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Global Report
Good things come in small packages.
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Local Report
Investment case for South African assets.
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Global Report: Good things come in small packages
By Nick Downing
As the proverb goes, “All good things come in small packages”. This is relevant to investing. Small-cap shares, although more volatile than the large caps, provide the best returns over time. This makes sense, given that they start from a lower base, but they are also relatively under-researched and so are more often under-valued. Attention today is predominantly focused on US mega-cap technology stocks, the so-called Magnificent-7, yet even they started life as small-cap shares.
US small-cap shares have seldom been cheaper relative to their larger peers. Independent research firm, MRB Partners claims that “In the past 35 years, there have only been three other times when the 1-year performance gap between small- and large-cap stocks was as wide or wider than at the recent relative lows (i.e. the early 1990s, the late-1990s, and the COVID-low). Each of these occasions proved to be a great buying opportunity for small-cap stocks.”
The underperformance seems incongruous because the 2025 earnings growth estimates of small-caps is solid, in fact superior to large-caps, if the Mag-7 are excluded from the comparison. At the same time there is a massive valuation disparity. The S&P 500 index trades at a substantial premium on all key valuation measures versus the S&P 400 mid-cap index and at an even greater premium versus the S&P 600 small-cap index.
The reason most cited for the valuation anomaly is the surge in interest rates which began in March 2022. Small caps are especially susceptible to rising interest rates. They carry more than double the debt-to-equity of large caps and pay three times more in interest costs as a share of earnings. This stems from having less access to alternative sources of capital funding.
When June’s US CPI report indicated a faster decline in inflation than had been expected, the probability of a September Fed rate cut became all but certain and as a result small-cap shares surged. In July, small caps staged their strongest five-day outperformance of large caps in at least four decades. The stage appeared set for prolonged outperformance, with the imminent start of the Fed interest rate easing cycle.
A steeper than expected increase in US unemployment in the first week of August ignited US recessionary fears and financial markets slumped, bringing to an abrupt end the nascent trend in small cap outperformance. While small caps typically outperform amid falling interest rates, there is an important proviso: There cannot be a recession, as small caps tend to be more leveraged to the economic cycle, explained in part by their greater use of debt but also their greater domestic focus.
Concerns over an imminent US recession are misplaced. The steeper than expected rise in unemployment is attributed to rapid growth in the labour pool stemming from the post-Covid normalisation in labour participation and a dramatic increase in the number of immigrants. A more balanced labour market bodes well for inflation returning to central bank targets, paving the way for interest rate cuts. Meanwhile, the global economy is slowly improving, led by rising trade volumes and strength in the service sector. Despite the excitement in the first week of August, The Federal Reserve Bank of Atlanta raised its estimate of third quarter US GDP growth. Its estimate lifted from 2.5% on 1st August to 2.9% on 8th August.
The current economic cycle is reminiscent of the late 1990s when the Fed was able to cut interest rates in the absence of heightened recessionary risks. In this so-called soft-landing scenario, when interest rates fall and the economic expansion is prolonged, small cap shares may well outperform as they benefit from an easing of financial conditions, an improving earnings outlook, and an unlocking of a substantial valuation discount.
We believe small cap shares play a key role in global diversified investment portfolios. Not only do they offer a strong probability of outperforming benchmark indices, but also offer useful diversification to investors’ portfolios, after a period when returns have been dominated by a handful of mega-cap US tech shares. In the US, the top 1000 shares by market capitalisation make up 95% of the total value. The next 2000 shares are worth less than the largest company, currently Apple. Even a moderate market realignment into small cap shares would have a significant impact on small cap share price performance.
Overberg Asset Management has added Edinburgh Worldwide Investment Trust plc (EWI.L) across our clients’ global private share portfolios. EWI is an investment company listed on the London Stock Exchange managed by Baillie Gifford with a mandate to invest in a global portfolio of smaller companies with significant long-term growth potential. Positions tend to be initiated at the start of a company’s commercialisation phase when the technology is proven but the market has not yet priced in its potential. EWI has gone through a difficult period of net asset value (NAV) performance and as a result the share trades at a compelling 8% discount to NAV. Given our belief in Baillie Gifford’s long-term track record in discovering successful future companies and the ability to generate exceptional returns from a small number of winners, we believe the best time to invest is after a period of unusually weak performance. By region, EWI’s largest exposures are to the US (76%) and the UK (12%).
Investment companies form the basis of Overberg’s global private share portfolios. Each portfolio typically comprises around 20 investment companies, providing effective global diversification across regions, currencies, and asset classes.
Local Report: Investment case for South African assets
By Werner Erasmus
Introduction
After a decade of turmoil under the Zuma administration, followed by the false dawn of Ramaphosa, the COVID-19 pandemic, record-high inflation and interest rates in 2022/2023, the collapse of Transnet, and record levels of load-shedding, it seems there is finally light at the end of the tunnel for the South African economy and its assets. The recent peaceful formation of the Government of National Unity (GNU) after the May 29 general election has led to a fundamental shift in investor sentiment towards South Africa. This optimism is further bolstered by the absence of load-shedding since 26 March 2024 (146 days), improvements in rail and port efficiencies, declining inflation, and a strengthening rand. Although risks remain, the confluence of these positive factors has significantly improved the outlook for South African assets, particularly given current valuation levels. South African asset valuations screen cheap compared to other emerging and developed markets. One swallow doesn’t make a summer, but in South Africa’s case, more swallows seem to be flying together.
Structural changes and improvements
a. Formation of a Government of National Unity (GNU)
The election outcome was likely the best that South Africans could have hoped for. The ANC peacefully relinquished power after losing its majority, leading to the formation of a GNU that includes the Democratic Alliance (DA), a party generally seen as business friendly. This outcome is especially significant when considering that one of the probable outcomes could have been a coalition between the ANC and the EFF and/or the MK Party—both of which support policies like land expropriation without compensation, the nationalization of mines and the SARB, and have made various attacks on the constitution. Such a coalition would have been a massive blow to South Africa’s recovery prospects and its overall investment profile. Fortunately, the new GNU has prioritized economic growth and is driving greater private sector involvement. While these developments are promising, investors will now look for concrete policy steps from the new administration to improve trend growth before increasing their portfolio exposure to South Africa assets.
b. Eskom
Load-shedding has been absent for nearly four and a half months. Based on previous SARB estimates of how much load-shedding has negatively impacted South Africa’s GDP growth, the economy has the potential to grow by an additional 1.5% simply from the absence of load-shedding. Is it realistic to expect that load-shedding is a thing of the past? This cannot be answered with complete certainty, but recent data is encouraging. Several Eskom generation units have returned to commercial operation, and this will continue to help alleviate load-shedding pressure this year. Eskom’s Energy Availability Factor (EAF) was 52.6% in the first quarter of 2024, improving to an average of 61.29% in the second quarter. The third quarter saw a more significant increase in the EAF to over 70% (the first time since mid-2020), supporting an ongoing recovery in economic activity. The EAF in 2024 thus far averages 58.3%, above the 2023 average of 54.7%. This improvement is largely due to a combination of factors, including increased private-sector electricity self-generation capacity and lower levels of unplanned outages.
c. Transnet
Kumba Iron Ore and Sasol have reported recent improvements in Transnet’s rail operations, attributing these to the company’s new management team and recent leadership changes. These improvements, though slightly below target, are also linked to legislative reforms that have allowed for greater private-sector involvement. A new board, appointed in July 2023, introduced a phased Transnet Recovery Plan aimed at stabilising operations and financial performance by March 2025. This plan focuses on structural reforms in rail and port operations through private sector participation, and there has been a notable increase in output levels.
Rail volumes have increased from 150 million tons in FY2022/23 to 151.7 million tons in FY2023/24. The significance of this increase lies not in the percentage but in the fact that this is the first year-on-year increase since 2018. Productivity at the Port of Cape Town has increased by 30% in the past six months, contributing to renewed optimism in the logistics capacity of the Western Cape. Transnet has also recently undertaken significant efforts to improve operations at the Port of Durban and expand container capacity.
Financial tailwinds
Inflation and Interest Rates
Inflation has been trending downward from its peak in 2022, in line with other global economies. The South African Reserve Bank (SARB) is forecasting inflation to reach the 4.5% midpoint target in the fourth quarter of this year, setting the stage for potential rate cuts starting in September. Declining interest rates will support asset valuations, improve consumer and business confidence, and over time increase disposable income for consumers and expand corporate profit margins.
Risks
Several risks, both local and global, could undermine South Africa’s recovery. These include potential instability within the GNU, water-shedding, high levels of crime and corruption, a slowdown in global economic growth, continued economic weakness in China, and geopolitical conflicts. While global risks will always exist, it appears as if South Africa has turned the corner on scoring own goals and is starting to address the political, economic, and structural challenges within its control.
Conclusion
Despite various risks, the confluence of factors such as the formation of the GNU, improved electricity generation, higher business and consumer confidence, declining inflation, expected future interest rate cuts, and a strengthening Rand have significantly improved the investment case for South African assets. Valuations remain relatively low, making the overall investment case attractive. The economic recovery may take time as initiatives are implemented and changes take hold, but financial markets, as we know, are discounting machines and will start pricing in improvements in advance.
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Reference: Capital Economics – Historical bond and equity return data.
The Bottom Line: Innovation and the Magic of Compounding
By Carel La Cock
The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.
Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.
After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.
Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.
As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.
Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.
Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.
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