Small cap can be a big deal

Financial Mail - Investors Monthly - - Analysis: Small-cap Funds -

ith 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

Wap­plied 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 Adapt IT 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.

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