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A measured exposure to small companies can deliver an asymmetric risk-return profile, which means there is a greater upside than downside.
Today’s small caps will become tomorrow’s large caps. Being small does not necessarily equate to higher risk.
Many smaller companies boast sound business models, established management teams, defensive balance sheets and a record of quality earnings growth, said Overberg Asset Management (OAM) in its weekly economic and market overview.
It noted that over the past fifteen years (to 15th May) the growth in the JSE Top 40 Index has been an impressive 14.57% annualised with the Small-Cap Index being the best return of all at 17.42% annualised.
"A measured exposure to small companies can deliver an asymmetric risk-return profile, which means there is more upside than downside."
South Africa economic review
• As expected the South African Reserve Bank kept its benchmark repo interest rate unchanged at 6.50%. The Reserve Bank Monetary Policy Committee (MPC) was unanimous in its decision. The MPC kept its GDP growth forecast for 2018 unchanged at 1.7% but lifted its 2019 forecast slightly from 1.5% to 1.7% noting positive global growth and improving domestic business and consumer confidence.
While keeping its inflation forecast unchanged, with consumer price inflation peaking at 5.5% in the first quarter 2019, the MPC noted that risks to the inflation outlook are tilted to the upside due to the rising oil price, potential sharp increases in electricity prices and recent weakness in the rand.
The rand has depreciated versus the US dollar by 6% since the MPC meeting in March and by 2.8% versus the trade-weighted currency basket. The Reserve Bank’s cycle of interest rate cuts is likely to be put on hold until the rand shows renewed stability.
• Consumer price inflation (CPI) increased sharply in April to 4.5% year-on-year from 3.8% in March due to the impact of the VAT increase from 14% to 15% implemented on 1st April. However, the CPI gain was less than expected, below the consensus forecast of 4.7%. On a month-on-month basis CPI increased 0.8%, driven mainly by rising fuel prices with the transport category contributing 0.3 percentage points.
The less volatile core CPI reading, excluding fuel and food prices, also accelerated although by less, from 4.1% to 4.5%. The 3.8% CPI reading in March is likely to have been the low point in the current cycle with inflation risks now titled to the upside amid residual effects of the VAT increase, recovering food prices and higher oil prices.
CPI is expected to peak in the third quarter at around 5.3% before declining again to below 5% by year-end, although this projection could be undermined by potential rand volatility. Rising global risk aversion emanating from US interest rate concerns could continue to impact emerging market currencies, including the rand.
• The South African Reserve Bank Leading Business Cycle Indicator dipped slightly in March from 108.3 to 107.4 its first decline since April 2017. While slightly disappointing some pullback had been expected given that the indicator had increased in February to its highest since June 2011.
The leading business cycle indicator, a barometer for expected business conditions 6-9 months ahead, remains at elevated levels despite the slight decline, signalling a rebound in economic activity in the second half of the year and into 2019. Among the index sub-categories, positive contributors included new vehicles sold, rising job advertisements, increasing manufacturing orders and a pickup in the average leading indices of South Africa’s largest trade partners.
Negative contributors included lower commodity prices, fewer hours worked in the manufacturing sector, a deceleration in broad money supply and a decline in residential building plans passed.
• S&P Global Ratings affirmed South Africa’s sub-investment grade credit rating and kept its outlook stable. S&P noted that: “After the recent political transition, authorities are pursuing key economic and social reforms, but we consider the economic and social challenges the country faces as considerable.”
According to the rating agency: “Our ratings on South Africa are constrained by the weak pace of economic growth, particularly on a per capita basis, as well as its large fiscal debt burden and sizeable contingent liabilities.” On the positive side, S&P said: “We could also take a positive rating action if policymakers were to introduce structural economic reforms that delivered improved competitiveness and employment.”
In a veiled reference to land expropriation, S&P warned that: “We could also consider lowering the ratings if the rule of law, property rights, or enforcement of contracts were to weaken, undermining the investment and economic outlook.”
The week ahead
• Private sector credit extension: Due on Wednesday 30th May. Growth in private sector credit extension (PSCE) will be closely watched for confirmation that the surge in consumer and business confidence is translating into actual demand for credit. An acceleration in PSCE would lead to a pick-up in GDP growth.
According to consensus forecast PSCE is expected to have grown in April by 6.1% year-on-year up from 5.9% in March.
• Producer price inflation: Due on Thursday 31st May. Producer price inflation (PPI) is likely to have jumped in April due to the first-time inclusion of the VAT increase, which was implemented on 1st April.
Since April’s consumer price inflation number increased by less than expected the PPI figure may also come in below the consensus forecast of 4.3% year-on-year, from 3.7% in March.
• Trade balance: Due on Thursday 31st May. The trade balance is expected to have remained in surplus in April to the tune of R5.0bn according to consensus forecast, down slightly from the surplus of R9.5bn achieved in March.
The expected decline is attributed to a slight softening in global trade combined with rising domestic demand for imports in line with improving business and consumer confidence.
• Absa manufacturing purchasing managers’ index: Due on Friday 1st June. The Absa manufacturing purchasing managers’ index (PMI), having surged higher in April from 46.9 to 50.9, is expected to have held above the expansionary 50-level in May albeit showing a slight decline to 50.7 according to consensus forecast.
The PMI may struggle to make further strong gains due to continued uncertainty over land expropriation and the disruptive effect of the general election in early 2019.
• New vehicle sales: Due on Friday 1st June. Helped by rising consumer and business confidence and moderate vehicle price inflation, year-on-year growth in new vehicle sales is expected to have remained positive in May at 3.2% according to consensus forecast.
This would mark a slight reduction from 3.6% in April.
Technical analysis
• Having broken the key resistance level at R/$12.50, the rand has returned to its appreciating trend, targeting a break below R/$11.00 over coming months.
• The rally in the US dollar index has reached its medium-term goal suggesting a correction from current levels. The dollar remains below a major 30-year resistance line suggesting the bull run in the dollar may be over.
• The British pound has broken above key resistance at £1.35/$ promoting further near-term currency gains to a target range of £1.40/$ to £1.50/$.
• 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 decisively above key resistance at 3.0%, targeting the next key resistance level at 3.6%. A break above long-term resistance at 3.6% would indicate an end to the multi-decade bull market in bonds.
• The benchmark R186 2025 SA Gilt yield has broken below key resistance at 8.6%% indicating a new target trading range of 8.0% to 8.5%.
• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.
• The Brent oil price has broken above key resistance at $75 indicating a new trading range of $75 to $85 per barrel. Base metal prices are in a bull trend confirmed by copper’s increase above key resistance at $7 000 per ton.
• Gold has developed an inverse “head and shoulders” pattern, which indicates a price recovery and a test of the $1 400 target level.
• Despite the consolidation since the start of the year the break in the JSE All Share index above key resistance levels at 56 000 and 60 000 in December signals the early stages of a new bull market.
Bottom line
• Buffett famously stated that: “A fat wallet is the enemy of high investment returns.” Joel Greenblatt explains his meaning succinctly: “As his wealth has grown, his investment options have narrowed.
There are now only a relatively few investment opportunities that are large enough to make a difference to the overall investment returns of his portfolio.
His choices are generally limited to well-known companies, where he must compete with thousands of large institutional investors to find investment bargains.” Joel Greenblatt is the founder of Gotham Capital, an investment partnership that achieved 40% annualised returns for the twenty years after its founding in 1985, and professor on the adjunct faculty of Columbia Business School.
• Small companies are generally too small for the large unit trusts or other institutional funds to buy.
With restrictions on the ownership stake in individual companies and due to liquidity constraints, any holding in a small company could seldom have more than a negligible impact on their overall investment performance.
• Institutional research does not usually cover smaller companies. Their shares do not trade in the volumes necessary to generate the stock brokerage commission that covers the cost of generating research.
Less research means there are many more undervalued and mispriced opportunities among small companies, creating the opportunity to invest in under-priced investment bargains.
• Small companies provide better investment returns than large companies over the long-term. With less available research and less competition from large investment institutions there are likely to be more bargains among small companies.
In addition, prospects for earnings growth in small companies is greater as it is being generated from a smaller base. Small companies tend to benefit from greater management ownership and a more entrepreneurial culture. Being less constrained by shareholder demands for quarterly performance management also has greater freedom in taking a longer-term view.
• Over the past fifteen years (to 15th May) the growth in the JSE Top 40 Index has been an impressive 14.57% annualised. Yet the Mid-Cap Index has gained a superior 16.43% annualised and the Small-Cap Index the best return of all at 17.42% annualised.
• 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.
• 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.
• A measured exposure to small companies can deliver an asymmetric risk-return profile, which means there is more upside than downside, delivering either a huge success on the one hand but only a small failure on the other.
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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