Honey, I shrank the stocks
Investors chasing value should pay attention to management
LISTED companies with relatively small market capitalisation can offer exaggerated risk-reward scenarios that make them attractive for the adventurous investor.
Despite an intimidating lack of available research or long track records, there are ways investors can do well at the junior end of the JSE.
It’s a risky gamble though. To list on the JSE’s breeding ground for small companies, AltX, a company needs only equity capital of R2-million, compared with the R25-million needed for the main board. But while the chance of a company failing on AltX is radically higher than on the main board, the chance of extreme growth is also much higher.
First, the bad news. Any small-cap stocks are out of reach for large institutional investors, especially cautious pension funds.
This means liquidity is usually constrained, especially in micro-cap companies, as it’s often quite tricky to get hold of the shares. Volatility can be extreme, especially in the short term, and the risk of capital loss is heightened — management decisions can have sudden and significant effects on a small company in a short space of time.
Also, smaller companies almost always start out focused on the domestic market. The JSE’s larger Top 40 blue chips, by contrast, play in multiple regions and territories, reducing the impact of SA’s economic weakness and even bringing into play extra profits from rand weakness against foreign currencies.
There is usually not a great deal of information available about small- cap companies — track records can be truncated, governance can be weak, management can be almost unknown and economic cycles can mask weak balance sheets more easily. So valuing a fast-growing company can be extremely difficult. Now for the good news. According to Keith McLachlan, fund manager at Alpha Wealth, you don’t just get higher growth at these smaller-cap companies; you’re paying less for that relatively high growth.
“The small-cap market tends to outperform the large-cap market because while these companies tend to grow quicker from a smaller base, you can also often pick them up at lower [price-to-equity] multiples,” he said.
McLachlan said that as growth slowed, the company often re-rated to a higher PE multiple. “Also, liquidity risk is priced into stocks — as shares become more liquid, there’s an unwinding liquidity discount you benefit from.” Which to pick, then? Alistair Lea, small-cap portfolio manager at Coronation Fund Managers, said that as with any company it was best to stick with quality.
“We count management experience and quality when we invest — that counts for a huge amount. We will not often invest where we don’t rate management because they’re a lot more important to the success of a small company.
“If you don’t invest in quality, there’s a fair chance the company will not be around in five or 10 years. There are cycles in small caps where you can invest in poor-quality businesses and make up to 300% in a short space of time — such as in the last cycle [and] the small-cap construction listing boom in 2006 and 2007, which fuelled the AltX,” he said.
At the time, it seemed investors made money no matter which small cap they picked. “It’s tempting to get involved in that, but unless you’re really good at timing the market that won’t work out. A lot of those companies are now out of business.”
The trick was to avoid poor quality, marginal businesses, with poor man- agement, and rather buy companies that sold products the market would still want in 10 years, he said.
Omnia, for example, was a good example of a high-quality small cap business that would still be selling its mine explosives and fertiliser products in 10 years.
“I cannot be as certain about many small caps with perhaps weak balance sheets. Protech filed for business rescue earlier this week. That company listed in the AltX boom, but is so dependent on contract wins, so dependent on customers paying its bills timeously — it’s a tenuous business model,” he said.
Lea said that while Protech looked cheap, trading at less than its book value, the problem was that companies like this were “typically one or two months from going under throughout their business cycle because if a big client doesn’t pay its bills it’s in trouble”.
Another small-cap winner was Distell, Lea said.
“Only 10% of its issued capital is available to the investor — the rest is held by Remgro and Capevin, so that company is by definition a very illiquid share. But that shouldn’t stop you — it’s a business of phenomenal quality,” he said.
Coronation had over the years built up a reasonable position in Distell, despite the illiquidity, and the share would become more liquid.
He said that was the case with most quality businesses.
“If we like a business enough it doesn’t matter if it’s illiquid. That’s not a good reason to not invest. If things go the way we see them, liquidity will resolve itself,” he said.