The upside down JSE

When investing in equities you can expect that, over time, small caps will always outperform large caps. This is known as the size premium – the fact that in taking extra risk in investing in smaller companies you will be rewarded with greater return if you are able to hold them for long enough.

Logically, this also means that in any market, the large-cap index will not, over the long term, be the top performer. A broad market index that includes mid- and small-cap stocks will do better.

This is so well established that when it isn’t the case, it has to be seen as an anomaly. And there is just such an anomaly apparent on the JSE at the moment.

For the ten years to the end of October this year, the All Share Index (Alsi) marginally outperformed the Top 40, as one would expect. But over the last five years and particularly over the last 12 months, the Top 40 has delivered a higher return.

Source: Inet BFA, Cannon Asset Managers

What is more noticeable about this is that up until the mid 2000s, the outperformance of the Alsi over the Top 40 was significant – as much as 5% per annum. This margin has however narrowed, and, over the last five years, disappeared.

“You would expect the Alsi, with a larger number of stocks and small caps to do better than the large-cap index over time,” says Raphael Nkomo, the chief investment officer at Prescient Investment Management. “That is finance. That should work, and it has worked in the past.”

It hasn’t however worked since 2012. There are primarily three reasons for this, and they are inter-linked – Naspers, the rand, and South Africa’s economy.

“You had the rand weakening, which has helped the large-cap stocks, and Naspers has been extraordinarily strong over this time, which has contributed a lot to large-cap performance,” Nkomo explains.

This has been particularly pronounced this year.

“Year to date Naspers is up around 60% and the market is only up less than 20%,” says portfolio manager at Investec Asset Management Andrew Joannou. “Naspers over the last year has distorted things a lot.”

Figures from Novare show that Naspers has contributed more than four fifths of the Top 40’s performance so far this year. As the chart below shows, this is comfortably the most pronounced this influence has ever been.

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Source: Novare

At the same time, the weak South African economy has had a significant impact on the performance of local companies, which are primarily found in the mid- and small-cap sectors.

“Over the last five years the ‘SA Inc’ companies have really struggled for various reasons,” says Cor Booysen, portfolio manager at Fairtree Capital. “Our economy is slow, we have political issues, there’s a lot of uncertainty among business and consumers, people are not spending, and growth is low.”

Structural or cyclical?

A question worth asking is how much of this is a structural change in the market, and how much is cyclical performance.

“Going forward, I think the small-cap premium is real,” Nkomo says. “It’s in the literature. All the research points to it, and it has worked in SA until the early 2000s.”

He believes that the last five years are therefore an anomaly.

“I can’t extrapolate the same returns from Naspers, and I certainly can’t extrapolate the same political issues we have had that contributed to rand weakness like Nenegate,” says Nkomo. “All of those are more cyclical than structural, so I still expect the small-cap premium to play in South Africa.”

Booysen does not however agree entirely.

“I think Naspers is more systemic than cyclical,” he argues. “Through Tencent, it is exposed to the economy with the largest population in the world, and one that is growing very fast. Tencent is also one of the biggest companies in that economy and it is therefore likely to outpace the growth of most companies in SA until it matures. And its not clear to me when that is. It could be another five or ten years, and by that time Naspers will be even larger and more dominant than it is now.”

A point in time

Investec’s Joannou makes one further point, which is that one must be careful about reading too much into a calculation done at just one instance. At the moment the Top 40 may have outperformed the Alsi over the last five years, but this is just a single data point.

“If you compared the rolling one-year returns of the Alsi and Top 40 going back every month to 2002, the Alsi still outperforms the Top 40 about 66% of the time,” he notes. “If you do this on a three-year basis it increases to 77%, and if you take five-year rolling returns the Alsi outperforms 92% of the time.”

The size premium is therefore still clearly prevalent.

“But when you get a huge share like Naspers that just gets bigger and bigger in the index, that share alone can affect the data,” Joannou says. “It’s not really impacting the size premium, it’s just distorting the data because you have one outlier doing so extremely well.”

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