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Small Caps Have Outperformed for Two Years, What’s Next?

Following a period of sustained underperformance, small-cap stocks made a remarkable comeback in the past two years, outpacing the broader equity market from 2021 to the end of 2022. Now, the important question is, where to from here?

Against a backdrop of global macroeconomic growth concerns and a rising interest rate cycle both globally and domestically, the reality is that the 'SA Inc' narrative has turned negative once again, exacerbated by the elevated levels of loadshedding since November last year.

Vanessa van Vuuren from Sanlam Investments is Portfolio Manager for the SIM Small-Cap Fund, which was named ‘Best South African Equity Mid- and Small-Cap Fund’ in the 2023 Raging Bulls awards.

She says that, while the macroeconomic outlook is not good for 2023, her team’s investment process is what has allowed them to navigate the preceding cycles and to reap the rewards of the embedded value within the small-/mid-cap universe.

“It is easy to get caught up in the negative narrative. However, there are plenty of mis-priced, attractive investment opportunities currently and we believe that the disciplined application of our investment research process — which emphasises a high degree of detailed work and well-thought-out scenario analysis — will continue to underpin our ability to select these opportunities for our existing or prospective clients.”

She says, given the headwinds on the horizon, the team is managing the SIM Small- and Mid-Cap Fund with heightened risk management currently. “We have enhanced our emphasis on scenario analysis and understanding the downside risk or “bear scenario” of each of the companies that we invest in on behalf of our clients.

“So-called ‘self-help’ stories — companies with unique dynamics that insulate their performance against the broader economic cycle, such as a strategic change or a recovery caused by a once-off event — and higher quality businesses are top-of-mind in our current selection process. However, we are also not afraid to select deeper value opportunities, where we expect much patience will be required, but we see material upside through the cycle. It is a delicate balance that we need to strike.”

The top five stocks currently in the award-winning fund are Famous Brands, Omnia, Sun International, Reunert, and Reinet Investments. Each of these shares is concentrated within the portfolio due to their unique investment cases and in each of these counters, there is some degree of insulation from the broader macroeconomic backdrop.

“For example, both Famous Brands and Sun International continue to benefit from a recovering base in their own respective cycles (hospitality and leisure) and still offer attractive upside to intrinsic value. Or in the case of Reunert, the company has a particular combination of businesses that are enjoying robust demand for their products and so we see a degree of insulation from the weak macro backdrop in conjunction with considerable upside in the overall investment case in terms of what we believe the business is worth on a ‘through-the-cycle’ basis, as an important foundation of our robust investment philosophy.”

Van Vuuren said sustained exposure to small- and mid-cap shares is a useful source of investment alpha and diversity within an equity investment strategy. “We have demonstrated how powerful the cycles can be within these sub-categories of equity investment — the extent of the dislocation can be material since the small cap universe essentially remains an area of the market often overlooked and not properly researched. We believe that our dedicated small- and mid-cap research process that has integrity and focus remains the crucial tool to unlock this value over time.”

*Rolling 3 year to 26 April 2023 (date of writing this article).

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