Time to Look at Small Caps?

Time to Look at Small Caps?

SHARE

Research has demonstrated that innovation occurs on average 22 years after the birth of an innovation (allowing time for a generation to grow up familiar with it) and that during that innovation period small entrepreneurial companies typically outperform large companies. It is about 22 years since the launch of cellular phones.

US research also shows that small caps have outperformed large caps during such periods, by factors of four and even six to one.

A local study by Dr Adrian Saville at Cannon Asset Managers, suggests that here too, small cap value-oriented investments can sustainably outperform the market. “The primary explanation is that investors push the prices of poorly rated investments down too far, and expect fancied stocks to shoot the moon. This creates a situation in which depressed value stocks rebound to outperform the market while overrated growth stocks are knocked off their pedestals at the first sign of weakness.”

Dogs and diamonds

To test the hypothesis, Cannon Asset Managers has run dog and diamond portfolios since 1996 as a ‘live simulation’. Allowing for a set of investment rules, the dog portfolio is a diversified set of shunned financial and industrial shares, made up of small to mid-sized caps, and some deeply undervalued large caps. The diamond portfolio is made up of a diversified set of popular stocks trading on the highest multiples.

The results of the study are compelling. Over the period 1996 to end-2010 a passive investor would have earned an annualised return of 13,7%. On the same basis the diamond portfolio delivered an average return of 12,3%, and the dog portfolio delivered 24,6% per year — almost double the market’s return.

Saville believes the sustainability of small cap value investing lies in the fact that investors are driven by psychological biases such as herd mentalities that prevent them from outperforming the overall market.

Does this mean we should all be exiting large cap stocks in favour of small caps? Only if you have the discipline to ride out the entire investment cycle.

“Three years ago we started the SuperDogs portfolio to take advantage of small cap opportunities. SuperDogs has doubled the initial capital and its return is 10% ahead of the market,” says Saville.

Don’t rush in where angels fear to tread

Warren Jervis, fund manager of the Old Mutual Small Cap Fund, says that even seasoned professionals struggle to identify small cap targets for investment, so the amateur has almost no chance. He recommends private investors be in the small cap sector for the out performance it delivers, but through a unit trust, leaving investment decisions to the fund manager.

“The biggest mistake one can make in this sector is to accept golf locker-room investment tips,” he says, listing two reasons for investors to be investing in small caps: alpha generation and diversification. Small caps are an excellent means of alpha generation. Over a long period of time they have delivered alpha of 1,8% to 2% a year (that ’s over and above what the market or benchmark achieves). The risk in small cap investing is that you can lose capital — it is more volatile and carries the risk of a particular stock imploding. However, the upside is that it is a misunderstood sector often ignored by general equity fund managers who largely stay within the confines of the top-70 stocks on the JSE.

“For reasons of poor liquidity, lack of information or general neglect some fascinating mispricings occur. The major liability is liquidity and it is the starting point of my investment process. Companies such as Consolidated Infrastructure Ltd in the power sector are typical of the type of good value available. Companies typically have strong management and balance sheets, are on a growth path and delivering good earnings — if you can get them,” says Jervis.

He warns that small cap does not automatically mean AltX. There are many small and medium-sized companies on the JSE main board, and he would not specifically look at the AltX companies. “Small cap investing is a different discipline to traditional investing. It is all about stock picking in a pool of companies for which there is not a great deal of information flow.”

As to where to look to invest, apart from his own fund, Jervis would be comfortable with the RMB Small Cap Fund and the Nedbank Entrepreneurial Fund. Saville is tipping Conduit Capital Ltd as a small cap stock with legs. Currently trading at around 85 cents, the company is on a trailing dividend yield of a mouth-watering 12%. With a sound balance sheet and good growth prospects, the share is highly attractive.

Finally, some common sense

Of course, others argue one should not rate size as a factor in stock picking, but fundamentals of the company, such as:

  • Positive earnings. Look at free cash flow as earnings can be manipulated.
  • Accelerating sales and improved operating margins.
  • Minor blemishes for fixable problems can make bargains out of well-run companies.
  • High insider ownership.
  • High rates of return on assets, equity, and capital: then catch them on the upswing.
  • A great product.
Eamonn Ryan
Before becoming a financial writer and freelance journalist in 1997, Eamonn Ryan was a legal adviser, company secretary and alternate director at listed company Cashbuild Limited from 1988 to 1997. Since becoming a financial writer, he has focused on the business and financial sectors, as well as personal finance, writing for Finweek, The Star Business Report, Sunday Times Business Times, Business Day, Mail & Guardian, Entrepreneur, Corporate Research Foundation (which brings out a series of books each year ranking SA’s best employers and best managers), as well as a host of once-off and annual publications such as ‘Enterprising Women’ and ‘Portfolio of Black Business’. He also writes media releases, inhouse magazines and sustainability or annual financial reports for various South African corporates and financial services groups, including the Ernst & Young annual M&A book.