Small-caps stocks: What you need to know

Cape Town - Overberg Asset Management looks at the benefits of smaller-cap stocks in this week's overview of the economic landscape.

It noted that over the past fifteen years (to 5th June 2017) the growth in the Top 40 index has been an 12.35% annualised, yet this pales compared to the Small-Cap index’s substantial 16.55% annualised return. (See bottom line)

"The prospects for earnings growth are greater from a smaller base. In addition, smaller companies benefit from greater management ownership and a more entrepreneurial culture," it said.

South Africa economic review

• The Bureau for Economic Research manufacturing purchasing managers’ index (PMI) recovered strongly, rising from 44.7 in April to 51.5 in May regaining the key 50-threshold, which separates expansion from contraction. The jump is attributed to an overstatement of negative conditions in April and Easter calendar effects resulting in a sharp increase in working days in May.

Among the sub-indices, business activity increased from 37.0 to 52.3 and the forward-looking new sales orders index rose from 44.4 to 54.1. Encouragingly, the index measuring expected business conditions in six months’ time gained from 55.8 to 61.4 signaling positive momentum in the months ahead despite political uncertainty.

The prices index fell slightly from 69.9 to 68.3 echoing the recent easing in producer price inflation. The rebound in the manufacturing PMI bodes well for a gradual recovery in manufacturing activity over the remainder of the year.

• The Standard Bank purchasing managers’ index (PMI), measuring conditions across both manufacturing and services sectors, fell slightly from 50.3 in April to 50.2 in May but remained above the expansionary 50-level for a ninth straight month. The PMI has averaged 50.6 since the start of the year above last year’s equivalent level of 48.8.

Encouragingly, among the sub-indices the employment index edged higher from 50.2 to 50.6 although staff costs rose from 51.4 to 52.0 signaling rising wage pressure.

However, the inventory index slipped from 51.1 to 49.3 in line with declining business confidence. The leading PMI indicator, measuring the ratio of new orders to inventories increased above 1.0 signalling a potential need for inventory restocking in the second half of the year.  

• The Quarterly Labour Force Survey recorded a jump in the unemployment rate from 26.5% in the fourth quarter (Q4) to 27.7% in Q1 its highest level since the data series began in 2008. Over the period employment increased by 144 000 but not sufficient to accommodate the 182 000 increase in new entrants to the job market.

Meanwhile the labour force participation rate, measuring the active portion of the labour force, increased from 44% to 46.2% as the number of discouraged job seekers declined.

Employment growth was recorded in seven of the ten economic sectors, with the highest number added by manufacturing at 62 000, finance at 49 000 and mining at 26 000. By contrast job losses were recorded in the agricultural sector at 44 000 and in the trade sector at 15 000. Perhaps the biggest concern is the surge in youth unemployment, which rose from 50.9% to 54.3%.

• The trade surplus fell from R11.3bn in March to R5.1bn in April, slightly below the R7.4bn consensus forecast although for the year-to-date the R9.9bn trade surplus compares favourably with the R26.4bn trade deficit in the same period last year.

While positive with regards to a narrowing in South Africa’s current account deficit, April’s trade surplus is more a reflection of falling imports than rising exports. Imports contracted by 5.8% year-on-year compared with 3.7% in March with weak domestic demand contributing to an 8.7% decline in non-mineral imports.

Exports contracted by 0.1% on the year with vehicle exports falling by a massive 28.3%. However, base metals exports increased 0.9% recovering from the 6.8% contraction in March while minerals exports increased by a solid 57.8%.

Although April’s overall export performance was slightly disappointing, the outlook remains positive buoyed by improving global trade conditions. The World Trade Organisation’s world trade outlook indicator increased in March to its highest level since May 2011.

• Growth in private sector credit extension (PSCE) increased from 5.0% year-on-year in March to 5.9% in April its strongest pace since October 2016. However, the bulk of the increase is attributed to the distortion of last year’s base by the treatment of African Bank’s loans.

The 2.9% year-on-year increase in household credit extension is likely to revert to March’s more modest 0.7% growth rate in the months ahead. Meanwhile credit extension to companies eased from 8.9% to 8.2%. Credit demand is likely to remain weak in the short-term amid political uncertainty and its impact on business and consumer confidence.

• Foreign investment inflows amounted to R5.4bn in the past week the highest in 7 weeks. The bulk went into the bond market with a marginal positive inflow into the equity market. Over the month of May net selling of equities was -R8.2bn taking net sales for the year-to-date to -R44.1bn.

By contrast net buying of bonds was R6.9bn in May and R45.6bn for the year-to-date. Strong foreign demand for South African bonds mirrors the global surge in demand for higher yielding emerging market assets and continues despite the uncertain domestic political environment and threat of further credit rating downgrades.

However, since the South African bond market is large and very liquid any change in broader sentiment will be felt more strongly in this market than other emerging markets.

• Both Fitch and Standard & Poor’s (S&P) kept South Africa’s local and foreign currency sovereign credit ratings unchanged although Fitch left its outlook at “Stable” while S&P maintained a “Negative” outlook. Fitch cited the country’s credit strengths including deep local capital markets, favourable government debt structure and prudent fiscal and monetary policy.

However, Fitch cautioned that low potential economic growth, deteriorating governance of state-owned enterprises and sizeable contingent liabilities weighed down the country’s outlook.

Fitch’s accompanying statement was mirrored by S&P, which announced that political risk could “distract from economic growth enhancing priorities, slow the pace of fiscal consolidation and impact upon investor and consumer confidence, more than we currently project.”

The week ahead

• First quarter GDP growth: Due on Tuesday 6th June. Following the -0.3% quarter-on-quarter contraction in the fourth quarter (Q4) GDP is expected to post growth of 1.0% in Q1, according to consensus forecast.

While the manufacturing and retail sectors have remained depressed the agricultural and mining sectors have staged a solid recovery amid rising international commodity prices and as the effects of the drought dissipate.

• Mining production: Due Thursday 8th June. Although positive momentum is expected to be maintained mining production is unlikely to match the stellar 15.5% year-on-year growth posted in March. Hampered by Easter calendar effects mining production growth is expected to slow in April to 3.5% on the year, according to consensus forecast.

• Manufacturing production: Due Thursday 8th June. Easter calendar effects are likely to impact April’s year-on-year manufacturing growth with the marginal 0.1% expansion recorded in March expected to deteriorate to a 3.5% contraction in April.

Technical analysis

• The rand has broken key resistance at R/$13.00 pointing to further gains towards R/$12.50 and thereafter R/$12.00.  

• The US dollar index has tried but failed to break through a major 30-year resistance line suggesting the three-year bull run in the dollar may be over.

• Following the announcement of the snap election the British pound has broken above key resistance at £/$1.25 which has now become a key support level and should promote further near-term currency gains. Recent strong gains have diminished prospects for a £/$1.18-1.22 target.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield has broken back below the key resistance level of 2.0% providing continued support for the multi-year bull trend in US bonds.

• The benchmark R186 2025 SA Gilt yield is trading in a tight trading range of 8.5-9.0%. A break above 9.0% is required for the yield to move decisively higher towards the 10.5% target level.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdqaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.  

• The Brent oil price is trading in a range of $50-55, which if broken to the downside could lead to a sharp decline to the $40-45 range. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $5500 per ton.

• Gold has developed an inverse “head and shoulders” pattern, which indicates further upward momentum and a test of the $1400 target level.

•  A break above 54 200 on the JSE All Share index would project an upward move to 60 000 marking a new high for the JSE.

Bottom line

 • Shares are categorised as small, medium or large depending on their market capitalisation. On the JSE the companies comprising the Top 40 index are considered large-caps and the Mid-Cap index comprises companies ranked 41-100 in terms of market capitalisation. The Small-Cap index comprises companies which rank 101 and below.

In terms of market capitalisation companies sized R10bn and over tend to be large-cap, companies from R2.5bn to R10bn tend to be mid-cap and anything less than R2.5bn is considered small-cap.

Being less constrained by shareholder demands for quarterly performance management also has greater freedom in taking a longer-term view.

• Furthermore, small- and mid-cap stocks are less expensive than large-caps. Due to a lack of coverage by research analysts there are many more undervalued and mispriced opportunities among small- and mid-caps.

They tend not to be covered by the large institutions, hence are not priced efficiently and are often ignored by private investors due to higher perceived risk. The price-earnings (PE) multiples of the small- and mid-cap equity indices are 17.72x and 16.49x respectively, well below the 20.01x PE of the Top 40 index.

• Today’s small-caps will become tomorrow’s large caps. Being small does not necessarily equate to higher risk. Numerous small companies boast sound business models, established management teams, defensive balance sheets and a record of quality earnings growth.

• Although smaller companies provide better longer-term investment returns they tend to be more volatile. Being less liquid means small-cap stocks are prone to wilder swings in investor sentiment. During periods of negative sentiment, it can become difficult to exit a position without prompting a substantial price decline.

• Holding small- and mid-cap companies in a share portfolio is key to achieving superior long-term performance with the caveat that exposure is spread across numerous holdings and balanced with less volatile albeit slower growing large-cap stocks.

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.

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