The small cap funds have just R6.3bn under management — little more than 1% of the assets held by domestic equity funds. It’s quite a contrast to the heady days of 1998, when it looked as if these funds were destined to overtake general equity funds.
Yet small cap funds are now much more reliable than in those days. They no longer focus on faddish IT businesses in which the largest item on the balance sheet was goodwill. They provide a blend of industrial, resources and financial shares, including such well-managed businesses as AVI, Santam and Italtile.
There are some large shares in this universe, such as Quilter, which has a R46bn market cap, Liberty, with R30bn, Impala (R61bn) and Sibanye Gold (R57bn). But small cap funds are usually seen as a proxy for SA Inc shares, especially industrial ones.
It has been a difficult market in which to operate, and over five years the sector has shown a negative return. This will be a big disappointment for investors who bought these funds on the strength of the widely held view that there is a small cap premium. While large caps have little room to grow in a stagnant market, small caps, with much lower market shares, have more headroom. They are also more likely to be driven by energised entrepreneurial management.
Sanlam puts some of the reasons to invest in the sector on its small cap fact sheet. They include the following:
• Small cap companies tend to outperform large cap firms as a result of being able to grow their earnings faster, with higher volatility;
• Due to a lack of research there are many more undervalued and mispriced opportunities among small caps; and
• Some growing and emerging industries exist only in the small cap area. These include private education and restaurant franchising.
Today’s small caps are the large caps of tomorrow. There have been virtually no net flows into the small cap sector, which helps explain why this part of the market has struggled to grow. Liquidity has also been an issue, as so many small caps are virtually untradable, and many of the funds have migrated into mid caps, many of which are large businesses in their own right. And in many cases the big businesses of tomorrow can easily bypass the stock exchange, now that the private equity industry is much more highly developed.
The large houses have nonetheless kept their small cap unit trusts open, with the exception of Stanlib, where performance was so inconsistent it was embarrassing. There is quite a marginal cost to keeping these funds on the platform, and the small cap research carried out for the funds benefits the stockpicking for the other equity products.
The two large funds in the sector, with more than R2bn under management each, are Nedgroup Entrepreneur and Investec Emerging Companies.
Entrepreneur carries many of the same themes as its sister fund, Rainmaker — it has the same portfolio manager in Anthony Sedgwick and a strong emphasis on industrials, with little focus on the other sectors. Investec has a more liberal approach, with a large resource weighting and a significant property holding.
The other three funds remain below R1bn: in the case of Coronation it is a bafflingly small R140m, even though performance has been generally quite tolerable.
Sanlam Investment Management at one point managed R7bn of small cap assets — it was common for pension funds to offer dedicated small cap mandates to fund managers. Now it manages less than R1bn, with just R400m in the SIM Small Cap fund. It positions itself as the fund for the patient investor.
At Old Mutual one of the great characters of this sector, Warren Jervis, has, sadly, left, but the firm was lucky to have a previous manager, Brian Pyle, on the bench to take over. He will step back into the mainstream equity products once he has trained rising star Khaya Nodada to be Jervis II.
The closest passive fund is the Momentum Mid and Small Cap Index Fund, which happens to have done a lot better than Momentum’s active fund in the sector.
Other funds in the sector include one from AlphaWealth, which has done so badly we should call it OmegaPoverty, and an equally disastrous high-volatility fund from Cannon.
Small cap boosters are now saying that all along small caps are geared for strong economies, not weak ones. There’s no doubt that counters in sectors such as construction and vehicles could improve hugely if economic growth bounced back to 3% or 4%. But few companies in these sectors can be considered quality — these funds also need evergreen companies, and they are certainly there.
Nedgroup Investments Entrepreneur
The fund has been run by Anthony Sedgwick at Abax Investments for more than 15 years. It focuses on high-quality industrials; even its basic materials positions are dominated by industrials AECI and Afrox.
But with the limited choice on the JSE, no fund manager can afford to be too fussy. Sedgwick says he does not like the numerous uncertainties that surround mining shares around issues such as currency and labour relations. He has sold out of Northam Platinum and his remaining mining share is chrome producer Merafe.
The fund has a 9% allocation to Naspers and British American Tobacco (BAT), which it bought before they were in the top 40 index. Naspers is considered to be in the spirit of the fund as it is an expansionary emerging company. The fund is not allowed to buy more Naspers or BAT and once it has sold them cannot buy them back.
In the second quarter, BAT was a drag on performance, along with Merafe, KAP Industrial, Netcare and Sappi. Sedgwick says that KAP has been disappointing — just when it seemed to have got out of the Steinhoff relationship intact, it failed to meet its earnings guidance. The winners in the quarter were sector favourite Italtile, Alexander Forbes, the Impala convertible debentures, Transaction Capital and the JSE. The only conventional retailer in the fund is Truworths, another disappointment.
The fund has a chunky 4% holding in Barloworld. Sedgwick says he believes CEO Dominic Sewela is doing the right things — though he stops short of calling Barlows a "quality" company — and at some stage the mining houses have to rebuild their yellow metal fleets, in which Barloworld’s Caterpillar products are the market leader. It is also, along with Combined Motor Holdings, a punt on a recovery of the motor sector as all the bad news is priced in.
The fund has just a tiny position in property — 0.3% in Balwin Properties — which builds housing complexes and which has suffered from a temporary decline in demand.
Sedgwick says a good example of a quality company in the portfolio is Santam, which makes up 5% of the fund. He says that even if its underwriting profit is a bit down, it generates a lot of cash, which it often pays out in special dividends. AVI, Italtile and the JSE all fall in the quality bucket, Sedgwick says.
Old Mutual Mid & Small Cap Fund
After 11 years under the stewardship of Warren Jervis, the fund was taken over by Brian Pyle, and then Kaya Nodada at the beginning of 2019.
Pyle and Nodada are part of the Old Mutual Equities research and portfolio management team and are plugged into the process. In contrast, Jervis was something of a maverick lone wolf.
Nodada says the small-cap shares are subject to the same ranking tables as the large caps, with a blend of fundamental valuation with momentum and quality factors. Pyle says there was a 20% turnover over about two months in the fund, to reduce the number of shares correlated with each other.
City Lodge has been sold but Tsogo Sun remains a top 10 holding. He says there will be a time to own Sun International, which has the added attraction of a South American business, but that time hasn’t arrived. They also sold shares where they were not comfortable with the business model, such as Invicta, and they are hoping to dump Consolidated Infrastructure Group soon. There is now little exposure to retailers other than the dominant ceramics business Italtile, the largest share in the fund with a 5.4% weighting.
Italtile is also held in the Old Mutual general equity portfolios, as is Santam, which makes up 4% of this fund. A number of the shares could be called large-cap proxies. Reinet (which until recently was in the top 40 in its own right) is primarily a cheap entry into British American Tobacco — it makes up 4.4% of the fund.
The biggest components to RMI Holdings are large-cap Discovery and unlisted Outsurance, probably the most valuable insurer after Santam. Impala Platinum (3.4% of the fund) could be back in the top 40 soon, though Gold Fields is ahead in the queue for promotion.
An old small-cap favourite, Trencor, is also in the top 10 with a 2.9% weighting. Pyle says he expects corporate action will soon unlock the value of its main asset, the Textainer container business, as the share has traded at a discount for some time. The fund also owns stalwart mid-and small-cap shares such as aggregates manufacturer Afrimat, electronics group Reunert and education provider AdvTech.
Pyle says he does not expect an immediate recovery in vehicle sales or the construction sector, but he has taken small bets in Combined Motor Holdings, Motus, WBHO and Raubex. "In construction the last man standing will be well placed if and when an upturn takes place."
SIM Small Cap Fund
This fund, run by Vanessa van Vuuren, is not designed as a trading fund. Many of its positions will not pay off for several years. For instance, Renergen, which focuses on the production of natural gas and helium in the Welkom area, is still at an early stage in its life cycle. It has been listed on the Australian stock exchange, where investors are likely to show more interest than here.
Most SA unit trusts wouldn’t touch it, but it makes up 4.2% of this fund.
There are three quite liquid mining shares in case there is a run on the fund and clients have to be paid out. These are Implats at 6.4%, Sibanye Gold at 2.7% and Exxaro at 2.6%.
After eight years, Van Vuuren has sold the fund’s position in Bowler Metcalf, which finally realised its potential after it spun off its stake in the soft drinks business and gave a large special dividend. Van Vuuren hopes for an eventual payday from Blue Label Telecom (4% of the fund). She says it is depressed due to concerns about its holding in Cell C, but that its core starter pack business is still highly successful.
Homechoice (3.3% of the fund) crashed financially when it was last on the Johannesburg Stock Exchange, but Van Vuuren says this time round it is much stronger, offering homeware, clothing and jewellery through digital channels and, more recently, unsecured loans.
Sygnia is a more familiar and widely followed share, and Van Vuuren says it has a strong position in two growing markets, index funds and umbrella retirement funds. Coronation, Quilter and Peregrine are the other financial shares.
In retail Van Vuuren has been building positions in Pick n Pay, Spar and Dis-Chem. The fund has been a longtime holder of education provider Curro, which has detracted from performance over the past year, but Van Vuuren believes it is quite realistically priced, given the growth potential, at a p:e of 27.
Investec Emerging Companies
The fund has a substantially higher exposure to resources than its peers. This has helped the fund perform better than the rest over 12 months. This was put in place by previous fund manager Daniel Sacks and it has largely been kept in place by his successor Andrew Joannou.
Joannou is a colleague of John Biccard in the Investec value team. Like the Value Fund, Emerging Companies has a large holding in Implats, 10.2% of the fund, and in Pan African Resources, 7%. It also has a somewhat contrarian 7.8% position in retailer Massmart, betting on a turnaround under the new CEO.
Joannou says the fund believes in buying when there are low expectations. As worries about the impact of National Health Insurance on the private sector mounted over 2019, the fund ploughed R40m into Netcare shares.
As interest in niche bank Sasfin dwindled, the fund acquired some shares. Small cap shares include Hosken Consolidated Investments (6.1%), which is particularly out of favour right now, construction group Raubex (4%) and Hudaco (3%). The fund also stands out for its property exposure, almost 11% of the fund.
In the second quarter it acquired new positions in Fortress A and Intu, and it held its combined 6.5% in Investec Property Fund and Vukile.
A curious holding is 1.3% in Blackstar SE. "I am surprised the share hasn’t done even better," says Joannou, "given the value of the Tiso assets alone. On my calculation I am getting the Hirt & Carter commercial printing business for nothing."
Joannou is cautious on consumer shares, Oceana and RCL make up less than 4% of the fund and there is a modest holding in Pioneer Foods.
Coronation Smaller Companies
This fund is run by Alistair Lea, who was an early manager of the Nedgroup Entrepreneur Fund. The co-manager is Siphamandla Shozi.
As the smallest of the big brand funds in the sector with just R140m under management it has the most flexibility. It does not aim to target a percentage breakdown between mid caps and small caps but looks for ideas on a purely bottom-up basis. It reflects the Coronation house view in favour of platinum shares, holding more than 6% of the portfolio in Northam and Royal Bafokeng combined.
Lea took a new position in Pan African Resources in the second quarter. But like most small cap managers he is wary of taking too large a position in resources, which at 11% of the fund sit at the top of the range. He prefers funds with strong brands, and his largest holding is spirits and cider group Distell.
This position was trimmed but it is still 5.7% of the fund. Lea says it has done exceptionally to increase revenues in SA by 9%. Spar is second at 5.4% (rival Pick n Pay makes up 3.2%) and Lea says its acquisition in Ireland has been successful but its Swiss stores are not giving appropriate returns.
Lea has both listed private school counters, though his holding in AdvTech, a lower p:e share is about four times the six of the Curro position. He has not sold any of his Famous Brands shares, which make up 5% of the fund as he believes it remains a quality business in SA. A full write-down in British Gourmet Burger Kitchen is reflected in the price.
He prefers the share to its competitors Spur and Taste, though he says Spur is looking more interesting since it fell from R35 to R21. The largest classic industrial share in the fund is Metair (4.9%), now primarily a battery business. It was knocked by the fall in the Turkish lira, as about a third of revenues are sourced in Turkey. It has been available at bargain prices.
An even braver position is 1% in troubled fertiliser maker Omnia. In financials, the three largest positions are RMI Holdings; financial planning and asset management group PSG Konsult; and Quilter, the former Old Mutual UK.
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