When I started out in the asset management industry in April 1998, little did I know that I was about to witness more bloodshed than in the last season of Game of Thrones. As shown in Figure 1 below, during the emerging market crisis of 1998, much of the pain was in the small cap sector of the market. Many of these companies should probably never have listed in the first place. One could therefore expect an element of natural selection, as companies with weak business models failed – you may recall Brainware, Global Village, and Sweets from Heaven. Ten years later, during the global financial crisis, we saw another significant sell-off in smaller cap shares as investors sought safety amongst the larger cap blue chip shares. Fast forward another 10 years, and small caps have taken a beating once more.

Figure 1: The relative performance (price return) of the FTSE/JSE Small Cap Index versus the FTSE/JSE Top 40 Index

Source:  FactSet, Denker Capital

Buy on the cannons, sell on the trumpets.

Figure 2 below illustrates the past three periods of large relative drawdowns when small caps have substantially underperformed the market. This may suggest a good enough reason not to invest in smaller cap companies because it is very hard to predict these periods of underperformance. However, for a long-term investor, the subsequent recoveries have been notable in both their magnitude and length.

Figure 2: Peak-to-trough drawdowns relative to their subsequent recovery (FTSE/JSE Small Cap Index relative to the FTSE/JSE Top 40 Index)

A crisis, like the recent small cap underperformance, is a terrible thing to waste.

Since March 2017, small caps have again underperformed their large cap counterparts by over 30%. We believe we are seeing another great opportunity to invest in better-quality small cap companies. In fact, the Denker SCI Equity Fund’s current exposure to small cap stocks is 17%. The small cap companies to which we have exposure have returned 8% since the ‘peak’ (as shown in Figure 3 below) in March 2017, significantly outperforming the FTSE/JSE Small Cap Index (-24%) over the same period.

Figure 3: Performance of small cap shares in the Denker SCI Equity Fund relative to the FTSE/JSE Small Cap Index in the recent sell-off

Source: Denker Capital

However, one should tread carefully and apply a disciplined and proven approach.

Smaller cap companies listed on the JSE are generally more exposed to the local economy. They generally don’t have the same flexibility to cut costs or diversify revenue streams relative to their large cap counterparts, which tend to operate in multiple countries. So, when GDP growth is under pressure, as it is currently, these companies tend to experience a disproportionate share of the pain. But for an investor with an appropriate time horizon, this presents a great buying opportunity. This is because when you buy at a time of extreme pessimism, you build a margin of safety that can increase the chance of better returns over time. Another great indicator of the emerging value amongst smaller cap companies is the recent increase in de-listings (including Verimark, Clover, Howden and Cargo Carriers). De-listings are a strong signal that asset prices are starting to look attractive again.

Business fundamentals, a good management team…and (only) then price matters.

Despite this opportunity, the universe of small cap shares is littered with gravestones and investors should tread carefully. Simply buying companies because they look cheap is no guarantee of success. Investors must firstly be satisfied with the underlying fundamentals of a business. Then you must ensure you are investing alongside a competent and trustworthy management team. Companies like Ascendis, Blue Label, Dawn and Group Five are recent examples of what can happen if you are too focused on valuation without being certain of the business fundamentals and management team first.

Disclaimer

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Sanlam Collective Investments (RF) (Pty) Ltd (SCI) is a registered and approved Manager in terms of the Collective Investment Schemes Control Act.

The information to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision. The manager retains full legal responsibility for the third party named portfolio. The Sanlam Group is a full member of the Association for Savings and Investment SA. If the fund holds assets in foreign countries and could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds, macroeconomic, political, foreign exchange, tax risks, settlement risks and potential limitations on the availability of market information. A schedule of fees and charges and maximum commissions is available from the Manager, Sanlam Collective Investments, a registered and approved Manager in Collective Investment Schemes in Securities. Standard Bank of South Africa Ltd is the appointed trustee of the Sanlam Collective Investments Scheme.

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