Why you should con­sider small caps

Finweek English Edition - - COMPANIES & INVESTMENTS - Jes­sica Hub­bard jes­sicah@fin­week.co.za

With the f inan­cial news head­lines tra­di­tion­ally dom­i­nated by the JSE jug­ger­nauts such as SAB­Miller, Bri­tish Amer­i­can To­bacco, and the ma­jor re­source stocks, re­tail in­vestors hear very lit­tle about the small guys. (For the pur­poses of this ar­ti­cle, we will de­fine small cap stocks as those with a mar­ket cap­i­tal­i­sa­tion of un­der R5bn.)

Yet for those who are pre­pared to do their re­search, small caps can be hugely re­ward­ing, on many lev­els. While you do need a healthy ap­petite for risk, there are a num­ber of fac­tors that make them worth in­clud­ing – par­tic­u­larly if you are look­ing to di­ver­sify your port­fo­lio away from the usual sus­pects. “For a re­tail in­vestor, the ad­van­tage of in­vest­ing in small caps is di­ver­si­fi­ca­tion,” ex­plains Keith McLach­lan, se­nior re­search an­a­lyst at Thebe Stock­broking. “Your pen­sion fund and unit trust port­fo­lio is of­ten largely in­vested into Top40 stocks, and by in­vest­ing in small caps in your per­sonal ca­pac­ity, you can di­ver­sify your col­lec­tive port­fo­lio ex­po­sure.

Jean-Pierre Ver­ster, an an­a­lyst at 36ONE As­set Man­age­ment, adds that small caps are un­der-re­searched by in­sti­tu­tional an­a­lysts and there­fore can be­come sig­nif­i­cantly mis­priced. “Also, be­ing small com­pa­nies, they can ben­e­fit sig­nif­i­cantly from one or two ad­van­ta­geous de­vel­op­ments, and they usu­ally have en­trepreneurs at the helm with sig­nif­i­cant share­hold­ings them­selves, so mi­nor­ity share­holder in­ter­est is aligned with man­age­ment’s,” he says.

An­thony Clark, a Fi­nan­cial & In­dus­trial small & medium mar­ket cap an­a­lyst at Vunani Se­cu­ri­ties, points out that with small caps you are of­ten buy­ing growth at an early start to a stock’s life (if it’s a new list­ing). “Even An­glo Amer­i­can was a small cap stock once,” Clark adds.

Nat­u­rally, how­ever, th­ese ad­van­tages come with a num­ber of cons that need to be con­sid­ered. “For a re­tail in­vestor, [one dis­ad­van­tage] of in­vest­ing in small caps is the lower liq­uid­ity of the stock which may make en­ter­ing or ex­it­ing a po­si­tion chal­leng­ing,” says McLach­lan. Also, as Ver­ster ex­plains, small com­pa­nies have a higher risk of be­ing neg­a­tively im­pacted by com­pet­i­tive and eco­nomic de­vel­op­ments due to a less di­ver­si­fied busi­ness model. “Bank fund­ing is of­ten harder to get or at puni­tive rates, so small com­pa­nies with high debt lev­els are less re­silient due to less ne­go­ti­at­ing power with their bankers,” he adds. Th­ese risks make it par­tic­u­larly im­por­tant to do your home­work when it comes to small caps, or en­trust your hard­earned rand with those who make it their busi­ness to look for the solid per­form­ers. So what are the op­tions? “The low liq­uid­ity of this ‘long tail’ of the JSE means that there are no ETFs that in­vestors can buy (although there is a sin­gle mid-cap ETF avail­able),” says McLach­lan. “There are

really only two ways to get di­rect ex­po­sure to small caps: put your money into a small (& mid) cap unit trust or in­vest di­rectly into the stock mar­ket by buy­ing shares in small caps your­self.”

An­thony Durham, di­rec­tor at Cog­ito Cap­i­tal, ar­gues that the best way to get ex­po­sure to small cap com­pa­nies is to find a spe­cial­ist small cap as­set man­ager “who lim­its as­sets un­der man­age­ment”. Ac­cord­ing to Clark, the best route to gain the re­quired ex­per­tise and ex­pe­ri­ence is via the var­i­ous Small Cap Unit Trusts on of­fer from many of the ma­jor in­vest­ing in­sti­tu­tions. “The Mo­men­tum, Corona­tion, San­lam and Stan­lib funds have well-es­tab­lished plat­forms and track records,” says Clark.

“Di­rect eq­uity in­vest­ment into a small­cap eq­ui­ties can be riskier as you are putting “all your eggs in one bas­ket” and as a rule of thumb, small caps should only be 5%-10% of a balanced fund due to the risks as­so­ci­ated with them.”

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