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15 Dec 2021

Small and mid caps — big opportunities

The small and mid-capitalisation sectors have been happy hunting grounds for Foord’s investment team over the decades. Portfolio manager MIKE TOWNSHEND explores the risks of investing in these less familiar stocks.

Firstly, investing in small-cap stocks can be a time consuming, but rewarding, endeavour. Stockbroker and other paid-for research on these companies is usually quite limited. The investment analysts must therefore do most of the fundamental analysis and research themselves.

Secondly, small-cap stocks are less liquid than their larger counterparts. Buyers need time to acquire the requisite quantity of shares, given the low trading volumes. This makes it difficult for large funds to buy enough shares for the investment to have a meaningful impact on returns. If economic conditions change or the company’s prospects worsen, it is also more difficult to sell the shares at a favourable price.

Another criticism is the assumption of weaker management teams or market position—meaning they are unable to compete with large, established competitors. Share prices of these companies can be slow to respond to changing economic fundamentals, which can frustrate shorter term investors.

I believe these weaknesses play to Foord’s strengths. Our investment approach is to invest in quality companies with long-term growth prospects that are superior to others available in the market. If a competent executive team translates these prospects into sustainable cash-backed earnings, we will hold our investment for very long periods. This could extend beyond a decade and often has done so. Liquidity risk significantly diminishes as we extend our holding period—if we continue to like the prospects of a company, why should we ever sell?

Foord’s total assets under management are a multiple less than the behemoths in the asset management industry. This means we can invest meaningful amounts in companies too small for giant fund managers to even consider.

Our analysts relish the challenge of ferreting out overlooked companies, based on our own in-depth, propriety research. Evaluating management teams is a core aspect of investment decision making. Many smaller companies have highly motivated and competent management teams, often with a significant equity stake in their companies. We like this natural alignment of interests. Wide-ranging discussions with these management teams also offer industry insights that benefit our decisions on larger companies.

Small companies by their very nature enjoy better room for growth. They are also able to exploit lucrative niches too small to have a meaningful impact on larger peers. Both points make them attractive options for long-term investors.

The Foord Equity Fund has 17% of the fund invested in small-cap companies (market caps below R20 billion) and 15% in mid caps (market caps up to R50 billion). This compares to a 3% and 8% weight respectively in the JSE’s Capped All Share Index. Shares such as Metair, Omnia, Invicta, Italtile and Massmart are examples that have contributed significantly to the strong performance of the fund this year.

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