Fishing for tiddlers is how you catch the next whopper

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Fishing for tiddlers is how you catch the next whopper

You’d be crazy not to take advantage of cheap small caps that statistically outperform, says fund manager

Giulietta Talevi


Small-cap investors have taken a thrashing over the past couple of years. But, argues AlphaWealth asset manager Keith McLachlan, the SA small-cap sector is among the cheapest equity in the world right now. He explains why the lack of liquidity in the market is even more of a reason to take a punt.
There are fewer people trading shares, which has a direct impact on the valuation that is independent of the underlying business. So let’s call it the discount for illiquidity. In other words, if you are willing, on average, to buy any small cap in this market, its valuation is 18% lower than it should be, purely if we had normal liquidity at the stock exchange level.
It must be so hard to sell the small caps story right now?
When I look around all I see is cheap stocks, but to get anyone to invest in a small caps fund now is a big challenge, whereas when the market is booming and everything is expensive, guys are throwing money at you and there’s nothing you want to buy.
The Top40 is only 40 companies, the JSE has about 400, so if you are not looking in the small and mid-cap space you are literally ignoring 90% of the market. The next big multibagger investments are almost certainly in this space, so you’re shooting yourself in the foot if you’re not taking advantage of a cheap market in a space that statistically outperforms and can offer material diversification. That’s not to say an investor should allocate everything to small caps, but there is definitely a case for a small allocation for a very long time horizon.
What is the ideal amount to invest in small caps?
Here’s the thought test: what amount of money are you willing to invest that you won’t need for 10 years and you won’t be emotionally attached to and watch on a day-by-day basis? And for most people that’s 5%-10% of a portfolio. If it’s more than that, they tend to be emotionally invested. My advice to many of our guys here is when deciding to allocate to the small-cap universe, decide how much you want to put in, and put in half of that.
You’ve written that SA small caps are among the cheapest equity in the world. Are we all missing a trick or should we be justifiably circumspect?
There’s no simple answer. At this point the small-cap index is trading at one times price-to-book. That means if I took every single small cap listed on the JSE and I liquidated them and settled all their liabilities, I would get my money back. Now, in reality, to go and rebuild all those businesses wouldn’t be done at historical cost – you have to do it at current cost, so in other words the entire sector is trading below its replacement value. Historically and traditionally, it should be trading at between 1.2 times book and the SA average is about 1.5 times.
So it’s 50% below its average?
Yes. Small caps are also predominantly exposed to domestic conditions and hence the argument is: they may be cheap but on a price-to-earnings basis they’re sitting at a 14 times multiple and that’s more or less in line with historical averages. One could argue that the prices have come down, but the earnings have come down even more, and so price:earnings is not a fair reflection.
But what has happened over the past 10 years is that increasing numbers of small companies have built businesses outside of SA. This did not exist 20 or 30 years ago in this market. These businesses have found growth because that’s how capitalism works: it rewards growth and provides you incentives to find it. And interestingly enough, with higher success ratios than the large caps.
Is that because they can’t bet the farm, like large companies?
There’s no way to prove my view as to why small caps have been more successful, but a large cap would have an extremely executive executive and they’d have a big board and decide to go offshore because of pressure from major shareholders. They’re protecting their jobs. So they call together advisers – and when you have highly paid advisers, typically they say yes and make every spreadsheet look fantastic. And then you throw a large portion of the balance sheet offshore because it will take too long to build organically and you want to satisfy your shareholders right now. And everyone high fives you around the boardroom table. And then it blows up because the moment you make a large acquisition in an offshore market, you tend to be the buyer of last resort. All the local, well-connected businesses have already turned it down.
Small companies don’t have this luxury. They have to entrepreneurially build these businesses. It’s the forced necessity of being agile and small but having finite resources. The small-cap market has become the least preferred investment in SA over the past couple of years and because no one wants to look at it, there are spectacular gems that exist here that in fact have less and less to do with SA.
A mindblowing statistic: the cumulative average growth rate in the earnings in the small-cap sector since 2002 to the present day is 15.6% year on year, yet the index since 2013 is negative. Absolutely there is risk, but when high-quality investments become ridiculously cheap, a selective approach to hand- picking the best of them and taking some risk on a manageable basis in a larger portfolio, it’s almost irresponsible not to.

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