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Local investors who stayed true to their investments in smaller companies have enjoyed incredible returns on their capital thanks to a reversal in some of the significant valuation dislocations that existed in the smaller company universe.
“The small cap phoenix is rising from the ashes and those who stayed the course and believed in South Africa Inc. instead of following an ‘everything offshore’ approach to equity investing, have reaped the benefits,” said Vanessa van Vuuren, Portfolio Manager and Equity Analyst at Sanlam Investments, during a presentation at the 2021 BCI Digital Global Investment Conference, held recently.
Some economic context is necessary in assessing the impact of COVID-19 on South African small and mid-cap companies. It emerges that South Africa Inc. was already in a significant rut when the pandemic struck, with an average annual GDP growth rate of just 0.43% in the five years to March 2020. “This lacklustre economic growth was a significant headwind to companies in the JSE Small Cap Index which are more correlated with the domestic economy than large companies that typically earn higher offshore revenues,” said Van Vuuren. With limited investor interest in the smaller end of the market, small cap company valuations have been declining for a long while due to the protracted weak macroeconomic backdrop. The small cap index had struggled notably since mid-2017, but despite this, both small and mid-cap indices fell as far and hard as other segments of the JSE during the March 2020 pandemic sell-off.
The long-term impact of the pandemic and subsequent national lockdowns on industry-specific earnings and revenue forecasts is only now becoming apparent, with some sectors far worse off than others. For example, local restaurant and bar sales and SA hotel occupancy rates show “falling off a cliff” between March and June 2020, with both industries languishing at around a third of their pre-crisis levels today.
“A look at the rolling 10-year return premium for JSE Small Caps over the JSE Top 40 confirms that small caps were lagging by an unprecedented, annualised rate of around -3% at the market low point in March 2020 (being small caps’ underperformance relative to large caps), well off the long-term trend of outperforming by an average 3% over rolling ten-year periods, measured from 1995 as a starting point,” said Van Vuuren. A rapid post-pandemic turnaround since March last year has seen the underperformance relative to large-caps reduce somewhat, as these shares make up for lost ground. Despite this, mid- and small cap returns still have a fair bit of catching up to do if they are to return to a trend of outperformance relative to large caps, as both areas of the market continue to underperform large caps over the latest rolling ten-year period measured.
The Sanlam Investment Management (SIM) Small-cap Fund is currently chipping away at its disappointing five-year return with a 20% surge over the latest quarter, 46% over the half-year, and an impressive 70% in the year to 31 March 2021. This return, which exceeds that delivered by the fund’s ASISA category peers, illustrates the value in running a dedicated research process that focuses on searching for ideas among the small and mid-cap companies, which are often ignored by the market. “We run a quality portfolio that gives our investors broad exposure to small and mid-cap companies in the sweet spot of the financial, industrial and resources sectors,” said Van Vuuren, who observed that fund managers were hard-pressed not to panic during the recent market crisis.
During the market crash of Q1-2020, the SIM equity investment team had to focus on and immerse themselves into the most crucial element of their investment process – a rigorous and thorough research process. This was executed by acknowledging historic market cycles, drawing on the decades of experience within the team, applying rigorous scenario analysis to all of the companies that the team analyses, and closely assessing structural versus cyclical damage to company valuations on a case-by-case basis.
“Our investment strategy is grounded in applying through-the-cycle valuation discipline, especially when market fear is pervasive,” said Van Vuuren. The team was able to back some incredible winners by considering base, bear and bull cases for various shares pre-crisis. One example is Adapt IT, which had been assessed in December 2019 at a base price of R10/share, a bear case of R8/share, and a bull case of R13/share. The share has since rebounded more than 480% from its R1.20/share pandemic low.
“Despite the recent rebound in South African small caps, there are still many mispriced and undervalued shares in this universe that we expect to outperform and, hopefully, grow into tomorrow’s large-cap shares,” concluded Van Vuuren. “We continue to scrutinise these opportunities and invest in attractively-priced companies with strong balance sheets and the added benefit of a potential rebound in earnings in coming reporting periods”. Careful stock selection and risk management is necessary to avoid the drag created by South Africa’s poor macroeconomic backdrop and the myriad structural challenges facing our society circa 2021.
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