Small- and mid-cap stocks are overlooked in the South African market, but there are gems to be found.
The general thinking around our market, which is by global standards small and concentrated, is that the real mispricing is going to happen in the small-cap share space. The FTSE/JSE Top40 Index’s stocks are covered by hundreds of analysts and has billions of new funds pouring into them every month due to regular pension contributions.
Graeme Körner of Körner Perspective, an asset manager, has often said to me that local investors should only focus on the small- and mid-cap space. If you want to buy a luxury goods company, why limit yourself to only the one JSE-listed luxury goods stock, Richemont? Buy the world’s best. The same goes for every other sector we have locally; often with only one or two stocks in the sector and in many cases, we don’t even have any listed companies in some sectors.
This was all brought home with the recent AdaptIT trading update. At the time of the update, the tech share was trading at 120c apiece. The company then reported an anticipated headline earnings per share (although it gave several different versions thereof) of at least 65c. This will place the stock on a forward price-to-earnings ratio of under two times.
Surely it should be closer to a P/E of ten times?
The lack of re-rating to a fairer P/E of ten times is because of a general disinterest in the small-cap space. Large institutions can’t invest in the space as the stocks are too small, but even retail investors are staying away due to several fears.
Fears such as South Africa’s lacklustre GDP performance, high unemployment, and concerns around corporate scandals (albeit they’ve mostly been in the larger stocks). So, appetite for the stock exchange’s listed small caps has disappeared, yet there are some really good companies and, as AdaptIT shows, some seriously undervalued ones.
How do we get some of the small-cap action?
First is to always be extra cautious. It is easy to get sucked into a great story, but is that great story truly as great as we think? What is a larger competitor decides to movie into their space with a new product? How likely is this? How possible is it? Do they have long-term contracts with customers and a product that is uniquely different to the competition?
Have a look at the company’s shareholdings. I like management to hold a fair chunk, but not too much. If management holds much over 50% then liquidity can be an issue and raising money can be hard as management may not be able to chip in their share for a capital raise needed to grow the business.
I also like to speak to management. I find CEOs of small caps very engaging and keen to talk over coffee, even to a small investor. Just be warned, management always love their own company’s shares.
The final point is something that I wrote about recently. What will get buyers in and spur the share price higher? Sure, an update indicating a P/E of under two times works, but that’s not going to happen often. You must be happy holding with modest or even negative price moves. For this you’ll be compensated by dividends, which means a strong and dependable dividend payment is hugely important.
Basically, we must treat these small caps like private equity investments in which buying is hard (low liquidity) and selling even harder. Be prepared to hold them for a long time. Thus, make extra sure you’ve bought the best stock at an excellent price.