(Sharenet)
  • South African shares have seen large losses in recent months.
  • Small and mid-sized companies are now trading at among the cheapest levels in the world.
  • Two investment experts pick their favourites among these shares.

South African shares are now down 38% from their best levels in the past year – the worst performance in the world, according to the US investment advisory firm Pension Partner: 
(Pension Partners)

Companies that mainly make their money in South Africa (as opposed to those who sell most of their products abroad) have been hit particularly hard.

Banks like Standard Bank and Nedbank, and retailers like Shoprite and Pick n Pay, are down almost 30% since April. According to historic valuations, they are starting to look cheap.

But not as cheap as South African small and mid-sized companies – which are, in fact, among the cheapest shares in the world.

Keith McLachlan, a small and mid-cap specialist fund manager at AlphaWealth, compared the share prices of these South Africa companies to their book value, the amount left over if a company sold all of its assets and paid down its debts.

On average, South African small companies are now trading at almost exactly their book value.

Historically, these shares were almost always rated much higher than their book value, McLachlan says.

And across the world, large and small shares are currently trading at even higher multiples of their book value than in the past.

In a report entitled “Once-in-a-crisis opportunity", McLachlan details how far behind South African smaller shares have fallen compared to shares around the world, leading to “quite an insane valuation differential at any point in time for any country or market that is not in civil war (SA is not), turmoil (SA is not) or massive, protracted recession (SA is not)”. 

“The returns generated from investing at these low valuations could potentially set people up for life. Just ask those people who  bought during the trough of the Credit Crisis a decade ago.”

McLachlan says that South African small caps are currently the cheapest shares in the world (apart from some equities in Italy, "that are cheap for a very good reason"):

The average price-to-book values of global market indices.

Medium-sized companies are also among the four cheapest sectors in the world.

McLachlan expects profitability of small and mid-sized companies to recover over the next three years thanks to an improving South African economy, and highlights the following

  • South Africa’s recession was caused by the Western Cape drought, which is now over.
  • South Africa’s economy has a very close correlation to spending by state-owned entities, particularly Eskom and Transnet. “These SOEs are currently under intense internal changes, audits of supply chains and the like that, in the long-term, will make them far better, sustainable organisations. In the short term, the freezing of activity here has further slowed our economy. In the long term, though, we need these changes to happen and when the SOE spending comes back, SA Inc will bounce.”
  • Telecommunication costs should decline significantly as radio frequencies are sold off for 4G services and a new wholesale open-access network (Woan), which will sell connectivity to service providers, is established. “The multiplier effect of lower communication costs on our economy is massive.”

McLachlan also says the “balanced” Mining Charter and the impact of changes to visa regulations on tourism should boost economic growth.

“Right now, it feels like the bottom in every respect,” he added. “Our local small cap market’s valuations offer a great opportunity for allocation right now. Never waste a good crisis”

Investing in smaller shares

“When you invest in small caps you want to do it in a smart and diversified way by screening all the junky ones out and focus on quality and maybe other factors like shareholder yield and free cash flow," says Bright Khumalo, portfolio manager at Vestact Asset Management. 

“You diversify these with your mid-cap portfolio and your large-cap portfolio. A small cap-only portfolio is a sure way to induce a heart attack.”

He favours companies with good management teams. Khumalo likes Stadio, AdaptIT, Afrocentric, AdvTech, and Transaction Capital. 

Piet Viljoen, executive chairperson of RECM, has a long list of smaller companies that he thinks offer value, including

  • Mining companies Afrimat and Merafe
  • Packaging company Bowler Metcalf
  • Financial services and investment firms Clientele and Sabvest
  • Tech and telecom companies Datatec, Reunert, Blue Label, and Mustek
  • Automotive firms Hudaco and Metair
  • Property developers Balwin Properties and Calgro
  • Bell Equipment
  • eMedia, the owner of eTV
  • Construction group Stefanutti
  • York Timber
  • Consolidated Infrastructure Group
  • Lewis

"The important point to remember is that any one (or even more) of these companies might even go under," says Viljoen. "You just don’t know which one."

"So a sensible strategy would be to buy a diversified basket of the equities of reasonably uncorrelated businesses.

"And then to leave them alone and resist the temptation to trade them. Over time, the winners should outweigh the losers by a large margin."

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