In SA equity markets, size matter

The South African listed equity universe is a relatively small investment environment, constituting lessthan 1% of total global equity markets. The FTSE JSE ALSI comprises around 163 listed shares spread across the large (Top40), mid and small market capitalization categories of the index. Withinthis narrow universe, there are several small- and mid-cap shares that trade infrequently and in small volumes. This makes it difficult to buy into and sell out of positions within portfolios. The result of thislow liquidity is that a large investor can push up the price of a stock by trying to hastily fill a position. Alternatively, it may not be possible to find a seller or a buyer to trade with, missing the opportunity totrade on investment idea.

The reality for asset management firms is that as ones equity assets under management grow, the breadth of the investment universe to select South African shares from reduces. As an asset manager’s equity portfolio grows in size, a material position of between 2% and 10% of the fund means purchasing a greater percentage of a company’s outstanding stock. For larger managers, higher demand faces the headwinds of lack of supply, higher number of days to trade and ownership limits within a company. Ownership limits may be imposed internally by the asset manager to avoid legal ownership obligations. An example of this is implementing a limit below the 35% ownership threshold which triggers a mandatory requirement for the asset manager to make an offer to minority shareholders to buy out their shares.

In certain cases, investment managers have an equity “House View” which flows through the equity component of their various portfolios. Although position sizing may differ, the respective portfolios should be traded with a fair allocation to the stock, thus increasing the overall order size. There are several asset managers in the South African arena who have grown to the point that their investment universe has shrunk to within the Top40 shares or less. Holding stocks beyond the Top40may have little impact on their performance due to the small position sizing in a large portfolio. The chart below illustrates the 1-year rolling performance of four of the larger, well established funds in the ASISA South African General Equity universe. The black dots referenced off the right-hand axis, illustrate the combined assets under management (AUM) of these four equity funds over time.

                                             

Source: Morningstar, 1 October 1998 – 31 July 2019.


A few notable features can be inferred from the chart above.

         
• The funds generated most of their significant alpha in their early years when their combined assets were smaller.
       
• Alpha generation has had a negative correlation to AUM growth over time.
       
• As the funds grew, they behaved more like the index, shown by the low alpha generation in later years.
       
• At a certain point in 2015, appetite for these funds became saturated and through a combination of performance and flows the combined AUM growth tapered off.

Over the past year to 2 September 2019, 66% of the mid- and small-cap stocks within the ALSI have underperformed the index with most of these deriving their earnings from the beleaguered South African economy. In this case, the larger managers have been protected from these under performing stocks due to their inability to invest in them. One would expect that their returns should have received a relative tailwind when compared to the ALSI, however as can be seen from the chart, their alpha generation has been muted. In an environment where more of the mid- and small-cap companies perform, boutiques may have the upper hand.

Many allocators and investors in South African have tended to cornerstone their portfolios to at least one and in some case many of these larger funds. We would argue that as an investor in the narrow South African investment universe, one should seek out managers who are able to invest in the broader South African universe efficiently, implementing their best ideas in high conviction positions. The structural headwinds faced by the larger funds will persist until such a time as they become relatively smaller, one way or another.

South Africa is currently spoilt for choice with the next generation of skilled established boutique asset managers coming to the forefront. When the new dawn eventually raises its head above the horizon and markets rebound, boutiques like Laurium Capital will be nimbler and more capable of positioning themselves in the mid and smaller listed SA companies which are currently sitting on multi-year low multiples.

Mike Titley

Laurium Capital