Of­ten ne­glected, small-cap shares have out­per­formed the JSE top 40 over the past 10 years, writes Stafford Thomas

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Smaller-cap shares have been out­matched of late in the mar­ket per­for­mance race by the likes of hard-run­ning JSE top 40 heavy­weights Naspers, Aspen, Stein­hoff and SABMiller. It rep­re­sents an ex­cep­tion to the rule, ac­cord­ing to mar­ket his­tory.

“The small- and mid-cap sec­tors pro­duce bet­ter re­turns than the big-cap sec­tor over the long term,” says Evan Walker of 36One As­set Man­age­ment.

Ham­mer­ing this home, the top 40 in­dex’s 510% to­tal re­turn over the past 10 years is im­pres­sive but no match for to­tal re­turns of 820% from the small-cap in­dex or 690% from the mid-cap in­dex.

Nor­mal­i­sa­tion of the per­for­mance race would seem to be only a mat­ter of time. It could be sooner rather than later. Sug­gest­ing this, the JSE top 40 in­dex’s PE rel­a­tive to the JSE small-cap in­dex’s PE is now at one of its high­est lev­els in 20 years, re­veals San­lam In­vest­ment Man­age­ment (SIM) re­search.

“Small caps more so than mid-caps is where the real value lies at present,” says Richard Mid­dle­ton, man­ager of In­vestec Emerg­ing Com­pa­nies Fund.

Ven­tur­ing into the smaller cap uni­verse brings the chal­lenge of stock pick­ing across a far higher num­ber of shares: 283 on the JSE main board. Two-thirds of th­ese meet the gen­er­ally ac­cepted def­i­ni­tion of a small-cap share: a mar­ket cap un­der R4bn. Be­tween the small caps and the top 40 lie the mid-caps.

Po­ten­tially also in the smaller cap in­vestor’s uni­verse is the JSE AltX mar­ket, home to 61 ul­tra-small caps. It is a mar­ket most pro­fes­sional smaller cap play­ers stay clear of.

“There may be some hid­den gems in the AltX mar­ket but the po­ten­tial re­turn is not worth the re­search ef­fort to find them,” says War­ren Jarvis, man­ager of Old Mu­tual Small Com­pa­nies Fund.

And there is no short cut to stock pick­ing in the smaller cap uni­verse. “You must have a thor­ough un­der­stand­ing of a business,” says Jarvis. One key pro­viso, he em­pha­sises, is that a smaller company’s man­age­ment

must also have a big stake in the business.

Pa­tience is of­ten also re­quired. “You must buy with a long-term view,” says Mid­dle­ton of a sec­tor that of­ten de­mands tar­get­ing shares shunned by most in­vestors. “Some com­pa­nies in the fund have been through a tough time in the past few years.”

One of th­ese he is back­ing as a top-10 hold­ing is build­ing sup­plies group Dis­tri­bu­tion & Ware­hous­ing Net­work (Dawn). Mauled by the build­ing sec­tor slump, Dawn’s head­line EPS (HEPS) have re­cov­ered from their 2011 low but still stand at only a third of their 2009 peak.

Mid­dle­ton be­lieves Dawn’s re­cov­ery has long legs: “I rate Dawn’s man­age­ment as one of the best of any small cap.”

With an ex­ten­sive re­struc­tur­ing be­hind it the next game changer for Dawn, says Mid­dle­ton, is the re­cent sale of a 51% stake in its plumb­ing and san­i­tary­ware man­u­fac­tur­ing business to the world’s big­gest player in the in­dus­try, Ger­man group Grohe, for R880m.

“It will al­low Dawn to re­pay its heavy debt bur­den [R500m] and con­cen­trate on its core dis­tri­bu­tion com­pe­tency,” says Mid­dle­ton. “With Grohe as a part­ner, ex­pan­sion in Africa will be a pri­or­ity.”

Another small cap on few in­sti­tu­tional radars is tim­ber prod­ucts group York whose HEPS have slumped over 60% since 2011. York’s at­trac­tion is the big dis­count to its R7/share tan­gi­ble net as­set value (TNAV), says Wil­helm Hert­zog of RECM which has built an 8% stake. York is trad­ing at a third of its TNAV.

Un­der­pin­ning York’s TNAV is its vast tim­ber plan­ta­tion in the Sa­bie dis­trict. Un­lock­ing the value of its tim­ber re­sources and restor­ing profit mar­gins is now the fo­cus of a raw ma­te­rial and pro­duc­tion op­ti­mi­sa­tion ini­tia­tive set to cost at least R1.2bn over the next four years.

Al­ready un­der way, CE Pi­eter van Zyl pre­dicts the ini­tia­tive will trans­form the company from one ham­strung by out­dated tech­nol­ogy and equip­ment into one ca­pa­ble of hold­ing its own with the best in the world.

A small cap that is at­tract­ing grow­ing at­ten­tion is Con­sol­i­dated In­fra­struc­ture Group (CIL). Al­ready a small cap win­ner, CIL has through a fo­cus on serv­ing high-growth sec­tors and as­tute ac­qui­si­tions mas­ter­minded by its CE, Raoul Gamsu, more than dou­bled its HEPS over the past four years.

“There a lot more growth still to come,” says Jarvis who has the en­gi­neer­ing so­lu­tions company as his fund’s sec­ond-largest hold­ing. “It has a record R3bn or­der book which could dou­ble rapidly.”

Mid­dle­ton shares Jarvis’s op­ti­mism on CIL, ramp­ing it up to his fund’s top hold­ing at a

Italtile is a phe­nom­e­nal business. It has one of the best man­age­ment teams in SA

hefty 8% ex­po­sure.

CIL’s win­ning growth for­mula is its fo­cus on the huge need for in­fra­struc­ture de­vel­op­ment in SA and the re­gion where it now gen­er­ates almost 60% of its profit, sub-Sa­ha­ran Africa.

CIL’s drive into Africa was spear­headed by its Conco unit, a high-volt­age elec­tric and re­new­able en­ergy project spe­cial­ist. Risk-re­duc­ing di­ver­si­fi­ca­tion came in 2012 with the ac­qui­si­tion of a 30.5% stake in AES, an An­golan en­vi­ron­men­tal business serv­ing the coun­try’s off­shore oil and gas in­dus­try. Just added to CIL’s line-up is rail­way elec­tri­fi­ca­tion spe­cial­ist Trac­tionel.

CIL has the mak­ings of another How­den Africa. A 55%-owned sub­sidiary of US en­gi­neer­ing equip­ment heavy­weight Col­fax, How­den’s equip­ment and ser­vices span large-scale power gen­er­a­tion, min­ing, con­struc­tion, petro­chem­i­cals and en­vi­ron­men­tal safety.

Sum­ming up How­den, CE, Thomas Bär­wald noted re­cently: “Its equip­ment un­der­pins eco­nomic de­vel­op­ment on the African con­ti­nent.”

Though How­den is it­self a light­weight with a mar­ket cap of only R2,7bn, it has heavy­weight per­for­mance cre­den­tials, grow­ing HEPS almost four­fold over the past five years.

How­den’s per­for­mance met­rics are as im­pres­sive and in­clude an ex­cep­tional re­turn on eq­uity (RoE) of 77%. As no­table, How­den’s RoE has been ris­ing for many years with no help from gear­ing.

In­deed, How­den is hugely cash-gen­er­a­tive and paid hefty spe­cial div­i­dends in 2010 and 2012, boost­ing to­tal re­turn to share­hold­ers over the past five years to well over 700%.

Another spe­cial div­i­dend may not be far off. How­den ended its half-year to June with its bal­ance sheet bulging with cash of R487m, an amount equal to 72% of share­hold­ers’ funds.

If there is a down­side to How­den, it is poor trad­ing liq­uid­ity. At about R40m/month this has limited in­sti­tu­tional in­ter­est in the share. But for pri­vate in­vestors, ac­cu­mu­lat­ing the share is more than fea­si­ble with pa­tience.

Ac­cu­mu­lat­ing Taste Hold­ings shares de­mands even more pa­tience, with trad­ing in the fast-food and jew­ellery fran­chisor’s shares av­er­ag­ing a mere R8m/month. But Taste could be worth the pa­tience.

Taste founder and CE Carlo Gon­zaga has big plans for Taste, a company he has al­ready grown from 200 to 630 stores since its list­ing in 2006. Cen­tral to his cur­rent strat­egy is ag­gres­sive growth in the pizza seg­ment where Taste’s Scoot­ers and St Elmo’s brands rank sec­ond to heavy­weight Fa­mous Brands’s De­bonairs.

It sets the scene for a bat­tle royal and has prompted Fa­mous Brands CE Kevin Hed­der­wick to de­clare: “Let the pizza wars be­gin.”

Taste has heavy­weight back­ing from US global pizza gi­ant Domino’s through a 30-year master fran­chise agree­ment cov­er­ing South­ern Africa. “Domino’s is a for­mi­da­ble brand,” says PSG Eq­uity Fund man­ager Shaun le Roux. “I do not think the mar­ket re­alises it.”

Con­ver­sion of Taste’s 140 Scoot­ers and St Elmo’s stores to the Domino’s brand is un­der way and will be com­pleted in 2015. Sup­port­ing Gon­zaga’s big growth

plans which in­clude pur­su­ing Taste’s ap­petite for ac­qui­si­tions, R180m was raised through a rights is­sue in Septem­ber while a fur­ther R880m is avail­able through its listed R1bn note pro­gramme.

For now, Taste is a small small cap with its mar­ket cap just top­ping R850m, a frac­tion of Fa­mous Brands’s R10.5bn.

But then Fa­mous Brands was it­self a very small cap less than a decade ago.

But mar­ket caps are not ev­ery­thing. Another player in the fran­chise space, Spur Corp, has never moved beyond be­ing a small cap since its list­ing 22 years ago. But it is a share that has proved it­self wor­thy of stal­wart sta­tus in a long-term port­fo­lio, says Ricco Friedrich, a SIM fund man­ager.

Value is not con­fined to small caps alone. In the mid-cap space Mid­dle­ton and Walker be­lieve KAP in the Stein­hoff sta­ble has the mak­ings of a win­ner. Mid­dle­ton puts it sim­ply: “It is a great company with great man­age­ment.”

Headed by veteran CE Jo Grové, KAP is hugely cash-gen­er­a­tive. It has en­abled the group to slash debt in­curred when Stein­hoff re­verse listed its lo­gis­tics unit Uni­trans and tim­ber prod­ucts unit PG Bi­son into KAP in 2012.

KAP, hav­ing also sold three non­core busi­nesses — Bull Brand, Brenner Mills and footwear man­u­fac­turer Jor­dan — is now po­si­tioned to em­bark on an ag­gres­sive ac­qui­si­tion strat­egy, says Walker.

Italtile is another company in the mid-cap space with a strong in­sti­tu­tional fol­low­ing. And for good rea­son.

Italtile, SA’s largest tile re­tailer, has earned its stripes. “It is a phe­nom­e­nal business,” says Friedrich. “It has one of the best man­age­ment teams in SA.”

Jarvis is also a staunch Italtile fan. “Its business model is ro­bust and has en­abled it to pro­duce an RoE of over 20% even dur­ing tough­est pe­ri­ods in its mar­ket,” says Jarvis.

Since 2008 Italtile has faced a build­ing sec­tor slump and a pe­riod of rand strength be­tween 2009 and 2011 that pit­ted it against cheap im­ports. At their worst in 2011, Italtile’s HEPS had fallen a mere 7.5% since 2008.

Italtile went on to re­bound, lifting HEPS by 75% be­tween 2011 and its year to June 2014.

Mar­ket con­di­tions are now strongly in Italtile’s favour, says Jarvis. Also in its favour is a high lo­cal con­tent with about 70% of the tiles it sells made lo­cally by its af­fil­i­ate, Ce­ramic In­dus­tries.

Italtile’s com­peti­tors who rely on im­ported tiles are be­ing “dec­i­mated” by the weak rand, says Jarvis. Com­bined with Italtile’s revamped lo­gis­tics in­fra­struc­ture, Jarvis pre­dicts: “Italtile is in for five years of strong growth.”

A ro­bust business model and strong man­age­ment is also to be had in pa­per and plas­tics group Mpact. Though Mpact just makes the mid-cap range with a mar­ket cap of R6bn, it is a company with big-company at­tributes that in­clude be­ing by far SA’s big­gest PET plas­tic bot­tle pre­forms and clo­sures pro­ducer.

“You can buy Mpact for the medium to long term, sit back and be sure its man­age­ment will

Taste founder and CE Carlo Gon­zaga has big plans for Taste, a company he has al­ready grown from 200 to 630 stores since its list­ing in 2006

do the right thing,” says Mid­dle­ton. “It is a sleep-easy in­vest­ment.” Un­bun­dled by Mondi in July 2011, Mpact has de­liv­ered con­sis­tently solid growth with more to come. A con­sen­sus fore­cast by an­a­lysts polled by I-Net Bridge look to Mpact lifting its HEPS 14.5% in its year to De­cem­ber and by 13%/year on av­er­age over the next two years. On a solid value 12-month for­ward 12.5 PE, an­a­lysts jus­ti­fi­ably rate Mpact a buy.

For in­vestors look­ing for po­ten­tially higher share price up­side and pre­pared to take a far higher risk, plat­inum group met­als (PGMs) miner Aquarius Plat­inum with op­er­a­tions in SA and Zim­babwe presents an in­ter­est­ing spec.

Ham­mered by the bear mar­ket in PGMs, Aquarius’s share price has col­lapsed by 95% since 2010, leav­ing it with a mar­ket cap of only R3.5bn. Mid­dle­ton sees the po­ten­tial for a big re­cov­ery.

“Aquarius has re­struc­tured its op­er­a­tions and op­er­a­tionally is do­ing very well,” says Mid­dle­ton. “If we get a re­cov­ery in PGM prices, my tar­get price for the share is R7,00.” Aquarius is now trad­ing at R2.40.

Aquarius is an in­ter­est­ing punt and one rad­i­cally dif­fer­ent to the de­pend­abil­ity of shares such as Italtile and Mpact. For good rea­son, Mid­dle­ton com­ments: “Smaller caps are the ex­cit­ing part of the mar­ket.”




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