ANALYSIS: Small-cap funds can be a big deal
With R6,9bn under management the mid-and small-cap category is the third-largest specialist equity category after large caps (R23bn) and industrials (R7,6bn).
The sector does not resonate well with investors looking for much broader multi-asset mandates. Most of the funds were formed in the late 1990s, when there was high demand for sectors promising high growth, much of it from "exciting" businesses with opportunity to take market share from slower rivals. Only two funds were launched in the past 10 years, by wealth management groups Nedbank Wealth and AlphaWealth.
Though popularly known as small-cap funds, the universe of these funds is made up 85% by mid caps. The funds have a mandate to invest in anything outside the Top 40, though there is a grey area now that Life Healthcare and Bidvest are simultaneously mid caps and in the Top 40. These funds are not obliged to sell shares when they come into the Top 40 and this presents unexpected opportunities. Recently, there was a short window when AngloGold Ashanti, Impala Platinum and Sibanye Gold were moved out of the Top 40.
Small-cap managers have always complained about the lack of quality resources shares outside the Top 40. Daniel Sacks, manager of the Investec Emerging Companies Fund, took advantage of this opportunity and is now close to 40% invested in resources. But many fund managers consider such investments to be against the spirit of the small-cap funds, which is all about backing entrepreneurs in consistently growing companies.
Anthony Sedgwick, manager of the Nedgroup Entrepreneur Fund, says a few extra tried-and-tested screens are applied to small caps to prevent poor share selection. It looks for companies where earnings is matched by cash flow.
The operating profit in the income statement can provide comfort only if it translates into cash in the bank. There also needs to be a great deal more care about the liquidity of a small cap. Nedgroup and Investec, as the larger funds in the portfolio, realistically need to take a holding in a share which accounts for 2% of the fund. This equates to R40m-R50m, which for some shares can take time to sell.
Sedgwick, who works at Abax Investments, says he is reluctant to acquire speculative investments (of course, they all say that). But he will pay up if there is a substantial profit growth momentum with some longevity. He believes it is essential to take a view of top management, especially the CEO.
These aren’t businesses like a Nestle or Unilever, which will continue to pump out profits even if there is an indifferent CEO. Often small companies are family businesses, not run primarily on a shareholder-value basis. And often small-cap CEOs have the ambition to get big, ignoring the impact on profit and dividends.
The attraction of a well-run small-cap fund is that even though small caps can be more volatile than the shares in the Top 40 they should provide a higher return over time. That might not be much compensation for people who have tolerated the weaker returns shown by small caps over the past 10 years.
Small-cap managers can also be criticised for playing in only one part of the market, particularly food and beverages, retailing, information technology (even though the sector is poorly populated on the JSE: EOH and AdaptIT are both popular) and construction-related businesses — through support businesses such as Raubex and Afrimat, not the traditional contractors.
Small-cap funds, though, have almost entirely missed the boom in the property sector, which makes up about 15% of their universe and which has been the best SA asset class over the past decade. Nedgroup Entrepreneur has one of the heavier exposures to property, of 2,5%, and only in niche businesses such as Balwin Properties, Delta and New Europe Property Investments.
The five funds that are featured this week do not make a homogeneous group. The one that comes closest to what the layman imagines to be a small company fund is SIM (Sanlam) Small Cap. Its largest holding is that classic small cap and longtime favourite of private investors, Bowler Metcalf. It has a 75/25 split between small caps and mid caps. Coronation Smaller Companies has a similar view, with some big operations such as insurers MMI and RMI. Not that investment purity has helped these funds gather assets. Even with the Coronation brand behind it, its Smaller Companies fund has just R168m, SIM’s R365m.
I don’t associate Warren Jervis, manager of the Old Mutual Small Companies fund, with purity. He is happy to hold some larger businesses such as Discovery, Reinet, Life Healthcare, Massmart and Imperial, and he points out that the R1bn-strong fund is a good 75% mid caps.
The big battle is going to be between the two R2bn-plus funds, Nedgroup Entrepreneur and Investec Emerging Companies. Nedgroup’s fund has been at times more than 30% exposed to Top 40 shares and still holds a few gigantic companies such as Naspers and BAT. It has a proven stockpicking methodology and will always be the fund to beat in this sector. That isn’t true of the Investec counterpart, which never repeated its superb start from 1997 to 1999. It was an interesting decision to make the fund much more focused on resources than any small cap fund had ever tried to be.