Financial Mail - Investors Monthly
SMALL, MID-CAPS TO THE FORE
Often neglected, small-cap shares have outperformed the JSE top 40 over the past 10 years, writes Stafford Thomas
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.”