Small caps growing earnings faster vs large caps

But unrewarded by the market.

CAPE TOWN – It is widely accepted that the JSE is looking expensive. With the All Share Index (Alsi) at a price-to-earnings (PE) multiple of around 18 times when its long-term average is under 15, this appears self-evident.

However, what is sometimes overlooked is that the market has not moved as a whole. These high valuations are almost entirely due to the re-rating of local large cap shares since 2012. As the below chart shows, small caps (the red J202 line) has not followed suit.


Source: Inet Bridge

While valuations on large cap stocks (purple J200) spiked through 2012 and 2013 and have remained elevated, small caps have continued to trade around their long-term average. What makes this even more interesting, is that this significant disconnect has largely been based on sentiment, and not on company earnings.

In fact, small caps have been growing their earnings faster than large caps, and yet the market has not rewarded them. As the below chart shows, over the last three years earnings from large cap companies are actually down, and yet average PE ratios have increased 35%.

Sentiment in the wrong place

Screen Shot 2015-09-30 at 6.10.50 PM

Source: Cannon Asset Managers 

Sentiment is in the wrong place

“In this low interest rate environment, people love the large caps that have inflated earnings,” says Andrew Dittberner, investment manager at Cannon Asset Managers. “But to invest at current PEs of 18 or 19 times, the expectation is that earnings will continue to grow at a healthy rate, and in recent times those expectations have not always materialised.”

He believes that this reflects an environment where sentiment may be in the wrong place. The question that investors should be asking is what happens when this sentiment changes.

“Three years ago small caps weren’t priced to do anything fantastic, yet they have grown earnings well ahead of large caps and they continue to be priced on relatively undemanding multiples,” Dittberner says. “As a result, I think there is a lot less downside risk in small caps than in large caps.”

He points to the example of Mr Price. It has been trading on high multiples for some time, and when it came out with a poor market update its share price fell sharply.

“The market is pricing in decent earnings growth for a number of the larger companies, which run the risk of re-rating if earnings disappoint,” Dittberner says. “Small caps are however not expected to come out with that kind of earnings growth, so if they don’t meet expectations the risk is lower.”

What makes this particularly pertinent is that one of the reasons that large caps have re-rated so significantly is because of foreign buying.

“Typically the large caps that trade on demanding multiples have a high level of foreign ownership,” Dittberner says. “If foreigners pull money out of our market, it will be these companies that are most susceptible to a sell-off.”

Investor psychology

Another factor for the relative preference for large cap stocks might be what happened in the 2008 market crash. Small caps took a particularly bad hammering in that period and investors have therefore been wary of getting back into the sector.

“Even though small caps have performed really well since then, they haven’t been given the credit that large caps or bigger mid caps have,” says Vanessa van Vuuren, small cap equity analyst at Sanlam Investments. “There is some fear around the sector.”

This caution has also been heightened by more general worries about the performance of the local economy.

“Because we have had weak economic growth and small caps are very much a domestic GDP play, they haven’t been given those ratings even though they have grown earnings quite nicely,” van Vuuren says.


Given the multiples at which small caps are currently trading, investors must be asking whether this is a buying opportunity. In an investment environment where it is so hard to find value, is this the place to look?

Van Vuuren believes that there are some very good prospects in the sector, but investors still have to tread carefully.

“There are two things that count against small caps,” she says. “The first is local GDP growth. A lot of these companies have had fantastic growth in earnings, but that is largely due to trimming down, and becoming smarter and more efficient. You can only do that for so long and then you need fundamental economic growth.”

If South Africa does not see a sustainable pick-up in its GDP, then the macro backdrop may make it difficult for these companies to continue to grow their profits.

“The other thing is that it’s very difficult to call small caps as a whole category,” Van Vuuren says. “There are a lot of nuances and different types of companies with very different drivers. There is value in small caps, but you have to research the sector carefully and pick your stocks.”



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