After quite an intense "reporting season" research month of March, the four best small cap punts have been released in a package available for purchase here! 

Contrary to all the critics (and perhaps that's actually why they offer so much value), three of the four small caps is actually from the AltX bourse.

Buy the research and see for yourself.

Kind regards,
Keith McLachlan

The growth rate of the small half of the JSE from mid caps down to the small caps tends to be higher than that of the Blue Chips.  One of the reasons is that these companies still have a lot of room for growth.  For example, look at SABMiller PLC (SAB), which has been a phenonomally successful business and grown to a global scale.  The problem is SAB's size: once you're selling booze to the entire world, where else can you sell it?  The moon?

So, if there is all this growth potential in the smaller side of the market, why don't more people invest in it?

One of the major reasons for this under-investment is the lack of liquidity.  Its hard to get in quickly in any sizeable amount and--heaven forebid there's a crash--its hard to get out quickly.

Adding to this lack of liquidity is the higher asset specific risk.  Put differently, the chances that a mid or small caps will go bang are a lot higher than that of a company the size of SAB going belly up.  In order to counter this asset specific risk, a good diversification strategy is necessary.

This said, the lack of liquidity makes the act of diversifying that more challenging as the underlying trading volumes aren't there.  Thus the more positions you take, the harder it is to take them and the harder it is to exit them.

Both of these points is ironically exactly why there is no Mid Cap Exchange Traded Fund's ("ETF") on the market and why there is actually a need for one and there would be a demand for it too.

Buying an ETF that tracks the top mid cap companies on the JSE Mid Cap index would allow you the ability to diversify your exposure with a single purchase in a liquid investment.  Bang!  Both liquidity and asset risk problems solved, while retaining exposure to the underlying growth potential of this market segment.

The problem is how to construct the ETF given this mid cap market's problems....  Here is what I've come up with:

Index to use: "Mid Cap Index" - allows for alpha while have more stable market caps and greater individual share liquidity and small bid/offer spreads (the latter two points being important for when the ETF re-aligns).

Share Positions in Index to Track: The current Mid Cap Index contains 61 individual shares and, at any given point, holds either businesses growing upwards into (eventually) a Blue Chip or businesses that once were Blue Chip size and are waning.  In other words the index holds shares rising through the index to stardom and shares dropping through the index to oblivion.  In order to protect against buying the shares that are dropping, but gaining mechanical exposure to the more liquid mid caps, I suggest the following transparent selection criteria for shares - take an equal weighting in the top 20 "three year market cap weighted" market caps on the index.

The last point has probably confused you, so allow me to elaborate:

 If the Mid Cap Index contained the following:

In this case, "Co B" would get the highest rating as it's market cap multiplied by its rising share price reveals a mid cap that is out growiing the rest.  In this way the Mid Cap ETF is protected from "Co C" that is fairly obviously a struggling (and probably heading for failure) Blue Chip with a large historical market cap.

The 3 year share price horizon could well be 1 or 2 year too, but I like three year as it strips out a bit of the year-on-year volatility that is inherent in the stock market.  This 3 year return could well also be averaged too or, in fact be the 3 year average growth rate in revenue or some other measure indicating momentum of the business...  For the purposes of this article the detail is not important, but the principle of avoiding shrinking businesses while gaining exposure to rising ones is important to understand.

In closing there is also a secret little advantage to this Mid Cap ETF: it will bring much needed liquidity to the Mid Cap market (and perhaps even trickle it down to the smaller caps).  As the ETF realigns yearly, half-yearly or quarterly, the Fund will be producing liquidity in the underlying shares that can only benefit the market.

Just a thought, but one that I think with a bit of tweaking could well produce a valuable product.