The South African small-cap market is stimulating a significant amount of debate with a number of shares looking “cheap” but liquidity constraints and a tough operating environment impacting the attractiveness of the sector. Asset management firm Westbrooke have released some new research into the sector:
By Jarred Winer, co-founder Westbrooke Alternative Asset Management and fund manager of the Westbrooke Special Opportunities Fund
Many in investments are discussing the undervaluation of the small-mid cap sector. Westbrooke Alternative Asset Management undertook extensive research recently to establish the extent of the undervaluation as well as the prospects for the sector’s recovery.
The research universe comprised companies between R100-million and R10-billion market cap. This provided 130 companies including 97 operating companies, 10 investment holding companies and 23 real estate companies.
Our research showed that all are trading at a discount relative to historical valuations, but those operating companies with a market cap below R2 billion and investment holding companies really stood out presenting a compelling, deeply discounted investment opportunity.
Despite valuation in the sector being under pressure since 2014, the operating companies below R2 billion market cap price to earnings multiple has de-rated by 10% to 7.9x since March 2017 and are trading at a 22% discount to their five-year average of 10.1x. Measured on an EV/EBITDA basis, these companies have de-rated significantly with an 11% derating to a multiple of 4.4x since March 2017 and are currently valued at a 16% discount to their five year average.
As a comparison, Westbrooke looked at the valuations of corporate and private equity M&A transactions. These have been at a significant premium to current listed valuations with transactions of a similar size being at EV/EBITDA multiples of around 6-8x.
Investment holding companies
The research included analysis of historical valuation metrics of ten South African investment holding companies. The research universe is currently trading at a 33% discount to intrinsic NAV while the four-year average to March 2017 was a discount of 16%. The universe traded at a premium to intrinsic NAV during 2014 – 2016.
To compare, the Thompson Reuters Datastream, World Investment Companies Index comprises 26 international investment holding companies currently trade at a 14% premium to NAV while its four-year average discount to NAV was 14%.
Westbrooke Alternative Asset Management believes that the discount of South African investment holding companies to intrinsic NAV will narrow to levels closer to historic norms as these companies generate attractive returns on capital or through an increase in corporate activity.
We unpacked the key risks to the small-mid cap sector, which has less liquidity and share price volatility. South African economic growth may take longer than expected to recover and there is political uncertainty related to the upcoming election. In addition, we may face capital outflows from emerging markets as the Fed continues to hike interest rates.
We concluded that the small-mid cap universe currently presents an attractive investment opportunity over the medium term particularly those operating companies with a market capitalisation below R2-billion. The potential for an increase in earnings across small-mid cap operating companies is strong with significant operational leverage driven by revenue growth and a reduction in operational expenses over the last few years. These companies have significant balance sheet capacity for corporate activity and corporates also have significant cash on hand to resume capital expenditure and acquisition activity. Small-mid cap investment holding companies are also trading at discounts far beyond historic norms and much higher than comparative valuations internationally. That discount is therefore likely to narrow.
We intend to act on this information to the benefit of the Westbrooke Special Opportunities Hedge Fund which is focused on special opportunities in South African small-mid cap listed companies. Our approach is closely aligned to private equity, where we follow a fundamental research driven valuation approach and utilise our strong networks, principal investing and investment banking expertise to enhance the value of the companies in which we invest.
The summarised research can be viewed here: www.westbrooke.co.za/wsoresearch