Small caps beat big guys

With the All Share Index (Alsi) at a price-to-earnings (PE) multiple of about 18 times when its long-term average is under 15, this appears self-evident. However, what is sometimes overlooked is that the market has not moved as a whole. These high valuations are almost entirely due to the re-rating of local large cap shares since 2012 – but small caps have not followed suit.

While valuations on large cap stocks spiked through 2012 and 2013 and have remained elevated, small caps have continued to trade around their long-term average. This significant disconnect has largely been based on sentiment and not earnings.

In fact, small caps have been growing their earnings faster than large caps and yet the market has not rewarded them. Over the past three years, earnings from large cap companies are actually down, yet average PE ratios have increased 35%.

“In this low-interest rate environment, people love the large caps that have inflated earnings,” says Andrew Dittberner, investment manager at Cannon Asset Managers. “But to invest at current PEs of 18 or 19 times, the expectation is that earnings will continue to grow at a healthy rate and in recent times those expectations have not always materialised.”

He believes this shows sentiment may be in the wrong place. Investors should be asking: what happens when this sentiment changes?

“Three years ago small caps weren’t priced to do anything fantastic, yet they have grown earnings well ahead of large caps and continue to be priced on relatively undemanding multiples,” Dittberner says. “As a result, I think there is a lot less downside risk in small caps than in large caps.

“The market is pricing in decent earnings growth for a number of the larger companies, which run the risk of re-rating if earnings disappoint,” Dittberner says. One of the reasons large caps have re-rated so significantly is foreign buying.

“Typically, the large caps that trade on demanding multiples have a high level of foreign ownership,” Dittberner says. “If foreigners pull money out of our market, it will be these companies that are most susceptible to a sell-off.”

“Because we have had weak economic growth and small caps are very much a domestic GDP play, they haven’t been given those ratings even though they have grown earnings quite nicely,” says Vanessa van Vuuren, small cap equity analyst at Sanlam Investments.

Investors still have to tread carefully. “There are two things that count against small caps,” she says. “The first is local GDP growth.”

If South Africa does not see a sustainable pick-up in its GDP, the macro backdrop may make it difficult for these companies to continue to grow their profits.

“The other thing is that it’s very difficult to call small caps as a whole category,” Van Vuuren says. “There are a lot of nuances … but you have to research the sector carefully and pick your stocks.”