The shares that have generated the highest returns since the launch of the Sanlam Global Financial Fund in 1999 were all smaller companies. In fact, small, quality companies offer many advantages. This includes often being mispriced due to the initial small market cap and perceived business risk. Sparebanken NN in Norway is an excellent example of a small, mispriced company that we identified as a potentially rewarding investment, and it continues to provide steady, low-risk returns to our investors.
Small caps can be very rewarding investments
When we look back on share performance since the launch of the Sanlam Global Financial Fund in 1999, the shares that delivered the highest returns (i.e. returns generated after making the initial investment) were smaller companies.
Our model enables us to identify potentially promising small caps globally
Those of you who have read Blink by Malcolm Gladwell will know what I mean when I say that our numerous company visits all over the world enable us to quickly spot the authenticity (or potential) of a bank or insurer.
When we launched the fund, I started building a model and database that would enable us to compare financial companies globally. Over the next 16 years, my colleagues Laura Ford and Liesl Basson continuously worked on improving it, learning from mistakes and performing back-testing. We are still building out the model in breadth (it now includes 400 companies) and depth (e.g. it includes features that enable us to identify and compare factors that existed in companies that have outperformed and to compare behaviour under different macroeconomic situations). This model has become invaluable when visiting banks and insurers, but particularly small and mid cap banks.
Small, quality growth companies have many advantages
These include no legacies, a low cost base, entrepreneurial management, quick decision-making, and, once they get it right, momentum. Gaining market share and being part of a winning team creates its own psychological tailwinds. Good recent examples of such companies in South Africa are Capitec, Curro, Coronation (there seems to be a correlation with winners and the letter C) and, in the past, Shoprite, Mr Price and Investec.
Winning small caps normally share a few common characteristics
- strong and entrepreneurial management that are either owners in the business or are incentivised to act as if they are owners,
- a competitive advantage over larger competitors (a moat),
- a high return on capital (this is very important, as the company will need capital to expand),
- efficient allocation of the capital generated,
- a replicable and scalable model, and
- being mispriced due to the (initial) small market cap and perceived business risk.
SpareBank 1 Nord-Norge (Sparebanken NN) – a good example of a mispriced opportunity
Over the past 15 years, we’ve uncovered many 10-baggers all over the world – Yes Bank, Shriram Transport Finance, Shriram City Union and HDFC Bank (all in India), Aeon Thana (Thailand), TSKB (Turkey), Panin Securitas (Indonesia), Catlin and One Savings Bank (UK), Sampo (Finland), and Tinkoff Credit Services (Russia).
Sparebanken NN (in Northern Norway) was an exception from the norm. The bank ticked only three of the necessary boxes, but these boxes were important:
- It is a conservative, well-run bank, which means the probability of negative surprises was low.
- We had a track record of the franchise and current management that went back to 1999, which means we had a long-term view.
- Most importantly, due to its small market cap, the bank was totally ignored by the market and therefore significantly mispriced (as shown in Figure 1).
Our model and ability to quickly rate a company helped us to identify Sparebanken NN’s mispricing. At a price-to-net asset value (P/NAV) ratio of 0.5x, it was very cheap for the benefit of safe and steady growth in a low-risk environment. One seldom finds a bank that has more than enough capital, is well reserved, and has an excellent track record at a P/NAV ratio of 0.5x. (For those who prefer price to earnings (PE) ratios, the PE ratio in 2012 was 6.1.) In a 2012 world filled with uncertainty, this was good enough for us.
Figure 1: Sparebanken NN’s fundamentals since 2012
Sources: Denker Capital, company financials
The low-risk profile of Sparebanken NN was the main attraction for us
For interest’s sake, Northern Norway’s GDP growth depends on tourism, farming, timber, mining and salmon fishing, and its loan book consists mostly of mortgages and loans to local businesses. This means that Norway wasn’t a high-growth country, the banking market in Norway was fairly saturated, and Sparebanken NN wasn’t going to become a Capitec or Yes Bank. However, its earnings and dividends were on a low base and depressed, as the bank had to increase reserves and capital to meet the new post-2008 regulatory requirements.
It was a classic case of a company not being noticed because of its small market cap. Normally one tries to find potential winners in this space. In Sparebanken NN’s case it was its low risk that attracted us.
When we look back at our forecasts, we were way too conservative. We had forecast earnings per share (EPS) growth of 24% over the 2012-2016 period (about 6% per year) and stronger dividend growth, due to the bank being overcapitalised. This meant there was enough scope for the bank to drop its interest cover in the future. However, it did much better than we anticipated – the bank delivered EPS growth of 43% and increased its dividend by 235%! From December 2012 to the time of writing (March 2017), Sparebanken NN generated a compound investment return of 23% in Norwegian krone.
(For the scholars: there is no tax on dividends in Norway, which makes dividends attractive. Also, to calculate the total return, we considered two alternatives: either reinvesting the dividends in shares or at an interest rate of 4%. Although there wasn’t a big difference in the outcomes over four years, it will make a difference over a longer period.)
The importance of a margin of safety
With our initial investment in Sparebanken NN, we believed that the low P/NAV ratio would give us a good margin of safety in case the environment changed and our forecasts were wrong. As explained above, our forecasts were indeed way too pessimistic. Fortunately, we did build in a margin of safety. Due to the oil price collapse, the Norwegian krone fell from 5.57 to 8.86 to the US dollar, reducing the compound return measured in US dollars from 23% to 12%.
The krone depreciation was unwarranted in light of Norway’s balance sheet strength and strong fiscal position. Nevertheless, the Swedish krone and other surrounding currencies fell 25%-40% and the Russian rouble halved, which means it was inevitable that the Norwegian krone had to follow. This highlights the importance of building in a valuation margin of safety for the unforeseen.
Sparebanken NN provides steady, low-risk returns to our investors
The value of our initial investment in Sparebanken NN has largely been unlocked. The bank has re-rated to a P/NAV ratio of 1.05 (a PE ratio of 9.30), which can be deemed as ‘fair value’ for such a small, illiquid bank. Its high tax-free dividend yield of 8.6% makes it attractive, but not a winner. It is important to have companies such as these that provide a low-risk, steady return in a portfolio. However, Sparebanken NN’s small market cap means it can only be a small percentage of a portfolio.
The world has changed since 2012 and we’ve found a new batch of undiscovered gems that are more growth-orientated than Sparebanken NN. That’s the value of our model – it continues to highlight new opportunities for us to research.