Small-cap equity a playground for boutiques
Iain Power, portfolio manager and shareholder at Truffle Asset Management.
The ability to generate alpha (returns in excess of the market) is a function of many factors, not least of which is the requirement to construct a portfolio that differs from the index. To generate alpha, a portfolio must contain active positions, away from the index, in shares, which together deliver index-beating returns. Logically, as one would expect, the bigger the portfolio’s active positions, the bigger the alpha potential of the portfolio compared with the index.
The investable universe for any investment manager comprises those shares that can be meaningfully represented across their portfolios. This means the bigger an investment manager grows in terms of assets under management, the more its investable universe shrinks. Many shares just become too illiquid and small in terms of their market capitalisation to make a difference to the overall portfolio returns. In comparison, a boutique investment manager with a smaller asset base has a much bigger investable universe. This translates into more potential opportunities to construct a portfolio, which is different from the index, i.e. contains numerous independent active positions. This means the vast majority of small- and mid-capitalisation companies listed on the JSE are simply not investable for many of South Africa’s large investment managers.
By way of example, Sephaku Holdings is a small-cap company listed on the JSE with a market capitalisation of R1.4 billion. Truffle, on behalf of its clients, owns about 9.3% of the issued shares in Sephaku Holdings. This represents an investment of R130 million and equates to about 1.6% of all Truffle’s investments. From a valuation perspective, the share is attractively priced at 720 cents per share (cps) as the company’s analysis suggests an intrinsic value closer to 1 100 cps. This means there is potential for more than 50% upside in the share from current levels.
Let us suppose a large manager with R100 billion of assets under management wanted to replicate Truffle’s position in its portfolios, the manager would need to buy R1.6 billion worth of shares, which is greater than the entire market cap of the company. Truffle’s R130 million investment on an asset base of R100 billion would equate to 0.13% of its portfolio, which, if it appreciates by 50%, as Truffle expects, would only add 0.07% of return versus the 0.80% for Truffle’s clients. One should, however, bear in mind that investing in many of these smaller businesses could significantly increase the risk profile of the portfolio. It is therefore critical that these investments are made in the context of their effect on the total portfolio’s risk profile.
While larger investment managers are not precluded from making an investment into the likes of Sephaku Holdings or many other small- and mid-capitalisation companies, the reality is that even when they do, the investments are so small in the context of their total asset base that they become irrelevant in terms of their effect on their total portfolio’s return.
Size in the majority of industries is beneficial, as it brings with it certain economies of scale. However, in the investment management industry, increasing asset size is a significant obstacle in the pursuit of generating long-term index-beating returns. Quality boutique investment managers with experienced people, a rigorous process and sound philosophy should over time deliver better returns than the large and mega investment managers, because of the advantages of their size. Finally, let us not forget that today, some of the highly regarded large and mega investment managers started out as small boutique investment managers more than three decades ago.
