The sector was subject to a great boom soon after these funds were started in 1997-1998. It wasn’t unusual for these funds to give 100% returns as there was a steady supply of small caps which investors were eagerly snapping up.
Then came the August 1998 crash. There have been signs of life since then but for the most part the small and mid cap sector has underperformed the general equity sector. With just R4.4bn under management, the sector accounts for little more than 1% of equity funds under management.
There is academic evidence in favour of the size premium, that small caps will outperform larger shares over time. A basket of entrepreneurially managed shares with lots of room to grow should outperform the dinosaur legacy businesses. But in SA most large caps are rand hedge shares earning the bulk of their income overseas, whether mining houses or dual listed industrials such as British American Tobacco (BAT) and Naspers/Prosus. More than two-thirds of the large caps’ income is derived from outside SA’s borders.
An optimistic reading of the mid and small cap sectors says 27% of their income is derived from foreign currencies, after Woolworths, Aspen Pharmacare and Tiger Brands were "relegated" into the mid cap sector. Covid-19 has shown how vulnerable most small caps can be. Comair, a long-time favourite of these funds, is in business rescue; City Lodge and Tsogo Sun are not far off it. Distell, as the leading producer of spirits and cider, is earning income only from exports.
Some fund houses have abandoned the sector as there is so little client demand. Stanlib has closed its small cap fund, Momentum is hanging on to the fund which won awards when it was run by Evan Walker, but Momentum is now a fund of funds business which is phasing out its direct equity management.
Alistair Lea of Coronation says there is no marketing of the small cap fund he manages. It is the smallest fund in the sector with barely R100m under management. But larger institutions can justify keeping these funds alive. The research on small caps would need to be done.
Lea, Andrew Joannou at Ninety One and Vanessa van Vuuren at Sanlam are all experienced analysts and company research is their main job. But running a fund gives them the chance, and the responsibility, of running money in real time.
At Old Mutual Kaya Nodada has integrated the Mid and Small Cap fund into the Old Mutual Equities process where he divides his time between research and managing the fund. And Nedgroup Entrepreneur is just one of the responsibilities of Anthony Sedgwick at Abax, who also runs the Nedgroup Rainmaker Fund and is the de facto chief investment officer.
Small caps is also an area in which there are opportunities to outperform the index. There are mid cap index funds, but it is impractical to offer a small cap tracker, as so many shares are illiquid. The funds are also directly comparable as their mandate limits them all to SA listed shares, though a few common currency shares such as Namibian Breweries appear in the Sanlam fund.
The funds were originally allowed to buy anything outside the top 40 index. This has been changed to the large cap index which may have between 35 and 45 constituents. As sectors have gone in and out of favour, a whole range of companies which don’t look like small caps come into the sector.
Who would have guessed in the 2007 resources boom that AngloGold Ashanti and Impala Platinum would become mid caps, even if only temporarily? The index providers don’t know what to do with Quilter, which at times has a higher market cap than its former parent Old Mutual. Most of the small cap funds have snapped it up while they can.
Coronation Smaller Companies Fund
The fund is run by Alistair Lea, who has been at Coronation for 15 years and before that ran competing fund Nedgroup Entrepreneur. His co-manager is Siphamandla Shozi.
Lea says investors in the fund must decide whether they consider SA to be a sound investment. The rand hedge component of the sector is far smaller than for large caps.
The total revenue from overseas in the sector is about 27%, and the Coronation fund has pushed this up to 32%, while in a large-cap unit trust such as Coronation Equity it could be as high as 70%.
Lea says the best strategy is to avoid mistakes and not get entirely caught in the any overhyped stories. Taste Holdings, now worth almost nothing, would be a good example of where that happened.
The Coronation fund’s top holdings are shares that enjoy steady annuity income. Spar, which makes up 7%, has a steady stream of repeat customers every week. The equally defensive Pick n Pay is also in the fund’s top 10 (at just over 3%). The second-and third-largest holdings are Rand Merchant Investment Holdings (RMI) and Quilter, at more than 5% of the fund.
RMI gives access to one of the best financial businesses in SA, Outsurance, as well as Discovery and Momentum Metropolitan. All these businesses might see lapses pick up this year, but in aggregate they are gaining market share over competitors.
Quilter focuses on the affluent sector of the UK and while many of these people will get poorer, few are likely to leave Quilter unless its service tanks. Other large holdings include stalwarts of the sector such as Metair, Altron, AdvTech, Cartrack, PSG Konsult and Distell. Distell is struggling most with the renewed booze ban, but at least it is no longer the largest share in the fund.
The fund has sold out of Oceana and Reinet, which has reduced the rand hedge exposure, but Lea says there was better value in other parts of the market. The fund has bought into the JSE Ltd share — one of the few that benefits of increased market volatility — as well as Truworths and Mr Price. Lea says the Truworths purchase was too early, as it preceded the closure of the chain in Level 5 lockdown, but Mr Price was bought at a low base.
Old Mutual Mid and Small Cap Fund
Old Mutual has had two experienced managers running the fund over the past decade, Warren Jervis and Brian Pyle. It was passed over to Kaya Nodada as sole portfolio manager after Pyle left the group earlier this year.
It has certainly been an interesting time to hold the baton. Nodada says he had to live through the fastest market correction in memory with small caps down 33% and mid-caps 36% in the first quarter, and we still have to see the full impact of Covid-19 on small companies.
But he believes the small-cap premium will come back over the long term. The fund had some defensive positions to steady the ship such as Reinet (almost 8% of the fund), Italtile (6%), Santam (4%) and AngloGold Ashanti (4%) — though, of course, Santam now has troubles of its own as its unwillingness to cover Covid-related claims has hit its reputation.
But lockdown hit two other large holdings hard — Tsogo Sun and Motus (the former Imperial motor dealerships). Tsogo Sun has been sold completely. Nodada did his best to reposition the fund weightings towards defensive food stocks and added Rhodes Food Group (now 3% of the fund), coffee and biscuit maker AVI (3%) and smaller positions in Pick n Pay and Spar. Shoprite, as a large cap, remains outside the fund universe. Nodada has sold more than half the holding in Implats, which is no longer in his top 10 holdings, and Assore has been delisted, though it accounted for barely 1% of the fund on exit.
Nodada says there needs to be a flight to quality in a crisis — a robust business model and lightly geared balance sheet are not negotiable. Italtile is considered to be a good example of this, especially as it has an integrated manufacturing and retailing model.
After Santam, RMI is the largest financial position. Old Mutual will almost certainly sell its holdings in Peregrine to private equity firm Capitalworks; Peregrine accounts for just over 3% of this fund.
Raubex and Afrimat, each 4% of the fund, are the main construction industry positions. Small-cap stalwart Reunert makes up 3% and Sea Harvest (3%) is a key rand hedge holding.
Nedgroup Investments Entrepreneur
This has been the fund to beat in this sector. It is run by Anthony Sedgwick at Abax Investments, who also manages the sister Rainmaker Fund.
Sedgwick says in current macroeconomic conditions it’s hard to expect many small caps to appreciate. For historic reasons the fund has holdings in Naspers and British American Tobacco (BAT), which it bought before they joined the Top 40. It cannot add to them, but it does not have to sell them.
Along with Prosus, which has almost identical underlying assets to Naspers, they account for almost 19% of the fund’s assets and made a positive contribution in the first quarter, along with Assore, up to delisting, and Northam. Reinet, which invests into BAT, makes up another 4% of the fund.
There were few places to hide — even Royal Bafokeng Platinum was in the red in the first quarter, so Sedgwick could not avoid red ink in the three months to March. Industrials in the fund also tanked such as KAP, WBHO, Reunert and Hudaco.
Sedgwick says it has been an unusually active year to date: it sold out of the Impala convertible bond and Sappi, as well as Pepkor and Barloworld. He believes Barlows made a poor capital allocation decision bidding for Tongaat Starch. He also sold down discretionary retailers Italtile and Truworths.
He believes many of the businesses in the portfolio can continue defending their level of profits. These include Alexander Forbes, Adcock Ingram (now 5% of the fund) the JSE Ltd as well as Santam and RMI. Afrox, with a near monopoly on certain gases, and AECI, with a dominant position in explosives and fertiliser, should remain dependable shares. They account for about 4.5% of the fund between them.
The fund has acquired positions in Life Healthcare, Northam, Astral Foods and Libstar. Among its top 10 holdings are Afrimat, Oceana and Reunert (all 4%).
Ninety One Emerging Companies
Emerging Companies is run by Andrew Joannou, who both works for John Biccard’s Value Fund and acts as an analyst for Chris Freund’s general equity team.
Joannou says he tries to stay as close as possible to the mid-and small-cap mandate. He likes to see the fund as a halfway house between the public and private markets. Many of the shares might realise their full potential price only when they are bought out. There are inefficiencies in the small-cap market that can be exploited. "Returns can be lumpy. Combined Motor Holdings is in a weak sector, but has a great management team and it could double if the market changes or somebody bids for it."
He has owned some gold and platinum shares that would not be considered small, but has sold out of Implats and Sibanye. He still has an overweight exposure to resources, but mainly through niche gold producer Pan African (7% of the fund, the largest position) and ferrochrome share Merafe, as well as Master Drilling, which is classified as resources but is really an industrial business.
Joannou says he went into the lockdown with a high cash holding — 16%, compared with a maximum of 20% — and a defensive portfolio, but he is disappointed with his performance. The defensive shares include Hudaco, a consistent industrial (3% of fund) and potentially Netcare (4%), which will soon benefit from clearing a backlog of elective surgery. But some other holdings may take time to recover, such as Sappi (5%) and Truworths (3%). Just over 10% of the portfolio is held in construction shares Raubex and WBHO.
In the pandemic he has cut more vulnerable shares such as Massmart, City Lodge and HCI (which is mainly a casino share), as well as Famous Brands and Imperial. He bought Telkom just before the share price recovered by 50%. Rand hedges are limited in the mid-and small-cap sector; one of the few is Oceana, which has large hake exports and a US fishmeal business.
In the financial sector the fund has a small exposure to Sasfin, its only exposure to banks, as well as asset or wealth managers such as Coronation and Quilter.
Joannou has nibbled at some property shares such as Vukile and Investec Property Fund in spite of the pressures on landlords to forgo rental income.
SIM Small Cap
The fund is run by Vanessa van Vuuren and San Naidoo. It tries to remain true to its small-cap label and it has some unusual investments.
Its largest shareholding, for example, is Renergen (7% of the fund) which owns rights to numerous liquid gas reserves, including helium. It had a large holding in the direct catalogue retailer Homechoice (as high as 5% at its peak), which has been sold down. The fund now prefers essential retailers Pick n Pay and Pepkor. Its main financial holding is Sygnia (4%). Van Vuuren says it will be a disruptor in both asset management, through index funds, and employee benefits, through its innovative umbrella fund.
SIM Small Cap also owns Coronation and Quilter (the latter will surely soon join the large cap index) as well as Transaction Capital. Recently listed Ninety One is now on the radar. It is also looking at shares which have fallen out of the Large Cap Index such as Woolworths, Aspen and Tiger Brands.
Grand Parade Investments was acquired as a value play as it is far cheaper than the sum of the parts. The fund also owns Blue Label, more for its SIM card distribution business than for its holding in Cell C. It also holds a small interest in African Rainbow Capital, another share at a deep discount to its holdings, mainly for its holding in the 5G data-only telecom operator rain. Sea Harvest (4%) is its preferred entry into fishing, Afrimat (3%) into the construction industry.
The rules do not prevent these funds from holding commodity exchange traded funds. SIM Small Cap has a rather quirky holding in Absa’s NewGold, a straight investment in gold bullion which is a good diversifier. It was by far the best performer in the fund after Stefanutti Stocks in the first quarter, gaining 34%. The platinum holdings hurt most that quarter, along with one of the fund’s favourite shares, Curro.
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