Investing in small caps in the current crisis – steer clear or lock down long-term rewards?
At times of crisis, like we are currently experiencing, market participants tend to seek the liquidity and perceived safety of large cap stocks and to steer clear of ‘riskier’ small cap stocks. It’s therefore not surprising that the FTSE/JSE Small Cap Index is down 18% since the start of the Covid-19-led market sell-off, compared to a decline of 9% for the FTSE/JSE All Share Index (as at 16 June 2020). Small caps are perceived as being more risky than large caps for various reasons. However, many of these risks can be managed, creating the opportunity to capitalise on the current mispricing opportunities. In fact, for investors with a long-term horizon, the opportunities available in the small cap sector are now even more attractive than in the past few months.
Small caps normally underperform in the initial stages of a bear market, as investors attempt to minimise their risk exposure.
The lower levels of liquidity and tradability of small caps tend to magnify the impact on the prices of these shares even further. These sell-offs are fairly indiscriminate, affecting all small cap companies in much the same way, irrespective of the underlying strength and quality of the company. However, over the long term, small caps typically outperform the market, rewarding investors who have a long-term horizon and who are not concerned about short-term volatility.
The performance pattern of small cap companies is not unique to South Africa, nor to the current crisis.
Figure 1 illustrates a similar trend in the US, with the S&P 500 Index underperforming the Russell 2000 Index by 12.2% since the beginning of 2020. However, looking back at the previous two crises – the 1998 emerging market crisis and the 2008 global financial crisis – investing in small cap companies at market lows would have delivered great returns for investors in the following years.
Figure 1: While small cap shares have underperformed in times of crisis, they have outperformed over the long term.
Source: FactSet, 31 May 2020
Many of the risks relating to small caps can be managed – and our experience in the small caps space allows us to do this, to the benefit of our investors.
Below we address some of the more misunderstood risks that, if managed correctly, can in fact be opportunities.
The risk: Small cap companies may have smaller profit pools.
The opportunity: Small caps often offer better growth potential than larger companies.
While their profit pools may be smaller, there are good-quality small cap companies with growing profit pools that are a source of attractive returns for long-term investors. For these companies, the growth potential is often better than for many larger companies that struggle to grow their already dominant market shares further.
A great example of such a business is Italtile. While the tile and flooring profit pool may not be large, Italtile’s market share has grown to almost 50%. As a result, its market cap has compounded by 18% over the past 23 years, growing from R273 million to over R13 billion today. Capitec is another example of a business that started out as a small cap and has since become the third largest bank in South Africa (ahead of Nedbank and Standard Bank).
The risk: Small cap companies have less experienced management teams.
The opportunity: There are many small cap companies listed on the JSE today that have proven management teams that have shown their resilience.
Small cap companies with weak business models and poor management teams that were unable to navigate a severe downturn have failed or de-listed over the past two decades. This has resulted in only the most resilient smaller businesses remaining on the JSE. For example, small cap companies Italtile and Combined Motor Holdings have been listed since 1986 and 1987 respectively. Both businesses have successfully navigated several recessions and have done very well in the process.
The risk: Small cap companies experience greater earnings volatility as their sources of income are typically not as diversified.
The opportunity: Investing in several small cap companies with different income sources can smooth out earnings.
Larger businesses tend to have more diversified sources of revenue since they often operate in multiple geographic locations where they often dominate their industries. Examples of such industries are beer, luxury goods, tobacco, banks and media. However, creating a portfolio of great quality smaller-cap companies that have diversified revenue streams can generate a similar outcome.
The risk: Investing in small cap companies requires a liquidity discount.
The opportunity: Investing for the long term can combat any liquidity discount.
Over shorter time horizons, such as a year, small caps are unlikely to outperform. In addition, research also shows that small caps tend to lag in the first two months of a recovery following a major bear market sell-off. This is consistent with what we witnessed in April and May 2020. However, over the coming months and in line with past trends, the performance gap should narrow as small caps play catch-up. Taking a long-term view when investing in small caps therefore provides an opportunity to arbitrage the liquidity discount, adding to the total return over time.
The risk: Small cap companies have higher financial leverage.
The opportunity: There are small caps without excessive debt.
Gearing levels for small businesses have recently been increasing at a faster rate than for large companies, as shown in Figure 2 below. Many small cap companies are under severe balance sheet pressure, partly due to being poorly managed, but also because of unsustainably high levels of debt. Examples include EOH, Tongaat, Blue Label and Omnia.
In the coming months, there will undoubtedly be a significant rise in business failures due to excessive debt. Some companies will have to raise additional equity (like Curro) or go into businesses rescue (as we have seen recently with Comair and Phumelela).
As part of our disciplined investment process, we remain extremely cautious of any companies that have excessive levels of debt, irrespective of their market cap size.
Figure 2: Net debt to EBITDA¹ of the FTSE/JSE Small Cap Index has been higher than that of the FTSE/JSE All Share Index.
1 Earnings before interest, taxes, depreciation and amortisation
Source: FactSet, April 2020
Low valuations create buying opportunities, but valuations alone are insufficient catalysts for small caps to outperform.
In the medium to long term, companies with strong balance sheets, strong business models and strong management teams will prosper.
Since launching our specialist small cap investment opportunity (the S-Alt SC Qualified Hedge Fund +) in December 2019, we have invested in 13 companies that we believe will be winners over the long term. On average, these companies have been in business for 38 years and have survived multiple downturns and financial crises. Figure 3 below summarises certain valuation and financial data for these businesses. These numbers show that the companies we are invested in generate above-average returns, have solid management teams, have conservative balance sheets, and are attractively priced.
Figure 3: The valuation and financial data for the holdings in our specialist small cap fund indicate these businesses’ strength and resilience.
1 Denker Capital’s assessment of intrinsic value
2 Last 12 months
Source: FactSet, May 2020
Buying quality businesses at extremely low prices increases the margin of safety.
Contrary to how many investors may think and act, the risk of not achieving your investment objectives increases when prices are at elevated levels (and vice versa). Given the recent fall in small cap prices, we believe the risks are in fact lower, since the margin of safety has increased – as evidenced by the average upside to our assessment of intrinsic value of 80% in Figure 3.
As shown in Figure 4, the opportunity to invest in high-quality small cap companies at bargain prices does not come along often. While a price to book ratio alone does not indicate the intrinsic value of a company, it does highlight the extremely low valuations we are currently seeing.
Figure 4: The FTSE/JSE Small Cap Index is currently trading at its cheapest price to book value on record.
Source: FactSet, April 2020
Small cap companies do well in economic booms.
When the economy begins to recover from this recession, small cap stocks should respond to the positive environment quicker and potentially grow faster than large cap stocks. The best period for South African small caps was during the 2004 to 2007 economic boom.
With panic defined as a decline of more than 20% in the S&P 500 Index, Verdad’s work illustrates the strong recovery in equity returns in the 24 months following a sell-off that exceeded 20%. Clearly it pays to be greedy when others panic. As seen in Figure 5 below, the biggest opportunities have been in small cap value investing.
Figure 5: The 24-month returns for different investment styles, starting three months from a 20% drop in the S&P 500, show the swift recovery of small cap value stocks.
Source: Verdad, Ken French Data Library
We have not yet seen the level of economic growth that will support small caps; however, the businesses we are invested in are still able to grow market share.
To spawn a revival of small caps, we don’t think steady economic growth will be necessary, but we will need to see improved growth prospects compared to the last three years. While we wait patiently, the businesses we are invested in are in good financial health and are able to grow market share in an otherwise humdrum market.
If you would like information on the funds we have that offer South African small cap exposure, please contact us at email@example.com.
Our small cap investment opportunity, the S-Alt SC Qualified Hedge Fund +, was launched in 2019 to capitalise on the mispricing opportunities available in South African smaller cap companies.
What makes it different to other small cap unit trusts is the combination of our investment strategy, experience and the investment vehicle:
- We invest in companies that are attractively priced relative to their long-term return potential. We currently see plenty of opportunities in the smaller cap universe to buy great businesses at bargain prices.
- The managers of this fund have been researching, analysing and investing in South African companies for a combined almost 50 years and have achieved several accolades for their track record in managing small cap funds.
- Using a qualified investor hedge fund as a vehicle (even though we don’t short stocks) means that investors are able to fully benefit from our convictions because there are fewer constraints relating to position sizes and cash levels.
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