The below is extracted from the December 2019 Alpha Prime Small & Mid Cap Fund investor letter where I briefly unpack our argument for quality in the small cap space:
- Quality: Above all else, we try to find good-quality, fast-growing, listed small cap businesses.
- Value: We invest in the cheapest of these options, constrained by our concentration & diversification parameters.
- Concentration & Diversification: Finally, we limit the number of stocks we hold to only the very best fifteen to twenty positions & limit our investments to different industries &/or geographies to maximize diversification.
You will note that the reference to ‘quality’ is underlined to emphasise how important it is. In fact, irrespective of valuation and diversification benefits, if we do not think that a business is at least of reasonably good quality, we would not consider it investable and avoid it.
While this may not be true of the large cap space, in the small cap space bad businesses rarely grow into being large businesses. Likewise, bad businesses have a greater chance of failing. Hence, by focussing on quality as a primary attribute, we hope to minimize (it is impossible to entirely eliminate) the risk of business failure while maximising the potential of investing early into a multi-year, multi-bagger as it grows well beyond our universe and into the large cap space (e.g. Capitec, which we held in the ASM Fund’s starting portfolio until it grew into the FTSE/JSE Top 40 Index).
While the ‘size effect’ of small cap equity has been well documented (Fama and French*), what is less known is that the sub-factors driving this return can be further isolated as ‘quality’ and ‘junk’.
In a 2015 paper published by Asness, Frazzini, Israel, Moskowitz and Pedersen**, the researchers found unequivocally that sustainable, non-seasonal, across domestic & international markets and independent of a range of other measures (liquidity, value and momentum) alpha exists in the small cap sub-equity sector when you control for the quality of the underlying business.
I.e. ‘Good’ small caps materially outperform ‘bad’ small caps over long periods of time and across a huge range of international markets.
Specifically, the researchers found the strongest statistical evidence for a quality-measure that tracked profitability (we use Return on Equity, Return on Capital & Gross Margin to measure this), profit growth (we use growth in HEPS or a related to measure this), safety (we use Net Debt:Equity to measure this), and payout (this is more nuanced and we consider this on a stock-by-stock basis).
Once stock selection in the small cap space was controlled for these factors, the small cap alpha did not just become more consistent but, in fact, more than doubled (over their sample period going back to July 1957)!
In a follow-up paper examining the ‘size effect’ published in 2018, Alquist, Israel, & Moskowitz*** found further evidence as to the importance of quality-over-junk in the small cap equity market and reiterated that it might be the key dominant factor in extracting alpha from this portion of the market.
The above may sound theoretical and a bit academic to readers, but we hope that it demonstrates not just the logic of our quality-based small cap investing approach but also that is has been robustly tested and backed up by long-term, statistically-significant evidence.
Our challenge is less philosophical and more practical: in the South African context, where are the best quality small cap stocks? What are reasonable prices to pay for these stocks? How do you construct a sufficiently diversified portfolio out of them? And how do we correctly communicate this to our investors so that they remain in the Fund long enough to benefit from these proven tailwinds (10+ years)?
We will get some of these answers wrong sometimes, but we hope over the long-term to get most of them right and extract attractive alpha out of this unique portion of the market.
The last couple of years has not shaken our view of this and we continue to try to best execute on this objective.
*Fama and French (1996, 2012); **Size Matters, if You Control Your Junk (2015); ***Fact, Fiction, and the Size Effect (2018)