholarship money, that actually was not a large amount of money at all.

So my rationale, however deeply flawed and hugely embarrassing, was because it was a penny stock – and therefore it was cheap.

It was trading at a few cents a share, and if went up a few cents a share, I could make money. Now there’s a lot of lessons [there].

Funnily enough, I did actually make money on that first investment, but that was despite myself, not because of myself. There are so many lessons in that. First of all, the share price does not tell you whether a company’s cheap or not; the valuation does. And in order to arrive at the valuation, you’ve actually got to understand a business. I had no clue what Zaptronics was doing, so it was a terrible first investment, irrespective of having made money.

RYK VAN NIEKERK: Zaptronics was one of many IT listings during the late nineties boom; all the technology stocks rushed to the JSE and most of them disappeared from the JSE after the dotcom bubble burst. An interesting company, nonetheless. What would you regard as your best-ever investment?

KEITH McLACHLAN: That is a good question. In the small-cap fund that I used to run we held Capitec from the beginning. That was an absolute multi-bagger and in fact, we would’ve carried on holding it, but it moved out of our mandate and moved into the Top 40. That’s a good example of an excellent investment, and bought for all the right reasons, held for the right reasons, and then sold because of a technicality.

In my personal account, one I still hold – and I think I’m going to get a couple more multi-bags out of it – is Santova. I think my average price in there must have been about R1 and it’s trading at about R6 now. That’s been a fantastic company. It has executed on strategy. It’s well run by a great and agile management team, and importantly it continues doing well – except the market hasn’t fully rewarded it. It’s still sitting on a low multiple. So that one, in fact, [we] carry on holding.

But there’s a range of other ones that have done well, from Datatec to Adapt IT, Calgro M3, Famous Brands; all of those have exited. Some of them exited a little bit later. I would’ve made more money if I’d exited, but [out of] all of them and the like of investments I did relatively well. But yeah, if I had to circle back to my two best, I would say Capitec and Santova – and Santova, I would argue, is not fully played out yet.

RYK VAN NIEKERK: And the biggest dog you ever bought?

KEITH McLACHLAN: [Laughing] I have actually got three there.

I’m not sure if you remember the AltX listing boom – that must have been around the early 2000s, into around the credit crisis and just after. There was a company that listed called Country Foods. What they did was they farmed and sold mushrooms, which has quite a high barrier to entry because you need some very specialised tubing to grow these mushrooms in. You can’t just plant them in a random field. So there’s a lot of IRP [integrated resource planning] and skill and capex that goes into it. I remember I bought Country Foods because I looked through their results. They were good. I looked at the valuation, it was extremely cheap, and a low price-earnings. I invested in that.

In between that set of results and their next set of results six months later, they went bankrupt – that’s how quickly it happened.

My mistake there was I wasn’t rigorous enough in terms of understanding cash flow, working capital and debt on the balance sheet, and that’s what really sunk them. So that’s a good example of a bad investment.

On the offshore side, I made an investment in Shaft Sinkers, which has got a long story behind it; it was a net asset value play and it was going to be binary – it was either going to come right, and I was getting multiples of my money because they were at such a fraction of their book value, or it was going to go wrong and I’d lose everything. I lost everything; it went wrong. So just because you’re taking a risk doesn’t mean you are going to be rewarded for it.

RYK VAN NIEKERK: You’re a CA, you can look at financial statements in a very detailed way, and you have lots of experience in that process. But many retail investors, amateur investors, are not CAs. They don’t have experience. They may base investment decisions on, like you said, Zaptronics. Sometimes you have a good experience with a company or you’re a big customer or client of the company, and you make investing decisions not as thoroughly financially researched as they should be. In your view what are the biggest mistakes retail investors make?

KEITH McLACHLAN: That is confusing price with value. I think that’s a key mistake a lot of people make, confusing graphs and share prices with fundamentals as well.

Don’t forget now, we’re not talking trading, we are talking investing. If you are going to be a co-owner in the business, surely you would like that to be a good business?

So just because a share price has come down doesn’t make it cheap. And just because the share price has gone up, doesn’t make it a good company. Go and understand the business.

So I think the starting point is [that] everyone in the market focuses too much on the share price, and not enough on the fundamentals and valuations. Understand what you’re buying and understand why you are buying it. From that you can start to make rational decisions.

The second most common mistake I would say is not being sufficiently diversified.

I see a lot of people talking on Fintwit and the like, and people posting about their portfolios, and they have five stocks in their portfolio, or they have three stocks. By all means pick stocks – you’ve got to start somewhere. Don’t let the diversification or the lack thereof stop you from investing, but have a goal to arrive at a good diversified portfolio.

If you think about it this way, everything we are talking about, about buying good companies, not overpaying for them; buying and investing in them is already focusing on the upside.

But after you’ve invested and after you’ve bought and you’ve made those investments, everything else is risk management, and the cheapest, the most obvious, and still to this day for a long-only investor, the best risk management is diversification.

I don’t think people give it enough thought. They’ve become far too concentrated in their positions. They might be right, but all you need to be is wrong once with a highly concentrated portfolio and you’ll suffer a huge drawdown that might take years to recover from.

I think those are the two key lessons. To summarise, they are confusing price with fundamentals and valuation, and not being sufficiently diversified.

RYK VAN NIEKERK: Let’s talk about your personal investment portfolio. What is your goal there, number one, and number two, how often do you actually trade and take profits or limit losses?

KEITH McLACHLAN: My goal is to generate the maximum sustained return for the longest period possible. But more seriously, because that’s every investor’s goal, risk-adjusting.

But what I do on my personal account, my objective [is] to hold somewhere between 15 and 30 companies, all on the JSE and all around the world. My objective is trying to find good companies, excellent companies in fact, buy them at good to ridiculously cheap prices, and make sure I have the least amount of duplication possible in the portfolio. Therefore I have the most concentrated yet diversified portfolio objectively.

Perhaps a way to think about it is going around the world, including our JSE here, but all around the world I try to find the most unique companies possible and collect them.

I’m almost like a collector of unique companies.

So if you think of something like Richemont, Richemont is big, it’s possibly quite boring, it’s listed on the JSE – would you be able to rebuild a global luxury-branded business of that scale on planet earth anywhere, anytime soon? No. Many of these brands have [taken] literal decades of history to build their brands. You cannot replicate that, ignoring all the distribution and the fact that you’ve got a bulletproof balance sheet with huge piles of net cash, and all manner of routes to market, and you’ve got a perfectly aligned management team that are deeply invested in the success of it. You cannot replicate a Richemont overnight.

The same with Renergen on the local space – Renergen, with its unique methane and helium gas reserves, is absolutely globally unique. You cannot just replicate this business.

These are the sorts of businesses I look for that have sustained competitive advantages. I back the management teams, I like when my management teams are co-invested with me.

Then the final check is to make sure I don’t overpay for them – which I’m quite comfortable [that with] none of these I have. That’s how I go about constructing my personal account.

RYK VAN NIEKERK: I think the dream of every investor is also to buy excellent companies at rock-bottom prices. But give us two or three more of these examples, these companies you have found in South Africa and the rest of the world that actually adhere to those criteria.

KEITH McLACHLAN: Let’s start domestically. We can have a look at our PGM [platinum group metals] producers – Northam Platinum and Sibanye-Stillwater come to mind. They are the two that I hold because they absolutely dominate the PGM market, and especially if you have a view on the hydrogen economy and all the further loadings on the catalytic converters, no one can artificially make more PGMs, and there are no substitutes for them.

So these are absolutely unique companies that just happen to be South African and happen to be listed here. Especially with the tragedy playing out in Russia and Ukraine – Russia is the big competitor, and those exports are by all appearances blocked. So these are unique companies to accumulate.

I’ve touched on Santova – I’m not going to go into that some more.

Stor-Age is another one that’s quite unique. It’s a property company. Some people will consider it a little bit more boring, but it’s absolutely dominant, with its self-storage properties all over South Africa that are very visible, very branded. You cannot build a self-storage property that is pre-tenanted, and therefore the barriers to entry for financing, building and tenanting a self-storage property [and] getting to a point where it’s break-even, is quite large. Only extremely deep-pocketed players who know what they’re doing can do this.

Other than storage, in the South African market there aren’t any others. They’ve obviously been expanding and managing in the UK. Once again, management is strongly invested in their own company. They’ve got an internal manco [management committee], so [management is] deeply aligned. This is a classic example of a high-quality company [with] huge barriers to entry, and it’s trading at basically book value. It has a very attractive dividend yield. Why wouldn’t you want to own Stor-Age?

Going offshore, I own Levi Strauss. [They] just – overnight – published their results, and they’re shooting the lights out. Revenue is up. They’re doing fantastically. Their direct consumer is doing brilliantly. They’re generating cash.

A long time ago, well, it feels like a long time ago – [the era of former US president Donald] Trump actually wasn’t that long ago – but the trade war initiated by Trump forced a relook at the supply chain from Levi Strauss, such that they diversified their supply chain and they don’t have any more than 20% of their sourced product coming from any single geography. Therefore, when Covid hit, they were perfectly placed.

Also consider the fact that one in three people have gone up a pants size on planet Earth from lockdown. [Laughing] I hear you laughing there Ryk, but it’s true.

Combine that with the casualisation trends that we are seeing in the workforce – most people are wearing more jeans and less suits and ties.

All of this feeds into Levi Strauss, which is deeply internationalising their business building a direct-to-consumer [platform], and basically following Nike’s model. Nike has proved it works. Levi Strauss is the one jeans brand that is globally known. They don’t need to go and build their brand. Again, it’s an absolutely unique business. It’s over a hundred years old. It’s trading on about a 13 times multiple. Why wouldn’t you want to own something like that?

Offshore I also own Netflix. I own Pfizer. Garmin is another example. So these are all absolutely unique businesses – well-known, [with] undemanding valuations. Some people would argue with me about Netflix, but I’ve crunched the numbers. I disagree with them, and the way the industry is going, I think they’re going to do well.

RYK VAN NIEKERK: You’ve referred to several exciting companies. That’s the term you’ve used, but Levi Strauss make jeans; Stor-Age build garages in which you just put stuff and store it. They are not, business-model wise, exciting. Are you referring to just valuation-wise exciting?

KEITH McLACHLAN: I disagree. First of all, the valuation is exciting. Generating a very high investment return I consider as exciting. But I think their business models are exciting because, at first glance, most of the market’s eyes will glaze over and not look at them.

When you dig deeper, what you don’t realise is the number of levers that these management teams can pull to generate growth within their businesses, and that is exciting. It’s hard to replicate.

So let’s go domestic. You touched on Store-Age as basically building garages for people to store their private goods. That’s not their business model. That’s a misinterpretation of their business model.

What they have is the ability to build – with deep convenience in very central locations that are highly visible first-world – properties that you can arrive at virtually. So before you even jump in your car, you’ve decided to go to a Stor-Age facility because it’s first in your mind, pops up in your Facebook feed and, when you Google it, it turns up there. That’s not a coincidence. They’ve got an internal marketing team that is one of the largest spenders on Facebook and Google ads, and who leverage this even in the UK. Then finally, when you turn up at one of their properties, the leasing out and the dropping off of your goods is absolutely slick. Yet, could you replicate this managing thousands upon thousands of individual leases? That’s very hard to replicate. How would you manage that?

So I disagree with you. I think when you dig into these companies, they actually have exciting business models. They’re extremely hard to replicate and therefore they have pricing power if they managed to keep growing their top line.

RYK VAN NIEKERK: Keith, we’ll have to leave it there. Thanks for your participation. I can hear the passion, and I think that is also a key element. You need to have the passion to go and find these companies. As you say, I think it’s a boring property storage company, but in fact it’s a lot more than that. Just that marketing model seems to be very, very innovative.

But thanks for your time today, and hopefully we’ll speak in a year or two, or maybe even sooner, just to see how these companies have performed.

KEITH McLACHLAN: Thanks Ryk, always great chatting.

RYK VAN NIEKERK: That was Keith McLachlan. He is the investment officer at Integral Asset Management, and he’s also one of the top small-cap analysts in the country.

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“Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality. One is capable of unwittingly playing Russian roulette – and calling it by some alternative “low risk” game.”
― Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets

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