Why is SA’s small cap sector so cheap?

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, it is Moneyweb’s weekly podcast, where I speak to leading investment professionals and my guest this week is Keith McLachlan of Alpha Wealth. He is, of course, one of the leading and most vocal small cap analysts and specialists in the country. Keith, welcome to the show, you wrote a very interesting blog last week, which was published on Moneyweb as well and was very popular amongst our readership but in this blog you stated that, apart from the Italian small cap sector, the South African small cap sector is the cheapest equity sector in the world. It is quite a statement, what was your methodology to come to this conclusion?

KEITH McLACHLAN: Thanks for having me here, Ryk. It’s relatively simple, we pulled out a whole lot of relative valuation metrics, stacked them up across the world and we tried to pick those metrics that are more stable over time, that are also geographic and gearing and various distortions agnostic such that is comparable across countries with different tax rates and different interest rates and things like that. Then we stacked them up from top to bottom and we didn’t just include the major indices in the world, very specifically wanted to control for size, in other words to make sure that we’re not saying that our small cap market is cheap just because small cap markets are cheap but our small cap market is cheap versus the big market and versus small cap markets everywhere else. So we specifically included small cap indices across the world and emerging markets’ small cap indices, and it pretty much stacked up that on almost all metrics it was in the first quartile of cheapest and in some instances it was second or third.

RYK VAN NIEKERK: What is the difference between cheap and underperforming?

KEITH McLACHLAN: Probably time period. That’s a loaded question, cheap is a relative statement and it is a point in time. Underperforming is a period in time and any market anywhere over different periods of time, depending on how selective you are, you can find them outperforming other ones. That’s a slightly less important statement and in my opinion it’s not a valuation-based statement.

RYK VAN NIEKERK: But why is the South African small cap sector so cheap at the moment? What are the underlying reasons?

KEITH McLACHLAN: There are a number of them that I have identified and it’s by no means a comprehensive list and it’s not necessarily in the order of priority either. So if you track our sector and specifically the small cap index on a price-to-book basis you can see that we are more or less near credit crisis lows in terms of the valuation, once they are in devaluation below mean and, in fact, this retracement or devaluation in our small and mid-cap equity market has been happening over the last five years but if you have a look at the index returns it’s actually been flat. So in other words, the companies have been crashing sideways. As time goes on if shares don’t move but if earnings keep on growing and companies keep on generating profit then actually valuations drop.

So what has been happening to arrive at this point? Well, over the last five years South Africa as an economy has pretty much not grown for a large number of reasons from political factors to geographic factors; there are even curveball factors like the drought over the last couple of years, where the last remnant currently remains in the Western Cape, and we saw that come out in the first quarter’s GDP this year. All of these factors combined have detracted from the top-down analysts and the top-down fund managers that ultimately arise in allocating capital into this sector. The bottom-up guys, which I include myself in, who specifically focus on this sector, it’s been a frustrating number of years, but many of the businesses after five years are incredibly profitable and in fact best of breed is often left in many instances. Then there are the slightly less obvious reasons why our small cap market is cheap and a lot of the risk capital has been either hurt or been made very, very shy after events, including Steinhoff, which, don’t forget, hurt a lot of investors quite badly and in some instances sucked liquidity out of this portion of the market. We have not, interestingly enough, seen that liquidity come back despite the ‘Ramaphoria’ that’s been happening. So there are a large number of reasons from global to South African, down to even very specific events that have all combined for us to arrive in this situation.

Plenty volatility in the local market

RYK VAN NIEKERK: Daniel Malan of Perspective spoke to me last week and he provided an interesting statistic and that is from the investible shares in his universe, and he has around 210 companies in that universe, he said around 55% or 115 of those the share prices have been down 18%. That story is not being told by your bigger indices and it shows you that there is a lot of volatility within the local market. I would assume that the majority of those companies that are down 18% plus would be your smaller and mid-cap stocks, are you seeing this too?

KEITH McLACHLAN: Yes, absolutely, the All Share Index is pretty much dominated by the Top 40 Index and the Top 40 Index is dominated by a handful of very large shares that are pretty much not South African shares. So when we quote either the All Share Index or the Top 40 Index you are pretty much quoting one and the same thing because the small and mid-cap indices in terms of market cap are only about 10% to 20%, I’m being non-exact, but 10% to 20% of the entire JSE. When we don’t view it like that, when we view it rather as each individual investible company, as a separate individual investible option, there are roughly 400 companies on the JSE and the Top 40 is only 40 of them. In other words, 90% of the JSE is the small and mid-caps and they’ve been under pressure, like I said, for the last five years. If you were to do an equal market cap weighted index of the JSE All Share Index I can almost guarantee it would have had very, very poor returns for the last five years. You are absolutely right, that does not come through in the major indices because of their construction based on market cap weightings.

RYK VAN NIEKERK: That begs the question, there are very, very few small cap funds in South Africa, a handful, if that, why are there not more analysts looking at this sector?

KEITH McLACHLAN: First of all it’s hard and it’s difficult, in the Top 40 space you can take many things for granted and there are many assumptions and you can utilise a strong amount of sell side research, in the small cap space you cannot. You actually need to go and do a lot of that work, primary research, yourself. It’s time consuming and it’s risky. Then your ultimate decision for the amount of capital that you can invest based on those decisions is also limited by the size of the companies and the liquidity. So for the very, very large houses it’s not just expensive, it’s actually not profitable because they can’t run multi-billion rand funds in this space. This space lends itself more to boutique investors, sophisticated retail investors absolutely but in terms of institutional money you can manage it from a boutique level so long as you have the knowledge and experience and you’ve turned over enough rocks in the space, done enough research and you have the risk appetite and processes in place. So there aren’t enough funds in this space predominantly because the vast majority of assets in South Africa are run by a handful of big asset managers and, for the reasons I have said, this is not attractive to them. In the boutique space I do believe over time I would expect more and more capital to flow into this space and from a man in the street perspective it’s very, very attractive. So there’s no reason not to be looking in this space, either through researching and buying your own companies or indirectly by investing in a small and mid-cap unit trust, for example, our one, the Alpha Wealth Prime Small and Mid-Cap Fund.

RYK VAN NIEKERK: We’re going to talk about that fund in a minute but I’m looking at the Moneyweb website where we have a tool that analyses unit trusts, there are nine small cap and mid-cap funds listed and I’m looking at the performance, they haven’t performed really well over the last 12 months.

KEITH McLACHLAN: Yes, to be fair the space, as with most equity spaces, judging over a 12-month time period is relatively meaningless, you need to be looking over a five to ten-year time periods and then you start to get much more meaningful results. But it has definitely been a weak part of the market for the last while but, arguably, therein lies the opportunity.

How to select potential ten baggers

RYK VAN NIEKERK: That begs the question, obviously not a lot is expected of the JSE overall, a flat performance this year, I think many fund manager would take that, maybe just beating inflation would be good. But within that sideways movement of the whole market there will be smaller stocks that shoot the lights out and the challenge is to identify those and be the top stock picker in the sector. How do you go about choosing those potential ten baggers?

KEITH McLACHLAN: Our starting point is quality, we don’t look at the share price and then rationalise how we can hold the business, we invert that process, we look first of all at the business to say is it a good business. Good being high returns, low debt, high cash generation, high margins, great growth, scalability, barriers to entry, competitive advantages and alignment to the interests of management. If it ticks all these boxes we then cast our eye towards the valuation to ensure that we are not overpaying for it and, the best case scenario, underpaying for it. Where we are in the market right now there are a lot of these businesses and many of them are undervalued, wherein we can include that within the portfolio, obviously within the constraints of the mandate and within the balance of diversification. So the way to find the next ten bagger is not to look for it but to look for the best businesses that tick all the boxes in terms of quality, that have the highest returns possible and scalable businesses that can grow with a very, very long runway and ensure that you hold them and you give them enough time to do exactly that.

RYK VAN NIEKERK: Looking at the Alpha Wealth Prime Small and Mid-Cap Fund, it’s the fund you manage, it has around R120 million invested in it, how many shares do you actually hold in the portfolio?

KEITH McLACHLAN: We run a concentrated portfolio; it’s one of the differentiating factors between us and many of our peers, that is a target of 15 to 20 companies, that’s it. When we reach 21 the twenty-first company has to be better than the worst of the 20 companies that we hold in order for us to switch it in and take one out. So it’s a concentrated portfolio focusing on buying only the best businesses on lowest possible valuations and because of that we can hold concentrated and large meaningful stakes. So let me phrase it slightly differently, in a diversified and broad portfolio that holds hundreds of companies, if one of those stocks double it will have a very negligible effect on the overall portfolio. If you hold 15 to 20 companies and you get a handful of them right or even one of them very, very right and you generate a positive return on it, it starts to have a meaningful impact on the total portfolio’s return. That’s one of the key differentiators here, just because there are lots of listed companies it doesn’t mean you should hold them all, why not just hold the best one.

RYK VAN NIEKERK: But conversely the same is true if one company would perform poorly. I see in your top ten holdings you have Tongaat Hulett in there, Blue Label, ADvTECH and Coronation, and all of them have not had it too good of late.

KEITH McLACHLAN: Tongaat is a good example of one that disappointed and we controlled risk around it. Unit trusts are always transparent and you can see through them but you don’t see through them in real time. So we have materially lowered our Tongaat investment such that after the results came out and they were reasonably poor and missed our expectations that it hasn’t had a major effect on the fund. But you are absolutely right, Ryk, we are not going to get all of them right and where we get them wrong it’s very important that we move on swiftly and we acknowledge that and find the next one that we can invest in. So we’ll always have a tail end of the portfolio that you’re considering exiting, considering putting into other businesses and the like. But moving onto the other ones, Coronation, ADvTECH, Blue Label, all of those you need to distinguish between the share price and the business. The businesses have actually been performing exceptionally well, the share prices have been weak, hence, the valuations have just made them cheaper and cheaper and more and more attractive to us. ADvTECH continues to put out fantastic results, they’re growing their learnership, they’re growing their tertiary side. Blue Label is trading at the value of its local operations, ignoring the fact that it now has a very valuable kingmaker role within Cell C and the telco’s industry domestically and it has free options on its India and Mexican expansions. Coronation, despite weak markets, actually managed through its variable cost structure to grow headline earnings per share 1% and generated dividend yield approaching 7% while maintaining an incredibly high return on equity that is almost entirely backed by cash. So I would disagree, I think all of these companies have done exceptionally well but it’s the share prices that have been weak.

RYK VAN NIEKERK: But why is there not a correlation?

KEITH McLACHLAN: Fear and greed, liquidity and just the general market malaise in South Africa. If markets were efficient then people like me would not have a job.

Get the business right, returns will follow

RYK VAN NIEKERK: But the key is and a lot of contrarian or so-called contrarian investors buy cheap shares and then the shares don’t bounce as they are expected to do, so you start to hold it, hold it and wait for the appreciation, and it doesn’t come. What is your view on how long do you actually hold a counter where the share price does not mirror the financial performance?

KEITH McLACHLAN: Ryk, I need to distinguish here and just clarify that in the small cap fund we are not a value manager and we are not a growth manager. Our methodology hinges around quality and an attribute of quality is not just all the returns and cash generation and debt and the like, it is also the growth, the ability for a business to sustainably generate growth. That growth with high returns keeps compounding. Thereafter we cast our eye to valuation and any day I would much rather hold a high quality business at a fair valuation, than hold a low quality business at what appears to be cheap. So by no means are we a contrarian manager, we are actually a quality manager. Now if you are holding a high quality business, which means that ten years from now it will still be here, the odds are much better than for a low quality business, and it has a very high return on equity and it has growth, its earnings will keep compounding period after period after period that even if you paid a slightly higher price and you didn’t get your valuation correct, the share, the business will grow into the valuation and grow well beyond it. The compounding and the high returns on equity will carry your investment returns beyond the initial sum that you paid, hence, generating the return. So we do not buy shares that have fallen a lot, nor do we buy shares that have risen a lot. We actually fundamentally don’t really care about share prices, it’s all about the underlying business because the share price in the long term will follow that. If we get the business right the returns will follow.

RYK VAN NIEKERK: Just lastly, do you think the small cap sector can outperform the broader market, especially the Top 40 for example, this year?

KEITH McLACHLAN: The longer time period that you give me with a greater certainty I will say yes. Over the next 20 years I can guarantee you the small cap market will, over the next ten years it almost definitely will, over the next five years it probably will, over the next year it would be nice if it did. It’s very hard to say but the combination of improving domestic fundamentals, coupled with low valuations, is a very attractive one for forward returns in any asset class and that’s what we currently have in the domestic small and mid-cap space.

RYK VAN NIEKERK: Thank you, Keith. That was Keith McLachlan from Alpha Wealth.

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