Investors have lost their appetite for small-cap and mid-cap shares as the rand takes a battering, South Africa’s economic and political outlook looks increasingly bleak and the big rand hedge stocks recover.
But there are investment opportunities beyond the JSE’s Top40.
The Top40 shares on the JSE make up roughly 80% of its total market cap, but they are just 40 of the roughly 400 stocks listed on the JSE, says Keith McLachlan, fund manager of the Alpha Wealth Prime Small & Mid Cap Fund.
Small- and mid-cap companies make up a huge proportion of the number of listed companies, so by only investing in the Top40, “there is a large part of the market you are ignoring, and you may have a concentrated and lopsided portfolio in the top 40 space”.
Investors should be looking beyond the Top40 but there are some important things they should take into account.
First, small- and mid-cap shares are a lot less liquid than the Top40 shares. “You have entry and exit risks in terms of building your investment and exiting your investment, and you may get caught short,” warns McLachlan.
Second, many small- and mid-cap companies are more locally focused than their larger peers, which are to a large extent rand hedges. “Not to say that smaller companies don’t go offshore or into the rest of Africa and have rand-hedge capabilities – there are plenty that do. But in general, small and mid-cap shares are more aligned to the South African economy.
“There has been a significant rotation out of South African stocks and small-cap and (less so) mid-cap stocks have felt the brunt, so valuations are favourable,” explains McLachlan.
If SA’s political and economic situation gets worse, the fact that a share may be cheap may not result in it being a good investment, and the market is pricing in the risk of this outcome.
If SA recovers, locally focused shares will do best, partly because they are linked to the economy but also because they have been marked down to such low valuation levels. “So if you are willing to swallow some risk, this is not a bad place to selectively pick stocks,” he says.
Many small- and mid-cap companies have also spread their wings offshore. “Ten to 20 years ago, it was a rarity to find a small-cap company with foreign exposure, but now a good percentage have gone offshore or have some exposure offshore,” says McLachlan. “But most are still weighted towards SA Inc.”
Peter Takaendesa, portfolio manager at Mergence Investment Managers, says investors in small- and mid-cap stocks must keep in mind that given the economic backdrop, the near term outlook might remain bleak.
Small-cap companies also don’t tend to be big brands that can sustain a big shock in the economy because they do not have substantial offshore earnings.
Takaendesa suggests investors look for stocks that have specific actions, developments and events on the horizon that unlock or add value.
Small and mid cap should not be terms that, in themselves, make your investment decision. Ashburton Investments senior portfolio manager Wayne McCurrie says: “It is incorrect to say the size of the company determines what the share price does – and investors must be cautious to make decision based on size.”
But investors should be aware that large-cap companies do, however, have some advantages as they have strong balance sheets and are well diversified. Smaller companies have advantages too and there is an opportunity to pick up an investment that has been somewhat ignored.
Anthony Clark, an analyst at Vunani Securities who specialises in small- and mid-cap companies, says that within the constraints of operating in SA, there are always areas of opportunity depending on the nature of the company.
Investments in smaller companies in sectors like manufacturing and mining may have lost investors’ money this year as external conditions translated into pressure on revenue and earnings.
Some companies in the food sector, on the other hand, have benefitted from a high maize output, which led to a dramatic drop in input costs.
“Looking at the current underlying economy, it is difficult for anyone to believe the domestic economy will improve over the next 12 to 18 months – companies in the industrial space will find it tough,” Clark says.
Below are some promising small- and mid-cap companies that have been selected by analysts and fund managers. Many of them are deriving an increasing percentage of revenue and earnings offshore, are showing signs of recovery, are significantly undervalued or have specific events in the future that will unlock value.
International information and communications technology (ICT) solutions and services group Datatec is a global company with operations in 50 countries, with SA only accounting for about 5% of its earnings.
Results in the six months to August were poor, with revenue marginally up and earnings before interest, tax, depreciation and amortisation (ebitda) down at $7.7m from $24.4m in the previous year.
However, it has sold Westcon Americas and 10% of Westcon International and the Dutch unit of Logicalis, and it plans to return $350m of cash to shareholders, while the outlook for Logicalis, which contributed most of profits, is increasingly positive.
“It has just sold the American division and will make about $630m from it, and that represents a big percentage of its market cap,” says Takaendesa.
Datatec was rolling out an SAP programme, and that affected sales and delayed sales momentum, “but it managed to unlock a lot of value selling one of its divisions, and with cash of over $630m, the market is at this stage not putting so much value on the business.
“It is currently trading at around R60, but if you add the sum of the parts plus cash, we get to about R80 at fair value, and the cash is already there, and it is planning a big dividend in the next few weeks.”
There is also a clear line of sight as to how value will be delivered, he says.
Grindrod, a freight services, shipping and financial services group and former darling and high performer on the JSE, is recovering from a series of setbacks.
Results for the six months to June show revenue at R13.4bn from R11bn previously, and ebitda up strongly, with earnings excluding its rail assembly businesses at R126.2m from a prior year loss of R367m.
Taking into account the rail assembly loss, it recorded a headline loss, which does not reflect the continued improvement in its business with higher volumes on the back of higher commodity prices and the effect of the completion of a new dredging project at Maputo Port.
Grindrod’s dry-bulk terminal utilisation has increased to 65% from 40% a year before, and capacity in its Matola (Mozambique) and Richards Bay dry-bulk terminals is fully contracted for the rest of the year.
“The cycle is good for Grindrod,” says Takaendesa. The oversupplied shipping market has normalised and commodity prices have recovered, so volumes have been strong, he says.
There has been a huge increase in volume at its dry bulk terminals in Richards Bay in Maputo, and the dry bulk index is showing strength, at around 1 400 points for an average of 400 last year, says Takaendesa.
“On the shipping side there has been some softness, but we are starting to see a strong pickup on terms of volume.”
Grindrod has announced plans to unbundle its shipping business. “They strongly believe the shipping business is not priced correctly,” he says, and there will be an unlocking of value on unbundling.
Most of its revenues and earnings are in US dollars, and while it is not as strong a rand hedge as Datatec, it has strong rand-hedge qualities.
Transport and logistics company Super Group is the current preferred stock of Lester Davids, trading desk analyst at Unum Capital.
“After nearly collapsing under a heap of debt a decade ago, management has positioned the business to be well diversified geographically, focusing on making bite-sized, strategic acquisitions over the past seven years,” he says.
These include ventures in Europe, which may have some economic runway and where fundamentals are improving, in Australia, which has a strong economy and in the UK, which is less strong, “although its home base of South Africa currently faces serious headwinds”.
“However, if the current environment is seen as a long term trough, then like the UK, any upswing should contribute positively.”
Davids says the business is well-diversified, with revenue and ebitda increasingly being sourced from outside SA, providing a rand-hedge component.
At the June year-end, the group’s non-South African businesses contributed 40% of revenue and 61% of ebitda, although the strong rand affected results. Revenue was up 15% to R29.9bn for the year, and headline earnings were up just 1%, although core headline earnings increased 8%.
On a valuation basis, the share trades at a discount to the broader market, Davids says.
Santova, which is also a supply chain and logistics company, is earning two thirds of profit (up from 58% last year) outside SA, says McLachlan, with a growing presence in the UK, Europe, Asia and Australia.
“It may have started in Durban and may have a market cap of 500m. It is a small company but it is a global enterprise.”
In the six months to August, headline earnings rose 13% and it made a number of strategic moves. These included the acquisition of the remaining 25% of Santova Australia, which facilitates further expansion and development in the region.
It has invested in upgrading infrastructure and operational capacity which it says will facilitate further growth in Australia, Germany, and the UK.
It started deploying its next-generation logistics software in Europe and the UK. It has also invested in its courier (TradeNav®) in those markets, as well as putting money into its client sourcing and procurement management divisions, which it says offer long-term revenue enhancing opportunities and where there was strong revenue growth this year.
Master Drilling, which makes world-class drilling machines for the mining sector, earns less than 25% of its revenue from SA. “Three quarters of group is global,” says McLachlan, and its key assets are mobile.
It has a market cap of R2bn, so is extremely small, but it is, in fact, a world leader and its nearest global competitor has a fleet a third of its size, he says.
Master Drilling (and Santova) are good examples of South African small-cap companies that have hedged against macro problems locally and gone global, he says.
In the six months to June the company raised revenue 12.5% to $60.5m due to the contribution of two new machines, but operating profit decreased 9.6% to $12.1m, with the company saying reflected investment “in people and capabilities to drive future growth.”
Results indicate a large order book and various opportunities beyond the mining sector.
Master Drilling is recognised as a world leader in the drilling services industry and it has operations around the world, from Africa to Europe and Latin America.
McCurrie also favours Master Drilling, saying that it has superior technology. “There seems to be very good demand for its technology throughout the world, and it has a good business plan.”
Dumping of chickens in South Africa and avian flu have done little to deter investors of SA’s major chicken producer Astral Foods, whose share price is up over 50% so far this year.
“The higher maize crop is providing strong benefits to the poultry sector and the food sector,” says Clark. “I would still be investing in Astral Foods – underlying demand is strong, input costs have dropped sharply, and it is poised for strong earnings growth.”
Clark says there are still concerns about cheap imports and avian flu in the sector, but import duties have had an impact on the number of products entering the country from the EU, and some smaller local producers have gone out of business, resulting in a chicken shortage in SA.
“There is a shortage currently and demand is growing as we go into the Christmas period and at the same time supply is constrained. This is why Astral is doing well – it is about scale and positioning.”
Astral surprised investors by updating an already bullish trading update (that earnings would be up by at least 65%) with a further, even more bullish update, that headline earnings would be up be between 80% and 100%.
This was attributed to excellent trading results and the fact that it incurred no further losses as a result of the outbreak of avian flu.
Things did not look as good at the March interim stage, when revenue dropped marginally and headline earnings dropped 54% as lower volumes and drought-related cost increases took their toll. New brining regulations affected the company’s product mix, sales volumes and average sales realisations.
As with Astral, higher maize production is likely to benefit Zeder Investments, which has been a poor performer in the PSG Group.
Zeder, with investments in the likes of Pioneer Foods, Kaap Agri and Capespan, has a R14bn portfolio of various agribusinesses. Half of this value reflects Pioneer Foods, which dropped headline earnings by 54% in the six months to March largely due to an “unfavourable” maize procurement position. It is, however, on the road to recovery.
“Given that input costs have fallen dramatically, Zeder is poised for earnings recovery in 2018 after a torrid 2017 when everything went wrong,” Clark says. The benefits of a Pioneer recovery will flow through to Zeder, whose other assets are discounted and have value.
Clark says concerns about its exposure to the drought-stricken Western Cape are unfounded. “Most of its agricultural companies are nationally diversified. The Western Cape will have an effect on some earnings in the group, but the rest are doing quite well.”
Zeder said in its results that there is “inevitable cyclicality”, but the agribusiness industry should offer attractive long-term returns and that it had a defensive portfolio mix.
RHODES FOOD GROUP
Food companies have had a terrible time recently, but there are businesses in the sector that are worth investing in.
Rhodes Food Group’s Rhodes brand is excellent and it is providing premium products to Woolworths, says McCurrie. “Rhodes is not just a food producer – it adds value to its products,” he says.
The group has been making acquisitions, including Pakco and Ma Baker, and growing regionally in sub-Saharan Africa.
In the year to September, according to a trading update, sales in sub-Saharan Africa including SA were up 21.4% and, according to the company, it gained market share in key product categories, but the stronger rand, reduced demand for industrial pulp and purée products, foreign pricing pressure mainly in Asia, and increasing costs on canned fruit because of the drought saw international sales drop 18.1%. Group turnover increased by 10.8% for the year. Headline earnings will drop by between 17% and 22%.
Hulamin is the only major aluminium rolling operation in sub-Saharan Africa, and one of the largest exporters, accounting for more than 60% of sales.
Resource-related companies are looking interesting, says McCurrie, but there are investment risks.
“Hulamin will benefit quite nicely from the rising aluminium price and it is virtually 100% rand hedge, even if it sells aluminium in South Africa, because its product is priced in dollars,” he says, adding that investors should see the results of efficiency gains.
A recent strategic update indicated that it planned to build on a continued improvement in its operational performance over 2016 and 2017. The company has made progress in inventory efficiency, utilisation of scrap metal and reducing manufacturing costs.
In the last financial year, to December 2016, headline earnings a share were up 222% on record sales of 232 000 tons, and Hulamin recorded strong cash flow of R415m.
At the year-end, the aluminium price was $1 713 per tonne – it is currently over $2 000. By the June 2017 interim, results were more subdued, but order books for rolled products were healthy.
With healthcare costs mounting, day hospitals could well be the hospitals of the future. McCurrie, who likes Advanced Healthcare, which has 10 hospitals in SA and Australia, does warn, however, that this is a risky investment “and people must put only a small proportion of portfolio into this investment”.
“It is rolling out day clinics at a furious pace. I have not seen its operating performance, but the concept is so good – a far cheaper health offering,” he explains.
Losses in the year to June and a rights offer may not give potential investors much comfort.
The results showed a good increase in revenue, wiped out by operating costs. There was a slow growth in patient numbers as large competitors adopted “anti-competitive strategies”, according to the company. Its hospitals are all in start-up phases, incurring costs and taking time to build up capacity.
“It may be too early [for investment] and the company may not even be successful,” says McCurrie, “but the concept is sound.”
This article originally appeared in the 30 November edition of finweek. Buy and download the magazine here.