Why you should consider small caps
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.”