Small-cap stocks to bet on

There’s still little evidence of the big things that have long been expected for the JSE’s bombed-out small-cap counters so far in 2019.

With the overall market — courtesy of an early resource sector rally and sprightlier performance from market heavyweights like Naspers, British American Tobacco, Richemont and AB InBev — looking firmer in the first quarter, there was a more than reasonable expectation from wide-eyed punters that small-cap counters might catch this swelling wave of improved sentiment.

Not quite. Risk aversion still seems prevalent in 2019, which probably means further outflows from smaller-cap counters — perceived as higher risk — to the relative safety of recovering blue-chip counters.

Some of the most popular small-cap counters have actually got cheaper — and, in some instances, a whole lot cheaper.

There are more than a few notable mid-cap fizzles — including PSG-owned agribusiness Zeder, health-care group Ascendis (now a small cap by definition), Blue Label Telecoms and EOH — that probably set the tone for jaundiced sentiment in the small-cap sector.

Not many of the small caps have suffered huge setbacks, as have some of the examples above — yet the value markdown has been pronounced. A few examples of nasty value smackdowns in the past 12 months would include Santova, financial services hub Finbond, document storage group Metrofile, infrastructure investor Gaia, insurer Conduit Capital and property developers Balwin and Calgro M3 as well as asset manager Anchor, fast-food franchiser Taste, junior miner Wescoal, electrical products specialist ARB Holdings, industrial services business ENX, services group CSG and technology groups Etion and Adapt IT.

The general consensus is that small caps remain largely overlooked — no matter their individual prospects — and that institutional investors are either exiting the sector as quickly as possible, or are willing to stare too hard at even the most promising candidates.

That said, in the past six to 12 months more than a handful of small-cap counters have adequately rewarded investors for their patience.

Punts on technology groups Mustek and ISA Holdings as well as logistics business Value Group, industrial conglomerate Argent, niche telecoms player TeleMasters, agribusiness Crookes Brothers, consumer goods distributor Nu-World and investment company Stellar Capital Partners have all been rather rewarding in the short term.

No doubt a few more counters will run hard in the next six to 12 months. Spotting these "winners", however, is no easy task.

Small-cap counters are largely under-researched by mainstream asset managers, and there is certainly no reassurance in the standard institutional response that "we’ve never looked at them".

There are also some off-putting generalisations around small caps. Profit (and indeed, dividend) track records need to be long before the mainstream investment houses sit up and take notice. This contention is certainly backed by the single-digit earnings multiples placed on a good number of small-cap stocks.

There is also the inevitable temptation, probably more so in companies generating consistent profits and cash flows, to pursue a path of ambitious corporate activity to bolster operational span and market value. While successful endeavours can attract more mainstream market interest, the execution risks and non-operational distractions can — and have — proved ruinous in the past.

With the large constituents of the JSE seemingly on a (gradual) upward trajectory, there might also be scant appetite for chasing illiquid and obscure counters tucked away in the musty corners of the JSE.

But Samantha Steyn, CIO of Cannon Asset Managers, still believes one of the best courses of action is to invest away from the stocks that make up "the market index" — specifically mid-cap and small-cap shares.

She concedes that the mid-and small-cap sectors tend to experience greater volatility than the broader market; these shares have historically outperformed larger companies over time.

"Structurally, most large investment houses are unable to invest in this part of the market due to their size.

"They can’t acquire a large-enough stake in a small-cap business to make enough difference to their large fund — and they are therefore compelled to invest in larger-cap stocks. As a result, in large investment funds, a significant portion of the portfolio is concentrated in a few large companies."

Steyn argues the result is that investors in these large funds miss 90% of the opportunities available on the JSE.

Of course, with valuations still dwindling to dismissive levels there is more share buyback activity, or a willingness to release excess capital as a special dividend.

Companies like Argent, Quantum Foods and Novus have most certainly perked up their long-depressed share prices with their active share buyback exercises, while counters like Hosken Passenger Logistics & Rail (Hosken Pax), Sabvest and Bowler Metcalf have sustained sentiment by passing back excess capital to shareholders in the form of special dividends.

There have also been strategic tilts at small-cap counters — like the activist thrust at Grand Parade Investments and the emergence of new strategic investors at companies like Blue Label and Sun International.

A growing number of buyouts and delistings from the JSE — including Clover, Cargo Carriers, Verimark, Howden Africa, Torre Industries, Global Asset Management, Interwaste and Master Plastics — also reinforce notions that there is longer-term value to be had in smaller counters.

Investors willing to delve into small caps at this intriguing time might consider these dozen candidates for consideration in the months ahead:

Insimbi: This low-key company provides ferrous and nonferrous alloys, refractory and foundry materials, plastic blow moulding production and alloy recycling processes, ensuring a diverse income stream from a diverse client base. Decent cash flows have sustained regular dividends, and allowed the company to buy back its shares, which trade on a forward multiple of less than seven times.

RECM & Calibre*: Though this company offers a discount ticket to a well-diversified portfolio of unlisted and listed investments (of variable quality, it must be said), the jewel is the controlling stake in alternative gaming group Goldrush. It seems logical that Goldrush will be separately listed to unlock its full value and dangle an attractive dividend yield.

Hosken Pax: This mobility counter revolves mainly around Golden Arrow Bus Services (GABS). Passenger transport may not sound like the sexiest small-cap pitch, but GABS offers a vital and highly efficient service in Cape Town that generates reliable income flows even in lean times. Hosken Pax won’t shoot the lights out, but it will drive solid returns for the foreseeable future.

Hulamin: This aluminium extractor should be one of the hippest investments on the JSE, what with aluminium viewed as the metal of the future and with the company’s determined feeding into green issues via its meaningful recycling effort. Hulamin is well managed, but perhaps dour market perceptions are informed by an inconsistent profit performance over the years. The latest results to end-December place the counter on a ridiculously low earnings multiple (compared to global peers), which surely flags Hulamin as a potential takeover target.

Combined Motor Holdings (CMH): This counter’s profit engine has been purring smoothly since it first listed in 1987. CMH has not changed too much over the years (save for a dalliance into watersports), with its most important and enduring attribute the conservative management of the company. Though growth is unlikely in the short term, CMH’s profitability for the medium term still means the ruling share price offers cheap fare for longer-term investors.

Quantum Foods: Most investors might find this food commodity player’s offering of poultry, eggs and animal feeds too bland. Quantum, however, is dirt cheap — which no doubt explains the share repurchase efforts of late. While the commodity range is admittedly prone to fickle trading conditions, investors are buying into a highly regarded management team determined to sustain a lean and mean operation. Quite frankly, it would be surprising if predators did not swoop on Quantum at this delicate swing of the commodity cycle.

Deneb Investments: This heavily discounted industrial company really revolves around its underlying properties, many of which are being redeveloped. While it’s really regarded as a pure value play, some commendable progress is being made by CEO Stuart Queen in securing sustainable profits from the various industrial operations (which formed part of the old Seardel Group). The short-term outlook is hardly enticing — but the downside is very limited and Deneb could have some serious legs over the longer stretch as its property portfolio comes increasingly into play.

Cognition: This specialist services company is now a work in progress, with Caxton emerging as the dominant shareholder after reversing its Private Property real estate marketing platform into the business. More operational assets will be ushered into Cognition from Caxton to hopefully create a compelling dominant platform. On the traditional business offering — most notably services offered to the fast-moving consumer goods market — dividend-paying Cognition is trading at modest levels, and offers a well-priced option on a more exciting longer-term proposition.

Workforce: This services business — which includes a sizeable human resourcing segment — is more unfashionable than yellow Crocs. But it’s difficult to look past a perennially profitable Workforce on an earnings multiple of just 3.5 times. The rating suggests a calamitous collapse in earnings. But that’s not exactly the case, even if shorter-term prospects are linked to a moribund economy. Longer-term plans to list the various business silos separately could be inspired in terms of an enormous value unlock.

ARB Holdings: This is a classic case of a good company in bad times.

The immediate outlook for ARB’s core electrical business won’t spark sentiment, but any further dulling of the share price is probably a good buying opportunity. The Eurolux lighting business (now with Radiant Lighting on board) remains a bright spot, and the company’s ungeared position with a net cash stash of R148m means opportunities for acquisitions, share buybacks or more special dividends. The share price is stoutly underpinned by tangible NAV of 363c a share.

*The writer holds shares in RECM & Calibre