With the All Share having rallied approximately 65% since its low at the end of 2008, investors who believe that the market is approaching its historical fair-value level are eagerly seeking the next source of growth.
Some have turned their gaze towards small-capitalisation stocks (small caps) in the belief that they offer greater potential for growth in a market that is fast becoming expensive. Generally small caps are not analysed to nearly the same extent as mid and large caps. On the face of it, it would seem as if this lack of information gives rise to more arbitrage opportunities. However, it is this very same fact (the lack of information) that makes identifying these opportunities so much more difficult. Added to this, small caps also have some unique risks associated with them which can make investing in them particularly daunting.
The prospect of investing in small caps gives rise to two questions: firstly, how have small caps performed relative to the market over the recent past, and secondly, does the out-performance offered by small caps necessarily compensate the investor for the unique risks offered by this subset of equities?
What makes small caps risky?
In order to answer these questions it is perhaps necessary to firstly identify why small caps are regarded as being more risky than mid- and large-cap stocks. By definition, small-capitalisation stocks are those counters that have a market capitalisation of less than R5-billion. Market capitalisation is the product of the share price and the available shares.
Over the past 15 years, the mid-cap index has outperformed the small-cap and top 40 index by 195% and 331% respectively. The small-cap index has outperformed the top 40 index by 136% over the same period, despite a prolonged period of dramatic underperformance between the middle of 1999 and the middle of 2004. A comparison of earnings shows that small-cap earnings appear to be a lot more volatile than that of mid and large caps.
Apart from the fact that small-cap earnings have fallen away in dramatic fashion during the most recent market crash, what is more interesting is the fact that mid-cap earnings appear to have been the most defensive. This defensiveness is as a result of the fact that the mid-cap space is comprised of a more diversified spread of industries than that of large caps.
Moreover, the top 40 index, on a market weighted basis, is dominated by resources counters which are cyclical and influenced to a large degree by fluctuations in the exchange rate. Since the start of 2009, small-cap, mid-cap and large-cap earnings have fallen by approximately 60%, 6% and 31% respectively.
Why are large caps more stable?
There are a number of reasons why larger cap companies have more stable earnings. Firstly, mid-cap and large-cap companies generally have a better quality of earnings than that of small caps. It is thus important for small-cap analysts to distinguish between earnings that have arisen out of specific opportunities or tenders and those which will be replicable into the future. It is more desirable for companies to exhibit annuity-like earnings, as opposed to earnings derived from flash-in-the-pan opportunities. More resilient order books make for more consistent earnings streams, and more consistent positively trending earnings streams make for more stable increases in share prices.
Secondly, larger companies more often than not have more skilful and experienced management teams who are able to deploy capital more effectively in order to grow the earnings base, but at the same time are able to adjust gearing levels so as to ensure that debt obligations can be met. This ability is particularly important when there are unforeseen adverse changes in the economic environment.
Thirdly, larger companies have more established competitive advantages, and have either dominated their respective industries for some time or have a presence in industries with high barriers to entry.
Lastly, unlike small caps, large- and mid-cap operations generally have stronger balance sheets, which make them better able to prevail during tough times. Simply put, in general, larger companies that have been around longer and have more established business models are less likely to go under than up-and-coming smaller companies.
Risk extends way beyond mere volatility, however. Unlike mid and large caps, small caps are not traded to the same extent. This introduces another type of risk, namely liquidity risk — the risk that a holder of the counter will not be able to exit that position as and when she requires. Even though this type of risk has little bearing on the quality of the business, the inability to move out of a position when desired can result in the locking in of losses or the inability to capitalise on gains as and when the opportunities present themselves.
Small-cap shares, like any other investment vehicle, can be impacted by speculation. Speculation is the result of ill-informed investors who pile into an investment entity either because it is fashionable to do so or because of the belief that there is a quick buck to be made. The mass injection of capital in turn pushes up the demand for the entity and in so doing raises the share price. Once rationality returns, the transient interest, and the money which follows it, disappears as quickly as it arose.
The challenge of analysing small-cap counters
Over the past 12 years, small caps have fallen victim to two such instances of speculation brought about by mass listings of small-cap companies. The first of these booms, which occurred between 1997 and 1999, saw no fewer than 229 new listings of mainly financial and IT small-cap companies, and the second, which occurred between 2006 and 2008, saw about 122 new listings of mainly construction companies on the Alt-X.
The listing booms gave rise to massive speculation, with investors piling into small caps and forcing up share prices way beyond their fair values. The late 1990s listing boom saw the small-cap index shooting up a spectacular 55% between the beginning of January 1998 and the end of May 1998, only to see it plummet by 42% by the middle of September that same year. Similarly, the listings boom of 2006/07 saw the Alt-X increasing 186% between the end of June 2006 and the middle of November 2007, only to see it drop by 78% by the beginning of 2010.
The difficulties surrounding small-cap investing has seen even the most astute managers under-perform. Ricco Frederich, an asset manager for Sanlam Investment Management, attributes most of this underperformance to poor stock selection brought about by the difficulty in analysing small-cap counters. These difficulties stem from the earnings volatility of these companies and a lack of understanding of the ways in which they generate their earnings streams, which in turn gives rise to estimation and modelling errors.
Another interesting reason for the underperformance of small-cap funds is a phenomenon referred to as the “passing-by” effect, which sees unhealthy companies passing through the small-cap space on their way southwards.
The difficulties of investing in small caps do not necessarily precipitate the writing off of this subset of asset class. Small caps can provide exposure to growth-geared companies and innovative industries and technologies. As with all investments, the risk-return relationship holds true, provided that the investment decision is based on sober rationale, strong fundamentals, rigorous analysis and an intimate understanding of the companies in question.
Small-cap investing is certainly not for the faint-hearted and is best left to professionals who are able to selectively exploit this subset of asset class as part of a diversified portfolio.
Ian Brink is an investment analyst at Glacier Research, Sanlam
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