After the last few months a growing number of South African analysts and fund managers have been highlighting what they see as a significant opportunity in the mid-cap sector on the JSE. They believe there is some serious value in this part of the market that is currently being ignored.
Mid caps have performed extremely poorly over the last two years, underperforming the Top 40 by a substantial margin. Mainly this is because most of the companies in the Mid Cap Index are South African-focused and sentiment towards them has been negative due to the poor state of the local economy.
This underperformance of mid-caps is however unusual. Over the last 20 years, the Mid Cap Index has delivered much higher returns than the Top 40 – 17.7% per annum, as opposed to 12.4%.
As the table below shows, this pattern held true for the most recent bull market between 2009 and 2014. For five of those six years mid caps outperformed the Top 40, with 2013 being the only exception. That was a year in which the Naspers share price doubled.
The last four years have, however, been quite different. It is only in 2016 that mid caps outperformed, and in two of the other years the index delivered a negative return.
This is also illustrated in the graph below, showing the relative performances of the Top 40, Mid Cap and Small Cap indices since October 2016.
This disconnect has been substantial, and for many market watchers it is creating some rare opportunities. As the share prices of many mid-cap stocks have stagnated or fallen, their valuations have become extremely attractive.
Reunert, for instance, is trading on a price-to-earnings (PE) multiple of around 10 times, and a dividend yield of 6.9%. Liberty Holdings is offering a forward PE of 7.3 times. Tsogo Sun’s PE ratio is currently a little over 10, and its dividend yield is 9.9%. Coronation’s dividend yield is also just under 10%. AECI is on a PE multiple of 9.2 times.
These are mouth-watering numbers for many fund managers. They include John Biccard, the long-time manager of the Investec Value Fund. Currently one third of the fund’s portfolio is held in South African small- and mid-cap shares.
“We think mid- and small-caps in South Africa are priced like South Africa is Zimbabwe, which is a debatable point,” Biccard told Moneyweb in a recent interview. “So we see lots of value there.”
David Lerche, senior investment analyst at Sanlam Private Wealth, wrote earlier this month that while the current state of the South African economy is negative for mid-caps, local businesses have shown incredible resilience in difficult periods in the past. There are therefore some quality companies in this segment of the market that are currently being overlooked.
“As the South African economy recovers over the coming years, we expect company earnings to follow suit,” Lerche argues. “While the ride is unlikely to be smooth, the combination of undemanding multiples and depressed earnings means the balance of risks when investing in our country’s less-visible companies may well now be positive.”
Since the start of 2019, there have been some signs of life in the Mid-Cap Index. It has picked up along with the broader market, and is up around 5% so far this year.
This is, of course, a very short period and it’s also worth noting that the Top 40 is up over 6%. It is nevertheless a positive start to the year.
What the technicals say
Technical analyst Peet Serfontein, director of Phoenix Investment Analytics, however suggests that there are reasons to be cautious in the short term. While the long term trend for the index is bullish, as indicated by the green inclining channel below, it is in a shorter declining trend, indicated by the parallel black lines.
“Short term, the index is close to overbought territory, perhaps another 1% to 2% upside potential, but then the index will be trading at its upper two standard deviation range,” Serfontein adds. “What this is telling us is that the price action might be extended to the upside and a correction will be healthy in nature.”
The relative strength index (RSI), shown by the black line in the lower panel, is also showing the index close to overbought territory.
“Currently the RSI is at 67, whereby overbought territory is from 70,” Serfontein explains. “This also suggests that a correction might be on the table.”
The last two times the RSI was in overbought territory, the index did correct.
“We are facing two scenarios,” Serfontein believes. “One, the index can make a correction from current levels and then eventually continue the upward price action or just break down and continue the downward price action. Or, two, the index can remain at current levels and drift, which will create space for the RSI to retract from overbought territory.”
Serfontein believes the second is more likely. Given the strong start to the year, it would certainly make sense for the market to take a breather in the short term.
However, over the long term, the index is near the bottom of the bullish (green) band, and that does suggest that momentum could point upwards from here. Investors should, however, remain patient.