Threading the small-cap needle is a delicate business

PUBLISHED : Monday, 11 April, 2011, 12:00am
UPDATED : Monday, 11 April, 2011, 12:00am


A whip through the headlines of news stories about Hong Kong-listed small caps (stocks with a relatively small market capitalization) gives pause for thought.

The former chairman of Gay Giano International was sent to jail in 2003 for defrauding investors.

In 2004 the ICAC raided Skyworth Digital's Quarry Bay headquarters and charged the chairman and a senior director with conspiracy to steal.

Euro-Asia Agriculture in 2002 went into trading halt and then into liquidation following an inquiry by the stock exchange into 'possibly criminal acts in China by the chairman'. And so on ...

But - apart from the fact that small-cap stocks can be illiquid, poorly covered and are prone to epic governance conflagrations - some analysts still recommend them.

Analysts also argue, partly because the securities are overlooked, there is value to be unearthed by the diligent investor.

Asian small caps sometimes present unique opportunities. While global markets sometimes price in a 25 to 55 per cent premium for small caps compared to large caps - on a PE (price-to-earnings-ratio) basis - in Asia the shares typically trade at a discount to the wider market, according to research from HSBC.

The discrepancy is often explained by the fact that US investors, for example, may choose to buy small caps for their growth potential. But, in Asia investors can get excellent growth according to HSBC just buying the main market, and are less willing to delve into the sometimes murky world of small-cap investing.

'People are looking at China, Asian high-yield fixed income and commodities. They are not looking at small caps in Asia,' said Bruno Lee, HSBC's regional head of wealth management, personal financial services Asia Pacific. 'Small caps might be too small and too risky given the opportunities for growth investing found in the broad market.'

Ex-stock exchange director David Webb has been investing in small caps for 16 years, and prosperously so. The endeavour neatly dovetails with Webb's other occupation as one of Hong Kong's most visible corporate governance activists.

'Even if you believe in efficient markets, small caps are often not efficiently priced because there is not enough research. There is mispricing that can run in both directions,' said Webb. 'The lack of research coverage is sometimes beneficial to the investor who does his homework.'

Aberdeen Asset Management launched a closed-end small-cap fund 16 years ago that has outperformed comparable large-cap funds by about 3 per cent annually, albeit with volatility.

'In any given year returns are all over the place,' said Hugh Young, a Singapore based managing director for Aberdeen who is close to the small-cap fund.

The fund's inevitable duds are lifted by occasional stellar performers.

For example, in 1996 Aberdeen took an investment in India's Satyam, back when it was a US$50 million company with a sole major client. Satyam quickly was swept up in the global tech bubble, listed on the New York Stock Exchange, and Aberdeen saw its investment increase a hundredfold when it sold its Satyam stake in 1999.

Aberdeen paid about eight times earnings for Satyam. When it sold down, earnings were rising at an annual compounded rate of 30 per cent, and its PE rating had jumped to 30 times.

Satyam also shows the darker side of small-cap investing: wobbly governance. In early 2009 Satyam was found to have inflated profits for years, sending its share price down 80 per cent and forcing the resignation of its founder and chairman, Ramalinga Raju. It's the biggest fraud in Indian corporate history and Raju is in jail awaiting trial, having had a bail application rejected.

Webb outlines some basic rules of thumb for addressing small caps' wayward governance tendencies. He says, for example, that firms should have at least a two-year track record as a listed entity, on the view that 'if a company has been listed to defraud investors they won't waste time doing it'.

Red flags include repeated issuance of large stock option grants to directors, multiple connected transactions and subsidiaries involved in money lending (which could be a front for moving cash around).

'Small caps offer better growth than blue chips, but they have quite uneven history,' said David Lai, a fund manager with Citic Securities International Investment Management. 'You have to double up the investment research work. You not only cover the company itself, you have to look at their upstream suppliers or downstream customers, and perhaps their industry peers.'

Lai noted, for example, that interviews with a firm's suppliers and customers can help an investor do a gut check on a firm's credibility. For example, they can find out whether a small cap delays payment to suppliers during down cycles, whether the principles in a firm have any record of bad debt, whether a company's cash position is as good as advertised, whether there is any evidence of stressed financials, etc.

'It's very difficult for individual investors to do this kind of research unless they are in the industry,' said Lai. 'And, even if you have done all of these you cannot protect against any possibility of fraud.'

Should they get comfortable with the idea that a firm is well managed, investors then have to figure out whether a small cap is a good investment.

The answer is often in the affirmative, largely because small caps are typically shunned by the big funds in favour of more tradeable securities.

Of the some 1,420 firms listed on the Hong Kong exchange, the top 200 account for 85 per cent of market value, and the next 80 another 5 per cent. That leaves about 1,140 shares making up 10 per cent of the market.

The typical fund needs to make a minimum US$10 million investment in a firm for the company to be worth its time. That amount could comprise weeks of trading turnover of a small cap, meaning that it would be impossible to invest in or exit without drastically distorting the share price.

For example, Aberdeen owns 15 per cent of Giordano, a hefty stake that would take a minimum 66 days to sell given average turnover. Even over such an extended period, selling in the open market at such volumes would flay the share price.

Due to the difficulty in exiting small-cap positions, Aberdeen views such investments as akin to private equity: the positions are expected to be long term, if not permanent. The Asian office undertakes a rigorous due diligence process when vetting new small caps, by which a team of 30 must review and come to a unanimous agreement about including a stock. And once they get comfortable with a stock they tend to stay put.

'To sell any position can push the price down quite sharply,' said Young. 'In an ideal world the profits would rise and the valuation on those profits would get rerated quite sharply, such that it becomes a large cap and we can then gently exit.'

Adds Webb: 'Particularly for larger investors, you have to treat small caps as semi-unlisted because they are hard to move in and out of. That is not the case with larger blue chips but I think the market overpays for that liquidity.'

Liquidity is less of a concern for individual investors, who would be looking to invest small sums that could be easily absorbed by even the smallest small cap.

The opportunities can be unusual. Webb for example acquired a large position in the Hong Kong-listed shoemaker KTP Holdings over four years due to its discounted valuation - around half its net asset value. KTP later sold its main business, and the stock became a candidate for a backdoor listing (by which a third party buys the listed company, buys up its existing shares, injects large assets into the firm, and then sells new shares in the firm at an elevated pricing).

In December last year, a Singaporean individual bought a controlling shareholding in KTP and launched a general offer for the existing shares at about twice the net asset value of the company, giving Webb an unexpected exit and roughly quadrupling his investment.

Webb does not invest in stocks purely for their shell potential. However, this feature does offer value that is unique to the realm of small-cap investing. 'The shell value of listings provides some cushion on the downside if things don't work out, and that shell value is not something you get with disappointing investments in large caps,' said Webb.

Aberdeen likes investing in spin-offs of large global firms. For example, it has taken stakes in the regional subsidiaries of OCBC and British American Tobacco, partly on the view that these firms would naturally take on the best practices of their parent.

Furthermore, there is a tendency for the parent to eventually buy back its more successful subsidiaries, creating a natural exit for the small-cap investor. Aberdeen saw this in its investments in BAT Indonesia, Otis Elevator India and Malaysian Oxygen.

'If we want to sell these subsidiaries, it would take one phone call to the majority owner and they would be interested at the right price,' said Young.

But the typical investor has to ask whether they are willing or able to do the kind of due diligence to invest properly in small caps.

Small caps in particular are vulnerable to price-ramping schemes, where share prices can easily be manipulated upwards with the aid of a handful of chunky buy orders and some well planted information and/or positive brokerage reports. Two UBS analysts in 2003 were arrested in Hong Kong for involvement in just such a scheme.

Truly, unless a personal investor is supremely skilled and dedicated, it is hard to argue against the logic of using a mutual fund when buying small caps.