Small Caps I’m Invested In…

The below is an exert from the Alpha Prime Small & Mid Cap Fund’s March 2020 investor letter: here.

Solvency & Liquidity Across Underlying Portfolio

Descending Order of Weighting in PortfolioNet Debt:Equity (%)Net Debt:EBITDA (x)Interest Cover (x)Current Ratio (x)
Metrofile Holdings Ltd95%1.9x3.0x1.3x
Grindrod Ltd (preference shares)Net cashNet cashNet cash0.8x
Adcock Ingram Holdings LtdNet cashNet cashNet cash2.0x
Stor-Age Property REIT Ltd*36%3.9x11.6x0.3x
Datatec Ltd29%1.4x4.3x1.2x
Coronation Fund Managers LtdNet cashNet cashNet cash0.9x
Sabvest Ltd (N-shares)****
Astral Foods LtdNet cashNet cashNet cash2.1x
Sirius Real Estate Ltd*46%10.5x1.0x
Master Drilling Group Ltd23%1.3x6.5x2.2x
Advtech Ltd89%1.3x3.9x0.3x
Santova Logistics Ltd21%1.2x8.0x1.5x
Pan Africa Resources Plc61%1.4x4.6x0.5x
Hosken Consolidated Investments Ltd****
Wescoal Holdings Ltd25%0.6x2.9x0.9x
Clientele LtdN/AN/AN/AN/A

Sources: Various company reports, Alpha Asset Management workings & assumptions; * Refer to specific commentary in the narrative below. Either unique circumstances or industry-specific solvency and liquidity ratios are more applicable.

Metrofile Holdings Ltd (Code: MFL; Price Earnings 10.8x; Dividend Yield 4.0%): The offer to delist Metrofile has been extended till 31 May 2020 due to the lockdown. While anything can happen, our discussions with management and our understanding of the parties involved make us confident that the deal will still conclude successfully. In the meantime, Metrofile’s core business (document storage) remains cash generative over this period and the Group balance sheet continues degearing, though net new boxes flowing in will likely be impacted as will one or two more peripheral businesses in the Group. The stock has also just gone ex-dividend, adding to the upside we see here via shoring up our cash weighting.

Grindrod Ltd Preference Shares (Code: GNDP; DY 14.3%): Grindrod’s balance sheet has nil net gearing but management are engaging with the banks regarding a facility over this period. The Group has suspended all capex, cut costs and does continue to move (only essential) goods through its ports and terminals. Results will likely be negatively impacted by this period but given that we are invested into the high-yielding preference shares, we expect Grindrod to keep paying us our current c.14.3% dividend yield. Yes, you read that correctly: we are currently getting almost four times inflation as a pure dividend yield on GNDP! Interestingly, as South African interest rates come down, an argument can be made that yielding preference shares become more valuable…

Adcock Ingram Holdings Ltd (Code: AIP; PE 10.3x; DY 4.6%): Adcock Ingram’s ungeared, cash-rich balance sheet is perfectly positioned for this period. Astute capital allocators, management have even announced that they will be buying shares back in the market over this period. Over and above these positives, Adcock Ingram is considered and registered as an essential service (i.e. healthcare) and, therefore, all the Group’s operations continue functioning. In fact, given that COVID-19 is a flu, Adcock Ingram has noticed some increased demand in certain parts of the business, especially analgesics, cough and colds, IV fluids and hand sanitizers while their supply chain continues to function, albeit under pressure. This stock may be one of the winners over this period.

Stor-Age Property REIT Ltd (Code: SSS; DY 9.2%): Stor-Age management has indicated that—prior to lockdown—South Africa was trading in line with budget. As Sirius Real Estate noted below, the REIT’s UK operations also experienced an uptick of enquiries before the UK lockdown took effect. Overall, though, the REIT’s balance sheet remains lowly-geared, its client-base unconcentrated and its underlying asset class deeply defensive. Much like preference shares, falling interest rates makes this REIT’s yield more attractive.

Datatec Ltd (Code: DTC; PE 75.3x; DY 3.8%): Datatec recently published an update indicating that trading has been positive, despite COVID-19 existing in all the territories the Group operates. Interestingly, as a distributor and integrator of predominantly networking equipment, the aggressive shift to remote-working should benefit demand for this equipment and we remain positive on the ICT Group and its prospects.

Coronation Fund Managers Ltd (Code: CML; PE 8.6x; DY 11.5%): Asset management is perfectly suited to remote-working while its revenue-generating mechanism (i.e. assets under management, “AUM”) continues to generate fees. Therefore, operationally, Coronation is largely unaffected by the lockdown. That said, the market turmoil and the drop in asset prices have likely shaved a large portion off of Group AUM and, therefore, its revenues and profits. Still, with a liquid and solvent balance sheet and business model with a large proportion of variable costs embedded, Coronation remains a comfortable holding that offers us upside in the case of a “V-shaped” market recovery.

Sabvest Ltd (Code: SVN; PE 3.0x; DY 2.6%): Many of Sabvest’s underlying investments continue to operate as essential services, while others operate either remotely or virtually (e.g. DNI’s airtime distribution). There will be some impact on some of the manufacturing assets, though, but Sabvest has a comfortable balance sheet and is offering liquidity to these underlying businesses. Furthermore, Sabvest held a key shareholder vote that has now approved its restructuring into Sabvest Capital with a single share class. This should aid the share’s liquidity and help unlock the material discount against its NAV that this good-quality HoldCo offers.

Astral Foods Ltd (Code: ARL; PE 11.4x; DY 4.7%): Ungeared and classified as an essential service (i.e. agriculture/food), Astral remains well-positioned to both operate and do so with cheaper inputs costs, a higher price points from firming domestic poultry prices & at a reasonable valuation in the stock market. The recently implemented poultry tariff further bolsters this Group’s topline.

Sirius Real Estate Ltd (Code: SRE; PE 22.8x; DY 4.3%): Sirius’ recent update points to comfortable solvency and liquidity across their balance sheet, a good debt maturity profile and reassuring major leases/tenant profiles. A freeze on meetings rooms and a halving of enquiries will no doubt negatively impact the Group’s coming results. Interestingly, the Group has noted a surge in self-storage demand across its portfolio (self-storage makes up 35% of their portfolio) – See Stor-Age REIT above on this note too.

Master Drilling Group Ltd (Code: MDI; PE 4.5x; DY 3.9%): Master Drilling’s geographically diverse operations offset some of the lockdown risks as it operates in countries without lockdown in effect (yet). That said, COVID-19 is global, and we cannot necessarily assume that it stays that way. Management performs daily stress tests on the Group’s balance sheet, solvency and liquidity. The Group remains comfortably solvent and liquid, but management is also investigating alternatives to bolster this. Overall, though, the Group remains conservatively geared, geographically and commodity diversified and with material ‘blue sky’ in its various projects and the fact that it services an industry (mining) that needs more and more of its services over time (mines are getting deeper).

Advtech Ltd (Code: ADH; PE 8.7x; DY 4.0%): Complying with our Government’s directive, ADvTech has closed its schools and tertiary institutes. Interestingly, over the years the Group has developed a fantastic distance-learning platform. While it has never been very loud about this online platform—we repeated told management that they should be!—it has allowed pupils and students to shift from contact-learnings to distance-learning. This is a competitive advantage as most competitors of smaller size will not have access to such a fantastic platform at short notice. Who knows, they may pick up market share with this? In the Group’s recent results presentation, management stressed that the Group has enough solvency and liquidity while it has suspended all non-essential capex until further notice.

Santova Logistics Ltd (Code: SNV; PE 3.4x; DY 6.2%): While business activity and trade volumes will be negatively affected, the volumes of essential goods will likely rise. Santova’s core platform—TradeNAV—is cloud-based and the Group has seamlessly shifted all its employees in all its offices around the world to remote-working. Many of the Group’s major competitors are struggling in this regard (they run older legacy systems) and, therefore, Santova is particularly excited about aggressively growing its market share over this period by targeting these un/under-services customers and winning them over. We expect them to be successful and expect margins to widen over this period as customers become less price sensitive and the Group’s ability as a Rand Hedge further bolsters upside. In summary, Santova may be one of the winners out of this period in history, yet—far from rallying—its share price has fallen with the rest of the market.

Pan Africa Resources Plc (Code: PAN; PE 7.6x; DY 1.1%): As noted earlier, the market crash saw asset prices correlate in a rush to USD-liquidity. While normally a hedge against downside, gold was no exception this time around. That said, the weakening ZAR offset this and Rand-gold hit new highs. Pan Africa stands to gain from Rand-gold appreciation but the lockdown will severely negatively impact their volumes over this period. The Group has announced key measures to extend some short-term debts and will maintain some volumes from tailings and the BIOX plants at Barberton. Post-lockdown, though, Pan Africa stands to gain massively from a buoyant gold price and a weak ZAR. We remain very bullish on gold in a global recessionary environment where central banks and government have run out of ammo and interest rates are likely to slip increasingly negative.

Hosken Consolidated Investments Ltd (Code: HCI; PE 2.4x; DY 10.2%): Of all our holdings, Hosken Consolidated Investments is the one that worries us the most. Given that its share price has collapsed by two-thirds in March, the market agrees with us. Its key underlyings—Tsogo Gaming and Tsogo Hotels—are at the epicentre of headwinds from the COVID-19 lockdown to the global collapse in the tourism/travel sectors. Both groups also have geared balance sheets. We have looked at the Tsogo family’s solvency and liquidity and think that they should both survive a short- to medium-lockdown. Perhaps more importantly, from an HCI-perspective, the market has written these investments to zero. HCI’s market cap is R2bn while its own portfolio of properties that it has developed and holds on balance sheet has a net value of R2.5bn! If we assume that these properties have followed all asset prices lower by c.-20% over March 2020, then HCI’s market is equal to its own property investments. Ignoring the Tsogo family, HCI also has its PGM, O&G, logistics, coal, media & industrial assets… We are not committing more capital to this investment but consider the share price reaction to be materially overdone.

Wecsoal Holdings Ltd (Code: WSL; PE -6.2x): Thermal coal mining for the supply of Eskom is classified as an essential service as it keeps our lights on. Wescoal will keep operating like normal, despite the pressure its share price has been under. While junior coal mining is risky, in this environment it has counted in Wescoal’s favour. Despite this, we lightened some of this stock into a large buyer in the market and managed to improve the Fund’s overall liquidity with that action.

Clientele Ltd (Code: CLI; PE 9.6x; DY 11.9%): Clientele’s insurance book should see a rise in lapses while its insurance float should feel some downwards pressure (despite being very conservatively positioned into short-term money market & fixed income investments). We were and remain worried about what a long-term lockdown scenario will do the Clientele’s core low-LSM client-base and, thus, lightened this stock into a large buyer in the market materially higher than where it is trading now. Once again, this improved the Fund’s liquidity while taking advantage of a short-term price action.

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Lessons: Mining is (Dam) Complicated

I’ve been invested directly in a growing, junior coal miner for going half a decade, amongst a number of other mining-related investments. Likewise, I’ve followed a wide range of mining companies closely for even longer and previously was invested in a mining exploration company and poked around a whole bunch of these too.

While I am no miner nor commodities specialist, I feel confident enough in the sector to say that I broadly understand it, the eccentricities of various resources, minerals & sub-markets, & the risks and valuation-metrics that matter.

And, after going a decade or more of looking through the sector, I’ve come to the conclusion that it is (dam) complicated.

(Forgive the bad taste in puns, relating to Vale’s tailings dam that tragically burst, creating a massive supply deficit in iron ore that has seen iron ore rallying to dizzying heights. And not a single analyst nor mining executive saw it coming!)

I have previously written a range of articles on some mining stocks that I like:

Hopefully, those articles are of interest in understanding both the individual companies but also how one can look at these sorts of stocks (including the mining-related upstream providers).

My objective here is rather to look at three investment lessons I’ve learnt in this space:

(1) You can be right for the wrong reasons & wrong for the right reasons:

As a fundamental investor, you can do all the research you want about a mining company. Go see the assets, work through the operations and financials, get to understand management and their strategy, and get to grasps with their commodity(ies) market(s).

These are the variables that you can control and will help drive the inputs into your valuation and, ultimately, your investment decision.

And you can still be epically wrong.

Likewise, you can throw darts at a board, hit a couple mining stocks, and turn out being incredibly right.

The world includes a certain degree of what appears to be randomness. Particularly in the commodity markets where there are so many unknown variables that have direct impacts on spot prices and currencies, which in turn then have huge impacts on mining stock share prices.

Likewise, the operations of a mine include a wide range of hard-to-predict but well-known risks that can negatively (or positively) impact operations and a stock’s price.

The obvious “known unknowns” include that the resource body being mined is worse than expected, the mine collapses or labour/mechanical disruption stops/hampers the production or some averse regulatory change negatively impacts on economics. But lesser expected risks include things like this stuff happening to a competitor (as was the case with iron ore miners when Vale’s tailings dam disaster hit), some technological/regulatory/system-change ramping up the demand for their commodity beyond existing demand curves (have a look at current palladium & rhodium prices), & a surprise takeover bid by some egotistical CEO busy empire-building with other peoples money (no names mentioned here).

Due to the vast number of unknowns, the global interconnectedness of commodity markets, the operating (and sometimes financial) leverage of mining companies, all these factors converge into what can be insane volatility of the underlying share.

The point I am making here is that an investor in this sector should have a healthy appreciation for both upside and downside risks, irrespective of how well they have researched something. While I would never advocate not researching a stock before investing, the work is no guarantee of success here.

(2) Sustainable mines do not exist a.k.a. “dividends matter”:

When you have dug up and sold all of a certain mineral resource in the ground, a mine basically has no value. At this point, it just becomes an expensive hole in the ground.

There is no such thing as a sustainable mine.

Too many times I have seen mining companies use the cash flows of a mine to build another mine. Thereafter, they then use those cash flows to build another mine. And so the music keeps playing…

Why would they do this?

Either consciously or subconsciously, the management team is basically “rent-seeking“. The rolling of one mine into another generates limited to no wealth for shareholders, but management often takes a small (or large) percentage of these cash flows as salaries, bonuses and wider remuneration.

Hence, who are they keeping the company operating for?

The logical capital allocation decision would be to run the mine as efficiently as possible and pay nearly all of the free cash flows out as a dividend, but very, very few executives do this.

Now, you need to start with one mine and build/buy another as you build a junior miner into a major. The material drop in your risk profile as you bring more mines on stream (lowering your individual mine risk by creating a diverse portfolio of individual mines under a single holding structure) can add serious value to shareholders if you get it right.

But few do, and rent-seeking looks very, very similar to this strategy…

Let me ask you this: in the last decade, has any single new mining company evolve into a new major globally-diversified miner? All the major global miners were built decades ago when mining laws & regulations barely existed, costs were crazy low and a visionary couple people put the foundations together.

Hence, if a company is not going to becomes a major, globally-diversified mining house (which is unlikely), shareholders need to see dividends. Not just a trickle, but a huge flood of dividends! The reality is that this is probably going to be the major source of their returns, in the absence of one of the majors swooping on them with a takeover bid.

(3) Position sizing is key:

Given the above risks, variables, volatility & the risk of executive rent-seeking behaviour, why invest in this sector at all?

Returns.

A rich, well-positioned mineral resource that is carefully exploited in a conducive environment can generate significant economic value. It doesn’t just have inherent barriers to entry (you either own the resource or you don’t), but it also earns hard currency in a real asset (the USD-priced commodity) and can generate fantastic, annuity-like income with a free embedded option on the commodity it is digging up.

After all the research and risks are taken into account, the final lever that one can pull to manage the potential upside with the risk of the downside is position size.

In other words, make sure you are not overexposed to any one of these stocks, nor in total to this sector. If you do that, you should be fine, irrespective of the randomness of mining.

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Astral Foods: Quality With Converging Positives

As a well-run, ungeared domestic poultry stock, Astral Foods (code: ARL) has two major variables that largely dictate its fortunes:

  • What cost must it pay to raise its chickens?
  • What price can it sell its chicken products at?

Firstly, Astral’s long-term track record is superb, proving the underpin of quality in the business. Over the last two decades, the Group has earned an average Return on Capital (c.25%) or nearly double its Cost of Capital (c.12~13%).

Secondly, South Africa’s receding drought pressures and the anticipation of a healthy 2019/2020 maize harvest should see prices remain accommodative. Likewise, the US-Sino Trade War receding has seen soybean prices loosening somewhat globally. Particularly maize–but to a lesser degree also soybean—forms a key input into feed prices that imply that the cost of raising chickens is falling.

Thirdly, following major supply collapses from swine flu in China to the recent appearance of some avian flu in the EU, global protein prices have been quietly ticking upwards. There also remains the potential for anti-dumping tariff protection in South Africa that would be an added positive for domestic poultry prices.

Logically, if Astral’s input costs are dropping while its sales prices are rising, the Group’s gross margins should be expanding. Combined with the positive operating leverage of its overheads, we expect strong performance from Astral going forward.

All this is matched with a reasonable valuation, an ungeared balance sheet and the Group’s quality track record. And, therefore, we are confident that Astral should make an attractive addition to our portfolio.

END.

Originally posted in the January 2020 Alpha Prime Small & Mid Cap Investor Letter (LINK).

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Lessons: Narrow Doors Make for Tricky Thoroughfare

As a fund manager of a small cap fund, I am keenly aware of liquidity in the stock market. It is not just a constraint but a risk that needs to be managed on both a granular and an aggregate basis. And, sometimes, it can also offer some opportunities…

What is “liquidity”?

It is a simple question, but nuanced in terms of how you view, measure, report and track it.

I view liquidity as the ease, speed and frictional cost with which an investment can be bought or sold. “Ease” refers to the type of investment. For example, listed stocks are easier to sell than unlisted stocks and, hence, are considered more liquid. “Speed” refers to how many willing buyers or willing sellers may exist to be counterparties to any selling or buying of the said investments. You cannot sell something no one wants and you cannot buy what no one wants to sell. And, finally, “frictional costs” refer to how any activity to buy or sell the investment may directly impact on its price, i.e. Price slippage across a wide bidding spread, thin market depth or other such “costs” in buying or selling an investment.

With that definition of liquidity behind us, one of the nuances of the metric is that it is not a constant.

A stock can be liquid one moment and illiquid the very next, or visa versa. An illiquid unlisted stock can be listed and become liquid. An illiquid listed stock can be the target of a takeover bid to take it private (and make it more illiquid) and become, briefly, highly liquid as buyers bid it crazily up. A liquid stock can report some disaster and see buyers disappear as it’s stock’s liquidity evaporates. Indeed, entire markets can get pumped full of liquidity while others can be drained thereof (like what has just happened in the US’s repo market).

I repeat: liquidity is a dynamic metric and not a static one.

If two identical assets exist with differing degrees of liquidity, then the market will typically discount the illiquid asset. Further, because liquidity itself is dynamic, this discount itself is dynamic. Hence, patient investors with patient capital can sometimes acquire great investments at material discounts based almost solely on illiquidity.

(The inverse is also sometimes true: impatient investors with impatient capital can acquire mediocre investments at material premiums based almost solely on liquidity. That is worth thinking about, but it is not the point of this lesson.)

While we probably all know all of the above, it is always good to revisit and remind ourselves about liquidity and its nuances. Specifically, in the case of a small cap stock, what happens when it goes wrong?

In a classic, multi-bagger small cap investment, an investor will invest in a small, fast-growing company whose share price is undervalued due to a combination of investor ignorance and a large liquidity discount. As the small cap grows, year after year, reporting higher and higher profits, the market slowly sits up and takes notice. While the growing profits naturally lift the share price, the market is also willing to pay more and more for these profits and the resulting re-rating of the small cap’s valuation is an important component of return. The combination of higher profits on a higher multiple makes the company’s market cap larger and its share relatively more liquid. In this way, the re-rating of its valuation is not just attributed to growing investor awareness but also slimming (and ultimate removal) of the liquidity discount attaching to the stock.

But–and herein lies the caveat–it all depends on being in the right small cap stock. No growth, no rising market awareness, no re-rating and/or any combination of these things lacking and the ultimate return may be significantly lower.

Even worse, if profits start to slide backwards, the growth story becomes a bankruptcy story and a small stock starts to become even smaller…and even less liquid.

The wide dispersion and fat-tail returns across the small cap market’s stocks make stock selection is so important. When an investor gets a small cap stock pick wrong, it can be incredibly hard to get out. This is even truer at a large, institutional investor level and, hence, why so many large small cap fund portfolios are made up hundreds of small caps (i.e. glorified small cap ETFs), limiting this risk (but also limiting the upside potential).

Partly due to these severely asymmetrical outcomes, I stand by my emphasis on quality in stock selection in this space. Bad companies rarely grow into large companies and, even if not all good companies do, the odds of hitting the above-noted virtuous cycle of growth, re-rating and increasing liquidity are certainly higher in a good-quality sample of small cap stocks.

In closing, liquidity is an important, dynamic variable to track for all investors in all markets and all asset classes. This is particularly true in the small cap space where it can have material effects, either on the upside or downside. I, personally, believe that a focus on quality shifts a (patient) small cap investor’s odds in their favour, almost irrespective of the stock’s liquidity.

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Lessons: Management Over-value Themselves

Per Wikipedia’s definition, “…illusory superiority is a condition of cognitive bias wherein a person overestimates their own qualities and abilities, in relation to the same qualities and abilities of other people.

People tend to think that they are of above-average intelligence while, statistically, at least half are not.

This is an all-too-human cognitive bias that is exhibited in listed companies by management teams that think that they are better, smarter and more valuable than they actually are.

Once again, by definition, half of all listed management teams are below average. Let that sink in.

I am yet to attend a results presentation, have a meeting or conversation with a management team or read a set of results or annual financial statements that do not highlight management as a company’s strength. At best, management does not comment on it and, at worst, management shout from the rooftops about how brilliant they are.

As I said earlier, half of all listed management teams are below average.

What is the harm in what is obviously healthy self-esteem? Well, it can end up being very expensive!

The harm can range, but let me list some of the more common risks of illusory superiority in a listed company’s management team:

Remuneration

The reality is that most listed Boards have “friendly” Remuneration Committees that determine their and management’s remuneration. In environments where the corporate culture either thinks that one or more of the Board/management are amazing, they tend to remunerate accordingly: i.e. generously.

This is merely an anecdotal observation, but arrogant management teams tend to accordingly overpay themselves.

To make matters worse, when shareholders reject rich remuneration schemes or complain, high-paid outside consultants are higher to find ways to justify the numbers. Surprise, surprise…but I am yet to ever see a Board-paid external consultant come to the conclusion that the Board/management that has just paid their fees is itself over-paid!

I’ll say this here and I’ll repeat it ad nauseam below, but the three most expensive letters in the market is: ego.

Risk-taking & Capital Allocation

Management teams that believe they are better than the market can sometimes talk themselves into taking on more risk than the market.

Talk to any professional trader and they will tell you the danger of over-confidence, yet you see this time and time again in the listed space when egotistical Boards take ludicrous risks (with shareholders’ money) with large acquisitions or bringing on major debt or even gigantic share buy-backs (or even rejecting generous take-over offers because they think they are worth more).

This becomes particularly true when management/the Board is not properly aligned with shareholders (Two-edged Blade of an Anchor Shareholder). Not just do they swing for the fences, but they do it with little to no downside to themselves if they are wrong!

Once again, the three most expensive letters in the market is: ego.

Circle of Competence

Finally–and related to the above point of poor capital allocation–over-confident management tends to over-estimate the size of their circle of competence.

In reality, even slightly-below-average management teams are probably quite alright at running their core businesses and, if that was all they stuck to, would do a fine job at delivering beta to shareholders.

It may be the pressures of the growth-hungry listed environment or the dark side of management (bonus/share) incentives, but over-confident management and Boards sometimes make large, dangerous and miscalculated acquisitions into areas that they should not have ventured. More importantly, these acquisitions are made outside of the capital allocators’ circle of competence, in which case they have no real advantage over anybody else here.

Sometimes these acquisitions look to be backward or forward integration, sometimes they are diversifications and–more commonly in South Africa–these look similar to their core businesses but exist in vastly different geographies that the management/Board obviously know little-to-nothing about.

(The moment South African Boards buy a large business abroad, they are probably the buyers of last resort. This is because all the well-connect, in-the-know local investors have already turned that investment down!)

Sometimes these gambles work out, but the odds are stacked against them and most end in tears…

Once again, the three most expensive letters in the market is: ego.

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Why Quality Matters for Small Cap Investors

The below is extracted from the December 2019 Alpha Prime Small & Mid Cap Fund investor letter where I briefly unpack our argument for quality in the small cap space:

  • Quality: Above all else, we try to find good-quality, fast-growing, listed small cap businesses.
  • Value: We invest in the cheapest of these options, constrained by our concentration & diversification parameters.
  • Concentration & Diversification: Finally, we limit the number of stocks we hold to only the very best fifteen to twenty positions & limit our investments to different industries &/or geographies to maximize diversification.

You will note that the reference to ‘quality’ is underlined to emphasise how important it is. In fact, irrespective of valuation and diversification benefits, if we do not think that a business is at least of reasonably good quality, we would not consider it investable and avoid it.

While this may not be true of the large cap space, in the small cap space bad businesses rarely grow into being large businesses. Likewise, bad businesses have a greater chance of failing. Hence, by focussing on quality as a primary attribute, we hope to minimize (it is impossible to entirely eliminate) the risk of business failure while maximising the potential of investing early into a multi-year, multi-bagger as it grows well beyond our universe and into the large cap space (e.g. Capitec, which we held in the ASM Fund’s starting portfolio until it grew into the FTSE/JSE Top 40 Index).

While the ‘size effect’ of small cap equity has been well documented (Fama and French*), what is less known is that the sub-factors driving this return can be further isolated as ‘quality’ and ‘junk’.

In a 2015 paper published by Asness, Frazzini, Israel, Moskowitz and Pedersen**, the researchers found unequivocally that sustainable, non-seasonal, across domestic & international markets and independent of a range of other measures (liquidity, value and momentum) alpha exists in the small cap sub-equity sector when you control for the quality of the underlying business.

I.e. ‘Good’ small caps materially outperform ‘bad’ small caps over long periods of time and across a huge range of international markets.

Specifically, the researchers found the strongest statistical evidence for a quality-measure that tracked profitability (we use Return on Equity, Return on Capital & Gross Margin to measure this), profit growth (we use growth in HEPS or a related to measure this), safety (we use Net Debt:Equity to measure this), and payout (this is more nuanced and we consider this on a stock-by-stock basis).

Once stock selection in the small cap space was controlled for these factors, the small cap alpha did not just become more consistent but, in fact, more than doubled (over their sample period going back to July 1957)!

In a follow-up paper examining the ‘size effect’ published in 2018, Alquist, Israel, & Moskowitz*** found further evidence as to the importance of quality-over-junk in the small cap equity market and reiterated that it might be the key dominant factor in extracting alpha from this portion of the market.

The above may sound theoretical and a bit academic to readers, but we hope that it demonstrates not just the logic of our quality-based small cap investing approach but also that is has been robustly tested and backed up by long-term, statistically-significant evidence.

Our challenge is less philosophical and more practical: in the South African context, where are the best quality small cap stocks? What are reasonable prices to pay for these stocks? How do you construct a sufficiently diversified portfolio out of them? And how do we correctly communicate this to our investors so that they remain in the Fund long enough to benefit from these proven tailwinds (10+ years)?

We will get some of these answers wrong sometimes, but we hope over the long-term to get most of them right and extract attractive alpha out of this unique portion of the market.

The last couple of years has not shaken our view of this and we continue to try to best execute on this objective.

*Fama and French (1996, 2012); **Size Matters, if You Control Your Junk (2015); ***Fact, Fiction, and the Size Effect (2018)

END

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Lessons: Two-edged Blade of an Anchor Shareholder

More than any other directive, human beings act in line with their individual incentives.

In the natural world and bleeding into modern-day addictions to drugs, social media and pornography, human beings are predominantly incentivized by dopamines.

In business, though, human beings are typically incentivized with money. The ability to earn it as salaries, bonuses and–more importantly for owners of stocks–via dividends and capital growth.

The Agency Dilemma of investing, though, is that investors typically do not run (or even materially influence) the companies in which they are invested. Rather, investors have to rely on the management of the company to manage day-to-day and execute on longer-term strategies in order to generate growth, dividends and, ultimately, returns.

Hence, traditional wisdom seeks to align management interests with that of investors via a large shareholder (failing that, some form of share incentive scheme). In theory, this alignment makes management similar to an investor and–following on the theory of incentives noted above–should lead to better outcomes for all investors as management seek to maximise their own gains.

Broadly, I completely agree with the above and think that the absence of skin-in-the-game and the misalignment of interests are crucial red-flags to look out for when analysing a stock as an investment.

That said, the converse is not always true and management being anchor shareholders in their own businesses is not always an indication that it will be a great investment.

Let me unpack two examples (I have decided to exclude company names so this does not get personal):

Company A: Asymmetrical decisions

I sometimes help listed small cap companies unlock their value (call it “free” corporate finance work or “soft” shareholder activism). In this instance, I lined up a large and willing buyer of the entirety of Company A. The buyer was offering nearly a 100% premium to the share price.

Company A was tightly controlled by a director who–along with his consortium–controlled the majority of the votes. As he was an empowered shareholder, the offer was angled to give him shares in a larger group (a share swap) and, thus, carry his empowerment into the larger group. The rest of the shareholders would get a plain cash offer.

This director (and his Board) blocked the transaction for what I believe are two reasons:

  1. Valuation: Despite the offer being nearly double their money, they–as most management teams do–believed their share was worth even more than that!
  2. Script Aversion: The anchor shareholder did not want shares for his investment, but cash.

The first reason has subsequently been proven wrong as the share price has basically halved, and the second reason is asymmetrical as it only affects the anchor shareholder and not minorities (minorities were always getting cash).

Unfortunately, due to both reasons, the value-unlocking deal never saw the light of day and neatly illustrates one of the sharp-edges of an anchor shareholder: asymmetrical decision-making by an anchor shareholder who block an entire deal or vote.

Company B: Businesses still fail but these have less options

Company B’s management team controlled it and, collectively, are the largest shareholders in its stock. They run the business and appear very involved down to a granular level.

Here the lesson is much shorter: sometimes things go wrong.

Company B was hit with macro-tailwinds, legislative tailwinds, a cyclical downturn in its industries/country and it even proceeded to make a bad acquisition or two that blew a reasoanble-sized hole in its balance sheet.

The acquisitions may be self-inflicted, but many of the other negatives were largely out of management’s control, irrespective of how incentivized they were.

And, herein lies the first half of the lesson: while skin-in-the-game is better than the absence of it, it is also far from a guarantee that the business will succeed.

The second half of this lesson is that if a management change is needed to reinvigorate this business and drive its turnaround, well, minorities do not have the voting power to do this while management will undoubtedly never vote against themselves.

Hence, a stalemate in a business where everyone stands to potentially lose out.

Conclusion: Skin-in-the-Game is better than nothing, but it is no guarantee

While I still firmly believe that the best alignment of interest for a management team is a large portion of their personal wealth invested directly into the same share-class as me, the outside investor, I now have a more nuanced view of this detail.

Beware ego’s and be cautious of Boards that predominantly serve the anchor shareholder at the expense of minorities. Also, skin-in-the-game may be a great incentive, but a management team also needs to have the ability to influence outcomes for it to matter.

And, despite all of this, things may still not work out.

Any day of the week, I would rather have aligned-interests with management, but beware the two-edged blade that can be a large anchor shareholder.

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Lessons: Over-reliance on Management

The last couple of years have been very hard on those that invest in South African small cap stocks. Unfortunately, me, the Alpha Prime Small & Mid Cap Fund and my (incredibly resilient) investors have been no exception to this.

Since the FTSE/JSE Small Cap Index’s high in 2017, the index has dropped by a third (-30%!) to the current intra-day spot price on the date of my writing this. From a valuation perspective, this index’s relative valuation peaked in around 2014 and it has been steadily de-rating since then (only hidden by profit growth for the first couple years that eventually dissipated and saw actual price downside thereafter) to such a point that it is the cheapest equity index in the world right now (Cheapest Equity Index in the World).

This drop is even more brutal when considered against the Top 40’s more resilient performance and the roaring double-digit annual gains across most global, developed markets!

Normally, when taking carefully considered, multi-year risk, you should be rewarded for it, but across the last three to five years in our domestic small cap market, the opposite has been true.

That is the context, but I am not going to blame “the market”. Rather, I am starting a series of long-form essays to try and explore and–more importantly–learn from the investing mistakes that I may have made over the last couple of years. While most professionals will not admit to this, we are all always just students in the market and we need to constantly be learning and improving.

Hopefully, this series will be of value to you too.

Over-reliance on Management: Explanations versus Facts

Typically, professionals in the market have good access to management of listed companies. This allows them to not just pose questions and glean a better understanding of both the business(es) and the current environment, but also to get a sense of management themselves, their competence, drive and direction.

Sometimes this can be an invaluable edge, but other times this can actually distort judgement via persuasion and personality bias. After all, management often has an incentive to put their and their company’s best foot forward and typically will have an overly-optimistic view of the quality of their business, their own brilliance at managing it and the valuation their stock should demand in the market.

Do not forget: much like pessimism, optimism is also a cognitive bias. Investors should strive to be neither, aiming rather for realism as a true, thorough and honest view of the world.

South Africa’s market has been rocked by a number of (let’s be honest) management-led scandals. From Steinhoff (SNH) to Tongaat Hulett (TON), these management teams were either clueless or actively deceptive in their communications with the market.

Perhaps as a reaction to this, a growing number of investors I regularly speak to tell me that they are stopping talking to management at all. Full stop. This will completely remove the risk that management lies to their faces, but it will not remove the risk that management has lied via their accounting and reporting… Likewise, it will leave blank spots in their understanding of businesses that may translate in incorrectly weighting valuations and judgement of risks and prospects.

I propose that a better approach is to openly and readily engage with management. Ask them all and every question on your mind and let them fill in any blanks or drive any narrative that they want.

But–and this is the key–do not simply believe it. Look for direct and third-party evidence that any assertions made by management are correct and likely honest. Work through the Group’s financial results and see if the numbers agree with management narrative. Look at customer reviews, track down suppliers and even speak to competitors to get a sense of what may be going on. If the business is a retail-facing one, then pop your head in and see if the shops, hotels, restaurants, banks, etc are full and/or busy. Even talk to the secretaries and ask them if this is true of most days or not. This is amongst a range of other sources of information.

As an example, I have done a fair bit of verification on Santova Logistics (SNV). I have spoken to a large range other logistics players, even unlisted direct competitors and it has always been very reassuring that even the direct competitors consider Santova a good business in their space. Likewise, in these self-same conversations and each time I am on a logistics or fleet site visit, I always ask about the fleet tracking provider they use and why? The telematics providers may differ between fleets, but the answers are consistent: the telematics companies and their products are all the same. Price is all that matters. This is in direct contrast to each telematics management team you meet who have long and complex reasons for why their product is the best…

Another example I could use is Ascendis Health (ASC). Despite a glowing narrative from the management years ago, a deep and thorough unpacking of their financials painted a very bleak picture. As usual, the facts outlasted the narrative and Ascendis Health is currently basically a zombie stock.

Finally, where management explanations and narrative diverge from the evidence and facts, trust the evidence and facts more.

There is a Russian proverb that says it best and translates as, “Trust but verify.

Over-reliance on Management: Promises versus Execution

Another challenge that comes with close encounters with management is that sometimes–despite their best efforts–they still fail. This is the gap between promises and execution, and this gap can be very wide indeed.

Business is difficult and sometimes things go wrong. Sometimes these things that go wrong are external in nature (natural disasters, industry/country/legislative changes, fires, unionized labour unrest, etc.), but sometimes they are internal in nature and could have been avoided by better management execution.

While a really good (and lucky) management team may actually see external problems before they happen and build solutions to handle them in advance, most likely this will not be the case. In fact, these external risks are really in the realm of the investor to see, call and position themselves for or against.

For example, is it really a PGM mining management team’s fault if all cars went electronic tomorrow and the PGM basket basically became worthless? No. Their job is mine PGM’s as cheaply and risklessly as possible. It is really the investor’s job to decide whether they invest in a PGM miner or not.

Therefore, I tend to be a bit lenient on management regarding external problems. I may be harsh on myself for these, but that is another story…

That said, internal problems are something else: avoidable by management.

I, as an investor, cannot ensure acquisitions are cleverly made, well-integrated and the businesses are properly managed, amongst countless other internal matters that are predominantly related to either day-to-day operations or high-level capital allocation. These things are very, very firmly in the realm of management.

Firstly, I really try to find businesses that do not overly-rely on management execution to work. In reality, every business relies on their management, but not always to the same degree. Consider, for example, ADvTech (ADH) that has a profitable, thriving educational group with good cash flows, good profits and pretty full schools and campuses, while Stadio (SDO) has a long list of promises and plans that management are executing on.

While ADvTech’s management have (some) room for error (although I would still hope they execute well!), if Stadio’s management fail in their execution, their shareholders will hardly have a business worth mentioning. Second-hand promises tend not to retail for much.

Secondly, when management fail, I try to do two things:

  1. Understand why they failed,
  2. Judge if they have learned from or adapted to it.

Thus, if (1) and (2) are not positive, I would consider the quality of the investment degraded and consider exiting. While success may breed success, failure tends to do the same. If the same execution has fallen short and management are not at least honest about how they messed up, then how are they going to fix it? And, even if they are honest about the mess up, if they just keep doing the same thing then surely they should get the same result as before?

Conclusion: Trust but Verify, Listen but Watch Closely

At the heart of small cap investing is backing a great management team in a great business at a great valuation and ages before anyone else realizes this. Herein lie the majority of double-digit-multi-baggers.

But, despite temptation and persuasion, management cannot be taken at face value. Be sceptical when management narrative and facts diverge. Be careful when management promises do not materialize. And, finally, do your own research and form your own opinion, whether or not it agrees with management.

After all, they are only human.

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Santova: Global But With a Domestic Rating…

Santova Logistics (SNV) has been a core holding in the ASM Fund since its inception due to its unique, capital-lite business model with global reach and the potential for a compounding network effect across its operations.

In brief, Santova offers a fourth-party logistics (“4PL”) solution for clients. The Group’s system—TradeNAV—embeds itself into client operations and allows it to aggregate logistical requirements, bulk-buy from existing logistics players, manage and track &, ultimately, report on the flow of inbound and outbound goods globally. Around this core, the Group is steadily building out its offering, including clearing, forwarding, buying, insurance & a range of other value-added services.

In summary, Santova’s logistical technology-orientated BPO offering has the following benefits:

  1. Capital-lite: Santova uses other logistics providers’ fixed assets (e.g. ships, trucks, warehouses, etc.). While this gives away some margin, it also means that Santova does not need to spend the capex or finance costs for the assets nor need to worry about downtime and filling capacity in slow periods. While the trade-off is a smaller gross margin, it potentially comes with less risk and greater cash flows (as free cash flows are not consumed by endless fleet and fixed asset requirements).
  2. Returns to Scale: As Santova gets bigger with more clients and more volumes, it can negotiate lower rates from the logistics providers due to having access to higher volumes. The ability to aggregate volumes from clients together means that Santova can not only get better logistics prices for its clients than they could for themselves but that Santova can even take more margin for itself, improving its own profitability while lowering client costs.
  3. Scalable: The core system of Santova is largely automated and, thus, with little to no capex requirements, the Group can keep adding more and more clients, and more and more volumes that all start to drop to the bottom-line. This works in harmony with the Returns to Scale noted above.
  4. Network effect: Beyond the benefits of and ability to scale, Santova also has several “network effects”. For example, as the Group gains more clients in more jurisdictions, it can start to offer platform advantages to all its clients. There are some future initiatives that should make this clear but already Santova can source products from its existing client base for its clients in other jurisdictions. The above noted buying power is another network effect.
  5. Diversified: At last disclosure, Santova did not just have almost 5,000 different clients, but the top ten clients only accounted for 11.39% of its revenue! For the purposes of the point we make below, it is more important to note that in Santova’s latest set of results a whopping 87.1% of profits came from outside of South Africa!

On Point (5), for years Santova has been diversifying offshore by building new trade routes, opening new markets and signing new clients. Some of these have been acquisitive and some have been organic, but over time, they have become the weight of the Group’s earnings (Figure 1).

In fact, we would argue that Santova should no longer be viewed as a South African group. If anything, it is now effectively a small but global 4PL logistics player.

Yet if we compare SNV’s market valuation to its larger, global peers, it is vastly out of sync with their valuations (Figure 2).

Why?

The only conclusion we can arrive at that market inefficiency is still pricing Santova shares as if they were a South African small cap logistics provider. While it is certainly a small cap, we strongly disagree with the lowly ‘SA Inc’ rating and think that the stock should be valued closer to the peer-group average Price Earnings (PE) of c.18x. This would imply material upside from the lowly 4.7x PE that share is currently trading at.

Originally appearing in the Alpha Prime Small & Mid Cap investor letter for November 2019.

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Metrofile – Potential 3rd-Party Offer

Below is an extract from the Alpha Prime Small & Mid Cap Fund’s investor letter, published 4 November 2019:

“In September Metrofile issued a cautionary over itself as it was engaging in discussions with a third-party for the potential acquisition and delisting of the entire share capital of the Group. This cautionary is still in effect at the date of writing this.

Despite a wobble and an own-goal in recent years, Metrofile is a high-quality, document storage business with strong cash flows and offers a dominant position in the South African market to any acquiror.

Assuming this takeover happens, what price could we expect?

Iron Mountain Inc. is the world’s largest document storage business, and, despite some differences, it does give us a good yardstick to measure the potential value embedded in Metrofile.

Iron Mountain’s Enterprise Value-to-EBITDA (‘EV/EBITDA’) is currently 11.2x and its 10-year historical average EV/EBITDA is 11.7x. Metrofile should attract a reasonable discount to this as it is smaller and sitting in an Emerging Market (ironically, sometimes EM asset attract premiums due to better growth potential!). That said, if we assume a nearly 30% discount to Iron Mountain’s EV/EBITDA, we arrive at reasonable EV/EBITDA of 8.0x for Metrofile.

Using Metrofile’s last reported EBITDA of R271m and multiplying it by 8.0x, we arrive at an Enterprise Value of R2.2bn. If we then chop out the Group’s last reported Net Debt of R558m, we arrive at an equity fair value for Metrofile of R1.58bn.

Importantly, this translates into a fair value for Metrofile of c.350cps (but it has also not assumed any EBITDA growth in the period nor any control premium; both are theoretically plausible).

Given that the MFL share is currently trading at 210cps, we are comfortable holding this stock. Not just is it cheaply valued but this corporate action may unlock material upside relatively quickly for us.

The only thing we prefer to generating a good return is doing so quickly.”

END.

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