One of the more welcome side effects of the pandemic has been that as the local economy recovered from the various hard lockdowns, sentiment improved for much-maligned small-and mid-cap stocks on the JSE.
This rosy sentiment had been Awol for a number of years as the domestic economy started to grind dangerously, and some counters were marked well below hard NAVs.
Surviving Covid seems to have brought the fact that a good number of local businesses are hardy and adaptable to the attention of investors, who now seem happy to buy into a longer-term recovery story. No doubt, the easy money was made in the latter half of 2020. But is there still good value to be had in small-and mid-cap stocks?
The formal definition of the small-cap index is all the companies listed on the JSE excluding those classified as top 40 or mid-cap shares.
IM prefers a broader definition of the smaller-cap sector investment universe as being all the companies listed on the JSE (including mid-caps and AltX), excluding the top 40 shares — providing a vast investable universe and spoiling the investor for choice.
In the past, small caps have created some extreme valuation opportunities, mainly because smaller-cap companies are generally ignored by the research departments of most major stockbroker houses. This is primarily due to the fact that the research process required for analysing these companies is as intense as that for the larger, more liquid counters — but the latter generate significantly more brokerage. This creates natural price inefficiencies in the market, and can present exciting opportunities. You can take advantage of this by actively researching these smaller companies, keeping abreast of the news flow and understanding the value of the business relative to the share price, then patiently waiting until there is a discount (the wider the better) between the share price and the perceived value.
Strong balance sheets are important but more so in the small-cap space, and debt needs to be managed carefully to be able to weather unpredictable events
The price you pay for an investment is often the only control you have over that investment (as the price you sell at may be prematurely forced by events out of your control such as having to sell shares to buy those law books your university-going son may suddenly need).
As market indices are typically classified by market cap, the classification of a company as part of an index can drastically change as a result of a market or sector event which causes the share price to fall, despite the company still remaining structurally sound. This share price fall can occasionally result in a company losing its place in the large-cap index, forcing a sale by passive investors who may be restricted to only invest in a specific index, for example the top 40.
If the business remains sound, an attractive investment opportunity may occur — the investor may, however, need to be patient as it may take a few financial reporting periods before confidence is reinstated in the share price.
Although small caps are defined as a sector classified by liquidity and market capitalisation, they typically share a common link to the domestic economy (there has been limited success by smaller companies moving their business models offshore, for example the failed acquisition by Famous Brands of Gourmet Burger Kitchen in the UK).
This is an extremely varied universe, however, and there is the opportunity to invest in a plethora of different business strategies, from mining to leisure, with the chance to back entrepreneurial and innovative management and strategies (such as Cartrack and Libstar), as well as businesses with established track records such as Hudaco and AECI.
Due to the more limited trading liquidity, smaller-cap investments require a longer-term commitment to the business and the ability (or strong stomach) to buy and hold despite short-term volatility in markets. The buying leg may be relatively easy, but when the chips are down, any forced selling may come at a far larger cost than with their larger-market-cap cousins.
Opportunities (and risks) are often found when businesses are least loved and liquidity is low, and this is ironically when the company may be offering the most value. Business cycle downturns (and upturns) are generally overstated in the share prices of small listed companies and investors are best off adopting a through-the-cycle view, and be prepared to accept a longer-than-normal holding period.
Buying into themes (such as the IT theme in 2000 or the construction theme leading up to the 2010 Soccer World Cup) has typically not proved to be a winning strategy — time after time it has proved best to rather wait until the theme dissipates, and then to sift through the survivors of that theme after the sector’s share prices have plummeted (usually as a result of lofty promised earnings not materialising), to find the one or two quality businesses whose share prices have come under pressure due to all companies associated with that theme being painted with the same brush.
An investor in small-cap shares already needs to accept the risk of lower-than-average market liquidity
As an example, if you had bought construction company WBHO at the peak of the World Cup construction boom in September 2008, and held it to date, your return would still be negative (the construction sector in SA has been particularly bruised in recent years because of a lack of government infrastructure spending during the "lost decade"). Had you, however, been patient and waited for the collapse of the construction theme as valuations returned back to earth, and then bought WBHO six months later in March 2009, your return would be a positive 22%. Still not a great return, considering the time period, but much better than the negative 50% return for the construction sector as a whole over the same period.
In recent market moves, the small-cap sector collapsed in line with the rest of the market last March. The sector has since almost doubled from the bottom of the collapse. Looking at the performance of different companies, it is clear that the share prices of those that benefited from the work-from-home dynamic rebounded quickly as investors anticipated the shift in spending as consumers moved quickly online (ICT company Mustek’s share price is up almost 100% from its low last year) and did more DIY (with companies such as Cashbuild and Italtile returning 200% and 75% respectively from last March).
Other areas have taken longer, such as the leisure sector, which completely collapsed (Sun International is still down some 40%) but may now be offering value if SA follows (with a lag) the dynamics recently seen in developed markets. In the US, for example, those shares most pummelled during the Covid crisis, such as cruise ship stocks, have rallied hard on the "reopening" trade, as it became clear that vaccine programmes would be rolled out quite rapidly in developed markets.
Domestically, property stocks — once the darlings of large-cap investors — have now been relegated to mid-and small-cap status and though they are at extremely cheap valuations, dynamics in this sector may remain challenging for some time. This is mainly a result of many property companies carrying more debt than is ideal and needing to focus on degearing their balance sheets as the environment remains uncertain.
An investor in small-cap shares already needs to accept the risk of lower-than-average market liquidity — compounding this challenge with high debt levels (and associated refinancing and bank covenant risk) is undesirable into a downturn and investors need to carefully consider balance sheet strength when valuing potential investments at different points in the cycle.
Strong balance sheets are always important but more so in the small-cap space, and debt needs to be managed carefully to be able to weather unpredictable events.
As the pandemic illustrated, companies with weak balance sheets at the onset of the pandemic, such as Sun International and City Lodge, had to accept wide discounts to their share prices when they were forced to raise cash to strengthen their balance sheets to survive the temporary Covid-related loss in income. Those businesses that entered lockdown with a relatively strong balance sheet, however, such as self-storage company Stor-Age, were able to take advantage of the crisis by raising cash at a narrow gap to their share price.
One of the pleasures of investing in smaller companies is that the managers are often the founders of the business and can be generous with their time
A key desirable attribute of all investments is the skill and strength of management, but in smaller companies this is essential.
One of the pleasures of investing in smaller companies is that the managers are often the founders of the business and can be generous with their time when interacting with existing and potential investors. They are usually large shareholders — having "skin in the game" — which can mean that their interests are aligned with minority shareholders.
A potential negative is obviously the occasional founder who operates with a sense of entitlement, conveniently forgetting that the company is listed and has other shareholders to deal fairly with, so keeping a watchful eye over corporate governance is crucial. Companies with a track record of flouting corporate governance issues should be actively challenged.
Though small caps can help boost performance in a portfolio, it is key to bear in mind your personal risk factors and investment horizon, as smaller companies by their nature can be perceived as higher risk. When building an investment portfolio, I have always adopted a strategy similar to that of owning a major shopping mall, with anchor tenants holding strategic positions and a number of smaller "mom and pop" stores positioned around them. In a portfolio context the "anchor tenants" could be large caps or use of a passive strategy, and the "smaller tenants" smaller alpha-generating companies.
Investing in small-cap companies may require a bit more work for investors (due to the lack of broader coverage), but you are rewarded with the potential for superior opportunities and returns due to market inefficiencies.
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