Companies that fall outside of the JSE’s 40 biggest firms, referred to as small-and mid-cap stocks, are among the cheapest in the world, but investors are largely ignoring them despite prospects for juicy returns, says Keith McLachlan, a fund manager at AlphaWealth.
SA’s small-cap sector was trading at almost the same lows experienced during the global financial crisis, McLachlan, a small-cap specialist, told Business Day on Wednesday.
He has benchmarked the JSE’s small-and mid-cap indices against similar indices worldwide, finding they rank consistently near the bottom of the pile when measuring the price of the index against the value of its profit, assets and revenue. Only Italy’s small-caps were cheaper, but SA’s fundamentals were better, he said. As the economic outlook improved, companies in this sector were likely to generate a good return.
SA’s equity sector is dominated by giant companies, with Naspers, Richemont and BHP making up nearly 40% of the JSE’s Top 40 index. Companies such as these have been popular because they are considered "rand hedges", protecting investors from a decline in the value of the local unit, by earning income in foreign currency.
Firms outside of the Top 40, numbering more than 300, are more exposed to the domestic economy, which has made them less attractive to investors seeking offshore exposure amid political and economic turmoil in recent years.
But even after accounting for risks, such as weak economic growth and capital outflows from emerging markets, small-cap stocks were trading at deep discounts to their historic norms and much higher than comparative valuations internationally, said Jarred Winer, who manages the Westbrooke special opportunities hedge fund. The discount was likely to narrow.
Westbrooke had been increasing exposure to deeply discounted investment holding companies, including Sandown Capital, Stellar Capital and Trematon. It also favoured companies that stood to benefit from improved operating margins, as a result of revenue growth in the medium term, as the economy picked up, Winer said.
On a price-to-earnings (P/E) basis, which measures current share prices relative to per-share earnings, 62 operating companies with a market value below R2bn were trading at a 22% discount to the five-year average, Westbrooke found.
This compared with the 9% premium at which the JSE’s Top 40 was trading relative to its five-year P/E average.
Investors had favoured larger companies with more liquid shares, Westbrooke said.
Small-caps were partly very cheap because liquidity, the ease with which stocks could be bought and sold, was a problem, Graeme Körner, founder at multi-asset manager, Körner Perspective told Business Day.
The limited number of shares available was partly to blame, since anchor shareholders, often management, held large stakes. While management teams needed to increase engagement with the market to diversify the share register, money managers were also guilty of not doing enough work in the small and mid-cap space, he said.
Small-cap research was more qualitative than quantitative, requiring a deep understanding of the company.
While investors "had to be brave" when buying small-cap companies, as they took time to deliver returns, large-caps were trading on high earnings multiples. Now was a good time to take money out of stocks that had run hard and "look for shelter in undervalued small-caps".
Of the 1,584 unit trusts listed by the Association for Savings and Investment SA at the end of March, only 10 had a focus on small and mid-cap companies.