Over five years to the end of May, the FTSE/JSE All Share index (Alsi) returned 46.8%. By contrast, the FTSE/JSE Mid Cap index delivered barely half of that, at 23.5%.
For many managers with an eye on value, this suggests that there is a lot of latent potential in this part of the market. Even though mid-caps are up 12.4% over the past three months, compared to the 4.2% gain on the Alsi, multiples on many caps are still extremely attractive.
As Perpetua Investment Managers CIO Delphine Govender pointed out, capturing growth in the mid-cap space is also an important source of alpha for the smaller managers who can invest there effectively.
‘If you look at larger managers like Allan Gray, Coronation and Prudential, when they were in their more exponential alpha generation phase, it absolutely came from placing the right bets on which mid-caps were going to become large caps,’ said Govender, who co-manages the Perpetua SCI Equity fund.
‘It’s the unrecognised growth thesis: mid and small caps don’t just have the potential to deliver very high earnings growth, but also then benefit from the subsequent re-rating, which large caps don’t necessarily get with the same power.’
This has happened most obviously in the past few decades with Naspers, but it is also true of stocks like Capitec, Aspen, Mr Price and MTN.
However, looking across the mid-cap universe on the JSE today, it’s hard to spot an emerging company. In fact, many mid-caps today lapse large caps – such as Pick n Pay, Liberty Holdings and Tiger Brands.
The majority of local mid-cap stocks are established businesses, not disruptors and market innovators. This may suggest that while investors can hope for re-ratings in share prices – in many cases from very low multiples – there is little to get excited about in terms of unrealised growth.
Dismissive of innovators
For Govender, there may be a few reasons for this. The first is that more and more growth is happening outside of listed markets.
‘There is no shortage of entrepreneurial, high-growth ventures. But it’s not transmitting into what we can invest in on the JSE,’ she said.
Secondly, she said there tends to be a conservative mindset in South African-listed company management teams.
‘Domestic companies have always had it quite easy because we’ve had very oligopolistic, concentrated markets, with high returns,’ said Govender. ‘So, companies never had to worry about being particularly agile or disruptive.
‘They tend to be dismissive of innovators. If you speak to offline retailers about online, for example, they are dismissive. South African management teams tend to think that structural trends are faddish and will eventually roll over.’
Roger Williams, CIO at Centaur Asset Management, shared a similar view.
‘I think many local companies lack the flexibility to adapt to a changing environment,’ said Williams, who manages the Centaur BCI Flexible fund. ‘For example, 20 years ago, I thought that internet banking would be a game-changer for banks. I thought they would get so much more efficient because everyone would be banking online, but it doesn’t seem to have paid dividends.
‘Yet, you have a disruptor like Capitec that has done exceptionally well using technology. The big banks, on the other hand, seem to have hung onto a lot of legacy practices.
‘Insurers have also been very slow to adapt. Liberty Life was an enormous success story 20 years ago and is now just a shadow of itself.’
He sees this as a broad ‘lack of institutional ability to reinvent themselves’.
‘A lot of companies are just pasting over the problems with acquisitions. But that is not necessarily creating any value.’
Citywire A-rated Vanessa van Vuuren and San Naidoo, co-managers of the SIM Small Cap fund, noted in a written response to questions that it is also more difficult for South African companies to achieve rapid growth in an environment that is increasingly digital and global.
‘Think about Netflix entering the market and challenging MultiChoice,’ they said. ‘Without this impact, we could still be thinking about Multichoice as a growth business with a fair degree of headroom to go in terms of household penetration in South Africa. But with the opening of the South African economy and the surge in digitisation, the competitive landscape is far broader in many industries.’
Nevertheless, there are still a few companies that may be able to exploit untapped sectors of the economy. One that Williams finds interesting is Stadio Holdings.
‘Stadio was unbundled out of Curro as a tertiary education provider. That is an enormous space ripe for a bigger player. If they can execute, that has massive potential because there is such a shortage of tertiary education.’
However, it is still such a small company that it is difficult to invest in because of liquidity concerns.
Another interesting opportunity is Rand Merchant Investment (RMI) Holdings, although not in its current form, Williams said.
‘OUTsurance is still growing well in South Africa,’ he said. ‘They are looking to take a much bigger slice of the commercial market. And they are also doing very well in Australia. But maybe there are structural issues there because if you buy RMI you are also getting discovery and MMI. As a standalone business, I think OUTsurance would be far more exciting.’
Among smaller companies, van Vuuren and Naidoo point to Sygnia, Transaction Capital and Curro as having interesting growth prospects. In the mid-cap space, they also think Dis-Chem is attractive.
‘With 194 stores and a target of doubling this footprint, Dis-Chem will further the formalisation of the pharmaceutical retail industry, which has remained fragmented outside of the domination of Clicks,’ they said.
They added that there are also some growth vectors being captured inside larger corporates with big balance sheets and the ability to seed new ventures in-house.
‘A practical example would be Vodacom’s financial service offering, which has scaled rapidly and is investing actively in fintech plays,’ they said. ‘Many of the larger corporates are also building internal corporate finance or M&A teams that aim to identify the next big opportunity.’
In Govender’s view, there may just be a growing realisation among local companies that complacency is no longer an option.
‘When we look at listed companies, we need to see that they are looking ahead to figure out where their next source of growth is coming from,’ she said. ‘For many of them, the core business is absolutely going to be under attack. We invest in companies for growth, and that’s what management teams need to be thinking about.
‘Tiger Brands, for example, announced a small venture capital fund last month. You might think it doesn’t move the needle, but it’s exactly what businesses that are highly cash-generative need to be doing to figure out where their next source of growth will be.’
Patrick Cairns is South Africa editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.