Should South African investors invest in small companies?

Free lance journalist Leon Kok was one of those who bought into the Investec Emerging Companies fund about seven or eight years ago, only to kick himself a year or two later for the seeming disaster that he had landed himself.

The bottom fell out of the small caps sector. Not least was because several so-called star new listings, technology companies included, had failed to deliver on their rosy forecasts of the early and mid nineties. Major disasters were Leisurenet, Regal and Macmed. Even some of those that had won profitable business contracts, lost fans. The premium awarded to those stocks over the previous number of years had been turned to discounts such that at the end of 1999, there was significantly more upside than downside. At its peak in 1998 about R10 billion poured into small cap unit trusts; today the sector is only a fraction of its former size.

I stuck with the fund mainly because the then Board of Executors small cap manager, Jenny Ferrini, persuaded me that the bottom of the market was not the time to sell, and in any event, she argued, if you exposed yourself to quality stocks, you'd eventually get good returns. Jenny's then counterpart at Standard Bank, Sean Seger, also said to me at the time, "there is no more risk in a small cap stock than a large cap stock, provided the right criteria are provided in the selection".

More harrowing, however, was what Glen Tetley, investment manager at Huntley Investments in Sydney, Australia, had warned: "Dive into a thinly traded stock with an order to buy a few thousand shares and you'll probably pay more for your stock than you expected. You've got to find stocks that trade with enough volume so that you don't erode your profits when it comes to sell.

"The trouble with small caps is that a market quote of, say, A$1 to A$1.20 a share can quickly become an 85 cent seller - no buyer - creating a 'hole' in the price. A lack of real volume can be a real problem. Holders of these stocks can suddenly find themselves in losing situations".

The long and the short of it are that small cap funds have at last acquitted themselves with some sterling results. They've shot the lights out during the past three years but sadly a great many investors have missed the boat. Arguably, there's still limited upside in the offing, though this is not the time for retail investors to climb in

Top performer over both one and three years is the Sanlam Small Cap Fund that generated an excellent 61,6% return during the past 12 months and an annual average 48,2% during the past three years.

Ricco Friedrich, assisted by Johan de Bruijn and Munaaf Kahn manages it. A chartered accountant by training, Friedrich joined Sanlam Investment Management (SIM) as an analyst on the industrial team in 1999 and moved into small caps in 2001. He has been credited for building up the small cap process at SIM.

Says Friedrich: "Shortly after taking over the management of the Small Cap Fund, someone asked when the performance of the asset class would turn around. My response was that it already has. Whilst hindsight is a perfect science, had I known of the returns that were in the offing, I would have shouted from the rooftops.

"The extraordinary returns came about due to their very attractive valuations at the time and the favourable economic environment that followed. These kinds of opportunities don't come very often".

Major drivers have been excellent earnings growth; the lower interest rate environment; the currency has been beneficial; delistings have exceeded new listings; more capital has chased fewer opportunities; and there's been an increased appetite for risk. So looking back, the past decade has taught that smaller companies can lag leading stocks for a considerable period of time. Smaller stocks are often more vulnerable, rise more quickly in a bull market, and are more vulnerable to bear markets. They can also be extremely vulnerable to the effects of economic slowdown, competition and poor management.

But despite all these negatives, smaller companies can add an extra dimension of performance to your portfolio, which over time should be higher than that available from large stocks.

However, investment in small cap funds should be kept in perspective and most conservative equity investors should maintain a bias towards the Top 40 on the JSE. Generally, smaller stocks should represent a maximum 20% to 25% of a well-balanced South African share portfolio.

Leon Kok writes for publications in the United Kingdom, the United States and Switzerland, in addition to local periodicals such as Finance Week. He writes in his personal capacity and views and comments should not be considered to be advice. If you are unsure which unit trusts to invest in please consult a financial advisor.