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The upside for small-cap funds in tough times

Vanessa van Vuuren from Sanlam Investment Management’s Small Cap Fund explains its strategy, and looks at two cherished long-term holdings.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast. It’s my weekly podcast where I speak to leading investment professionals. My name is Ryk van Niekerk, and my guest today is Vanessa van Vuuren. She is one of the managers of the Sanlam Investment Management Small Cap Fund. The other manager is Santhiran Naidoo. Vanessa, thank you so much for joining me. How long have you been managing this fund?

VANESSA VAN VUUREN: Good afternoon, Ryk. I’ve been managing this fund since the beginning of 2012. So we’re looking at just under eight years.

Read: SIM Small Cap Fund – fund fact sheet

RYK VAN NIEKERK: The small-cap sector in South Africa has probably for the past decade been under immense pressure. How do you approach managing a small-cap fund in such an environment?

VANESSA VAN VUUREN: You’re hitting the nail on the head. It’s been an extremely tough period, and it’s been very protracted – as you’ve said, 10 years. In my experience what you need to do is you need to go back to the basics.

So, at the end of the day, we’re looking for ideas to make money for our clients. We’re looking for investments where we can invest in companies at an early stage and reap those rewards.

The critical issue is we don’t have any assistance from the macro environment. So we need to basically do much more detailed research, much more detailed risk management, and understand everything that we’re investing in, and the risks around that, because you don’t have the “rising tide lifts all ships” kind of environment that you had in the previous decade. So that’s pretty much how we approach it.

It’s just very rigorous research.

We do still find great opportunities and a lot of particular corporate investments and self-help type stories, as opposed to just depending on a macro recovery.

RYK VAN NIEKERK: As opposed to just holding Naspers and everything becomes quite easy, what is your mandate in the small-cap fund? In which companies can you invest?

VANESSA VAN VUUREN: Our mandate is pretty straightforward. It’s basically anything outside of the large-cap Top 40 space. The JSE publishes a benchmark for the large-cap index, and those stocks are all out of our limit. We cannot invest in those stocks. So, effectively we would look at the Swix or the let’s call it the all-share index, excluding those large-cap stocks. That’s effectively the small- and the mid-cap universes and lower down the indices. You can go into the fledgling and the AltX space and so it’s anything that’s not large cap.

Finding JSE gems

RYK VAN NIEKERK: Many analysts believe there are only around 100 or 120 investable shares on the JSE, companies with sufficient liquidity to allow good trading. How big is this investment universe you have and may invest in?

VANESSA VAN VUUREN: Look, it has shrunk a lot, Ryk, over the last few years. I mean, that is the issue – our investible universe has contracted, not only just because of very poor performance, but also because of companies leaving the stock exchange when we’ve had companies going bankrupt, exiting, being bought out, and so on. So it’s been very tough from that point of view.

You can basically invest across the whole spectrum, down to the smallest company, depending on the size of your fund – and I think with many of us [our] funds have contracted materially. So our fund is sitting at just shy of R300 million at the moment, which does make our fund fairly nimble in terms of the ability to invest in stocks down to quite small market caps. But, having said that, the risk environment is such that we also need to be cognisant of that, from a liquidity point of view from the smaller companies; the very smaller companies’ perspective.

So we do tend to concentrate at the moment tactically more on the larger small caps and mid caps. But we do not ignore an opportunity if it’s lower down in the fledgling space, which we would call the “nursery area” of the market.

RYK VAN NIEKERK: How many holdings do you have?

VANESSA VAN VUUREN: At the moment we’ve 45 holdings in the fund.

RYK VAN NIEKERK: From an investor’s perspective, why would an investor invest in a small-cap fund?

VANESSA VAN VUUREN: Historically there is a very compelling and historical argument around the small-cap premium. We’ve done a lot of work on that, and we have unfortunately witnessed in the last decade that premium eroding completely, and it’s moved to a discount. So, if you compare the performance you’ve had out of large caps versus the mid- and the small-cap space, it’s materially different, a major underperformance – up to double-digit underperformance in the last three years. And that has largely eroded that argument around “you can get a protracted outperformance from small and mid caps”.

But it has been a very brutal cycle. We’ve gone through an unprecedented economic decline in this country. And then, with what’s happened in the past year, the introduction of Covid has just added a whole other layer of risk and complexity to the investment environment.

So I feel that it’s almost a penal environment to look at in the past 10 years, but the argument is that there is a differentiation – there is a diversity that we offer. We are an area that’s neglected by people, especially after that performance you’ve seen in the past five to 10 years.

So a lot of very decent companies that exist in our universe are just not considered by large investment managers. And if you don’t take the time to do the research – many people feel that it’s not worth the effort – you will not be able to mine the gems that come out of that universe.

So the idea is that we will nurture our companies and extract those returns, over the long run, as those companies mature and evolve through their own evolutions. That’s the kind of investment. We need an investor with a very long-term horizon, and someone who can stomach significant downturns and hopefully then reap the rewards over more of a 10- to 15-year type horizon, I think.

Bullish on Renergen

RYK VAN NIEKERK: I am looking at the fact sheet of the Small Cap Fund, and the largest holding is in Renergen. It’s a very interesting company. It’s involved in renewable energy, not only in South Africa but in southern Africa. But it’s an AltX-listed company – an interesting choice. Why are you so bullish on Renergen?

VANESSA VAN VUUREN: Ryk, we’ve held Renergen for many years and more recently, and probably in the last two years, we’ve increased our stake. It’s a very unique asset, it’s very below the radar. People are not interested in it because at this point in time it’s an oil-and-gas play. It’s got the gas asset, which basically regenerates itself. And the interesting part about it is that it started out as a natural gas play and it’s evolved into a helium play because, as they explore the resource better, they’ve discovered that there are very high concentrations of helium in the resource, which doesn’t replace itself. It doesn’t regenerate. So it’s a finite resource globally, and a lot of the major helium fields in the world have actually been depleted.

Globally helium is used in all sorts of things, like MRIs in medical processes. It’s used for many, many manufacturing processes. It’s a critical gas, so we need more of it. And that is what’s attracted me more and more recently to that side of the holding. And again, it’ll only start production in the next year-and-a-half to two years, so it’s a longer-dated asset. But in the medium term you can see significant upside from the asset versus where it’s trading at the moment. So it’s one that we’re taking a very long-term view on. But we see great demand for both gas and for the helium in that asset.

Selecting Sygnia

RYK VAN NIEKERK: It has performed well over the past year – around 60% higher, and I would assume most of those gains would have been last year. But [it has] great prospects.

Second on the list is Sygnia, Magda Wierzycka’s company. Why Sygnia?

VANESSA VAN VUUREN: Sygnia has been a company, again, that we’ve held for a long time. As you know, we take a very long-term view on these businesses, and with Sygnia we’ve seen a lot of innovation in the investment case. We’ve seen a place where she’s coming to the market as a disruptor, particularly in the passive universe.

There’s a lot of growth there. We know in the active universe how much competition we face from the passive side of the industry, and just a lot of innovation in the product range. Inherently asset-management businesses are great businesses. They’re highly scaleable, good returns, with low capital investments.

And so Sygnia has been through a large part of its heavy investment – let’s call it that – and it’s now at the point where it’s potentially going to reap very nice returns.

Obviously there’s volatility with the market, but it sets itself up very nicely and is very disruptive in both the employee-benefits space and across the spectrum of the passive space. So I just think it’s a really nice opportunity, again, taking a very much longer-term view on it, and we are quite happy to back this management team in the longer term.

RYK VAN NIEKERK: [Wierzycka] has indeed made some serious successful investments in recent times – year to date 35% higher over the last year, around 60%. But both Renergen and Sygnia’s shares are very illiquid. How do you deal with that challenge?

VANESSA VAN VUUREN: As I indicated earlier, our assets have become quite a bit smaller just through performance. So that does give us a little bit of an edge in terms of tradeability. But generally we’ve been able to cope with the liquidity profile of our top 10. I know that those stocks are more illiquid than the average, but we still manage to trade them. We’re just tactical in how we trade. If we have a big outflow, we will trade very carefully in terms of that. But so far we have been able to manage it.

If I look across my top 10 and the most concentrated area of the portfolio, there isn’t anything that I cannot move – like overnight. It’s something you’ve got to manage carefully, and obviously you’ve got to look for ways to move that stock carefully, and you’ve got to trade within limits. But we can move the holdings in our fund, definitely.

Small and mid-cap prospects

RYK VAN NIEKERK: Let’s talk about the future, because I think that’s going to be very interesting. The world has changed. The economic prospects for South Africa have fallen off a cliff, and most of the smaller and mid-cap stocks are largely focused on the local market, and are therefore linked to the performance of the local economy. How do you foresee small and mid-cap companies’ prospects of changing in this environment over the next few years?

VANESSA VAN VUUREN: Ryk, it’s a difficult question to answer in terms of timing. What we do know in terms of the history is that, as I indicated earlier, the cycle has been extremely brutal. And so we’ve seen a lot of companies go through extremely tough times and have to remodel their whole structures, and look at what is potentially obsolete in their businesses; what is structurally at risk. That’s a constantly evolving process.

But I think the companies that have survived the economic environment that we’ve been through for 10 years, as well as the recent onslaught of Covid, surely there must be an argument for these companies being in a very strong position longer term. We have seen more marginal players exit the market. We have seen companies with problematic balance sheets undertake rights issues, and so on.

So we think that, as soon as you do see an improvement – I cannot see a scenario in which we’d have 20 years of economic decline. Surely that would be absolutely unprecedented from an economic theory point of view, from a business-cycle point of view – the government has to get its act in order. The environment, the entire macroeconomic framework, has to really change its trajectory.

There is enormous pent-up value in these underlying shares that reside in the mid- and small-cap space, especially on the financial, industrial, and property sides, because we know resources has had its own independent drivers and it’s had a phenomenal performance in the past five years.

So you’ve seen companies with high-quality franchises, high-quality brands, superior businesses with great and economic moats around them, that are trading at really, really attractive levels. That in itself is an argument for building a portfolio at this point in time

…and just closing your eyes and knowing that in 10 years’ time, hopefully, you could have doubled or tripled your money. That’s the kind of scenario I should foresee.

But, again, I cannot time for you exactly when the government gets its act in order, when the macroeconomic trajectory gets properly on a better course. So we just have to wait patiently and we have to risk-manage, and we have to basically look for ideas where there is an ability to navigate the very treacherous macro-backdrop for these domestically orientated companies.

RYK VAN NIEKERK: Value is an interesting concept, and it seems with the value on offer in this sector, a small-cap fund may become a contrarian fund in the near future.

VANESSA VAN VUUREN: Absolutely. I mean, Ryk, there is absolutely no interest in our space. We have no institutional broader interest, so there are no large mandates out there where people are looking to make a tactical switch to the other side of the market. There’s no interest whatsoever. There’s limited liquidity. So all of that is causing this negative cocktail. At some point that will turn. And when you see these companies start to perform better on a sustainable basis fundamentally, there will be an attraction back to the sector. It’s a cyclical thing. It will come back. And I think then there will be a lot of money to be made.

So we just have to continue to ride this out. It has been very protracted, but I firmly believe that, by risk-managing and by selecting companies that have a sustainable future, there is a lot of money to be made in the space.

RYK VAN NIEKERK: Vanessa, thank you so much for your time today. That was Vanessa van Vuuren, one of the fund managers of the Sanlam Investment Management Small Cap Fund.

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A small cap’s share price won’t be 10 cents etc. for anything other than its true valuation.

I think its fake news that small-cap stocks have historically outperformed large-cap stocks, save to say that they have been more volatile and riskier investments.

It’s a mug’s game in today’s world (with the one financial crisis after the other) for any investor who believes that buying small caps gives him/her the opportunity to beat institutional investors through growth opportunities.

The size of a business does not have anything to do with risk. A small business with a strong balance sheet (i.e cash) and business model is not risky. If size determined risk Intu, African Bank, Steinhoff, Tongaat, Brait etc, would have been safe investments.

Small-cap stocks also tend to be more volatile, and usually have a higher level of market risk or beta than large-cap stocks. These firms are generally less established, have shakier financials, and often do not pay a dividend, and, therefore, exhibit higher market risks

A good interview with a fund manager trying to sell a product no one wants.

In a failing economy, the small companies die first. The Portfolio Manager notes that the investable universe has been shrinking. If you believe things will get better, then this may not be a bad strategy. There is no evidence to support this.

https://www.sanlam.com/productcatalog/SanlamFundFactSheets/SanlamFundFactSheets/SI_SIM%20Small%20Cap%20Fund.pdf?webSyncID=6412340c-2a6d-3327-9912-c9c05cb71081&sessionGUID=2e201923-7a2d-2916-95eb-19ca75b11155

So her longer term track record over 10 years is delivering 5.8% vs the 7% odd of the benchmark. I’m sure cash give you better returns? How does she maintain her job after 8 years of poor performance?

End of comments.

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