Finding value in SA’s small- and mid-cap sector

Diversification across sectors is the best hedge against bad luck, stresses Keith McLachlan from Alpha Asset Management.

NOMPU SIZIBA: There tends to be a lot of focus on the Top 40 index when looking at the equities market, but there are plenty of other companies listed on the JSE, some of which we’ve engaged on this platform when releasing their financial results, for example, who have plenty of current and potential value that perhaps gets overlooked.

To tell us about the trends taking place in the small- to mid-cap sectors, and why this area should be of interest to potential investors, I’m joined on the line by Keith McLachlan, a fund manager at Alpha Asset Management. Thanks very much for joining us, Keith. You tend to focus your sights on the small- to mid-cap stocks. For those who may not know, what are small- to mid-cap stocks, and what measure is used to distinguish the two?

KEITH MCLACHLAN: Sure. Small capitalisation is really a classification in terms of size of the market capitalisation of a business. What I mean by that is, if you take all the shares, and you multiply that by the share price, you get the market cap of the business. You can rank the biggest businesses down to the smallest. We typically in the market classify the smallest as small caps.

From a global perspective, that market cap – remember, the share price multiplied by the number of shares as the size of the business – globally a small cap is about $1 billion market cap and down. So, from a South African context, that’d be about a R15/16 billion market cap and down. Hence, although we talk about small cap, some of these businesses are not in fact that small.

Now, the South African market is quite small, so what you find is a R15/16 billion market cap classification would in fact take you into the mid-cap index range. From a South African perspective I tend to say everything that is outside, or smaller than, stocks in the Top 40, is largely classified as a small- and mid-cap; so let’s view them as a homogenous bunch.

NOMPU SIZIBA: Yes. Now, why is there value in investors looking at being invested in the small- to mid-cap sector, as opposed to being invested in your more popular Top 40 type of counters?

KEITH MCLACHLAN: The first thing is quite obvious. Finance typically works with trade-offs, and when you take more risk, you tend to achieve more return. So, as you go lower down the scale in terms of size of a listed company, you often find smaller companies that are growing faster because, don’t forget, every large company started as a small one, and what took them there was growth. Typically speaking, small- and mid-caps outperform large caps. In short periods of time, that may not be true, and that hasn’t been true for a couple of years in South Africa – we can touch on that in a bit, but I’m saying that in a lot more periods of time they do tend to.

The first one is easy to explain – “upside”. If you want to generate good performance, this is an exciting part of the market globally, as well as domestically.

The second one is less obvious. You kind of said it in your question to me. There are 300 to 400 stocks listed on the JSE, but the Top 40 has only 40 of them. And, in fact, there is huge amount of duplication within that index, where you’ve got the major banks. So, if you buy Capitec, Standard Bank, Absa or First Rand, on paper it looks like you have diversification, but in reality you are deeply concentrated in the banking sector. So you’re only focusing on 40 stocks, whereas there are another about 360, 300-odd, that are outside of the Top 40. So ignoring that part of the market means you’re ignoring 80 to 90% of all listed stocks. And that includes business models and companies and exposures that you can get in the space that are simply not represented in the Top 40.

So the two simple reasons are you want to generate higher returns – this is a good place to be – and you want diversification instead of duplication of the Top 40. It’s a great place to be.

NOMPU SIZIBA: Which also speaks to spreading your risk as well.

KEITH MCLACHLAN: Definitely. And, like I said, there are business models here that just don’t feature elsewhere.

NOMPU SIZIBA: So, with the year 2020 dominated by Covid-19 and its impacts, what sort of trends have you noticed in the small- to mid-cap sector?

KEITH MCLACHLAN: Globally there has been a trend for a number of years where small caps, as a sub-equity asset class, have been underperforming large caps. I need to provide context to explain this year. First of all, small caps in South Africa are part of global small caps, and they’ve been underperforming that. But couple that with the fact that we are also an emerging market, and emerging markets until recently have been very out of favour. So developed markets, notably the US, has been outperforming emerging markets. And then couple that with our market being so cheap  that it falls deeply within the value bucket – and the value factor as a style of investing has been underperforming for a number of years as well.

So our market arrived in this space into 2020 limping; it was already pretty crippled, to phrase it mildly, and the final nail in the coffin was small caps –  and smaller businesses tend to be more domestically focused. Hence the weak macroeconomic environment and the lack of GDP growth in South Africa for a number of years obviously negatively impacted them. So we entered this year down, and we entered this year weak, and obviously the floor fell out in March, where all correlations pulled to one; it didn’t matter what company you were in, what asset class, because there was a scramble for cash.

Let me run some numbers. From the relative highs in 2017, this market to date is down 35%. That’s massive. That’s across years. It’s almost dropped by a third. In fact, year to date, it’s still down about 80%[or 8%? Mins 6:21] But, and this is the incredible thing, from the trough in March/April this year to where it’s trading today, it is in fact up 50%.


KEITH MCLACHLAN: Once again, that needs to be viewed in context, because South Africa remains a fragile country and, although our fiscal debt trajectory is worrying, there are a range of other elements that are starting to go right.

Emerging markets are back into fashion again, as the world de-risks and guys look to allocate. Second of all, small caps globally have started outperforming large caps. And then, finally, values started outperforming growth. And all of these play into this theme where our small-cap market has started to experience what is hopefully a bottom. And 50% up from the trough is not a small number.

NOMPU SIZIBA: Not bad at all. This is not a stock-pick question. One will follow in a moment. But just tell us where you see investment value in this space, especially in light of the pandemic? Are there any particular sectors that you’re eyeing for growth right now?

KEITH MCLACHLAN: My investment methodology in the small-cap space focuses on quality before it focuses on value. The reason is that this part of the market has businesses that can struggle and potentially go under. It is a higher-risk part of the market. And, don’t forget, in the perfect scenario you want to buy a business when it’s small and it grows into the Top 40 and becomes a huge business. Only a good business will do that. A bad business won’t grow into being a large business. So, focusing on quality, it hopefully first of all de-risks your downside, and second of all positions you for upside before you flip it around and look for value and haggle over evaluations and the like.

The challenge about valuations in this market right now is obviously that earnings have been decimated. How does one value that? Hence you fall back on a market that’s trading below book, but the entire South African FTSE/JSE small-cap index is trading on 0.8 to book. Everything is cheap, but not everything is worth holding.

So my starting point would be not to look at sectors and industries, but to look at balance sheets, cashflows, margins of safety and competitive advantages, barriers to entry. I am focusing on quality before valuation, given that everything’s cheap.

NOMPU SIZIBA: Makes sense. So, more specifically, what would you say are your current stock picks that you think could be profitable to a long-term investor?

KEITH MCLACHLAN: First of all, a full disclaimer; I’ve got skin in the game on these stock picks; I hold them. I’m going to run through them very quickly. I’m happy to zoom in if you want to chat about one or two of them more in detail.

Santova is a global non-asset-based supply-chain manager that grows superbly. It earns over 100% of its profits outside South Africa, and the real trick is that it’s valued as a South African small cap, even though arguably it isn’t. It’s sitting on about a five times price/earnings, despite being what I would argue a global stock.

Metrofile is a more defensive one. It’s a fantastic way of going long of bureaucracy, because it does document storage. That’s where all your Fica documents end up. But as a deeply cash-generative business, they are well priced, they’ve got very attractive forward dividend yields, good management de-gearing the balance sheet. And in fact, you’ve got a free option for a potential take-out on the table – about 30 to 40%-odd higher than where the share price is trading.

There is Reunert as well as a good-quality business; ungeared balance sheet. We haven’t touched on South Africa’s green shoots in the infrastructure-spending space, but Reunert is well positioned to that in the renewables and cabling side. It has a strong export-defence business, and it has a high-margin, nice defensible ICT play.

And then there are companies like Grindrod, Coronation, Distell and Adcock Ingram, which are all really good-quality slightly larger small caps than some of the ones I’ve touched on, all playing in different areas but all of them cheap, all of them well run. All of them have good-quality balance sheets, and with all of them – if South Africa continues to do well, if small caps continue to rally, if all the themes I’ve spoken to continue to play in their favour – there’s no reason why any of them can’t do well.

NOMPU SIZIBA: I guess it’s not like comparing oranges with oranges, but what if somebody said to you: “Adcock Ingram, how does it differ from Aspen, which of course is in the Top 40?”

KEITH MCLACHLAN: That’s a great question. Well, it’s completely and utterly different. That’s how it differs. Aspen is really global, but focused on emerging markets, a generics-manufacturing business. They hold dossiers and they hold some IP – but view them as an emerging-market proxy for generics volumes.

Adcock is in fact an entirely South African-focused business. It has no outside-of-South Africa exposure. Second of all, it has ethicals and generics, but it’s really a branded product and healthcare business. Things like Panado sit within it.

If one even zooms a little bit deeper, and looks at the balance sheets and finance structures, Aspen has an absolutely ginormous amount of debt. Adcock Ingram is completely ungeared. So these are totally different businesses. Even though they lie in the same market and the same classification, they’re not really that comparable.

NOMPU SIZIBA: And then, lastly, Keith, just in terms of attitude to investment, the importance of diversification – if you can just share that with our listeners?

KEITH MCLACHLAN: Definitely. None of us knows what the future is. You can do all the research in the world – and what lockdown has shown us is you could have bought the best hotel operators in the world and have justifiable reasons for buying them, and still be wrong, because the lockdown and collapse in tourism just shut down airlines and hotels and the like.

What we do is we want to maximise our return by making intelligent investment decisions in building a portfolio. We want to earn based on our skill, not based on our luck. The way we hedge out bad luck, because we’re not sure which one of these picks will work, is that we make sure that there’s minimum duplication across the portfolio – that is, maximum diversification – such that if even one or two of them has bad luck, the balance of the portfolio generates a return that offsets them, and hence we still generate a good portfolio return going forward. So diversification is your best hedge against bad luck.

NOMPU SIZIBA: That was Keith McLachlan. He’s a fund manager at Alpha Asset Management.



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What Keith has to say here could seem a little old school and conservative. But for me, it is the “blockchain” of investment thinking.

If you want to invest in a way that avoids losing everything to one bad trick or show some guaranteed progress in your financial position over time, this is totally sage investment strategy advice.

Save the cheap thrills for the movies and/or the casino- where you will mostly empty the pockets. This way, when you get back to reality you can debit entertainment and credit experience!

End of comments.



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