How to get great value in small caps

AT a time when analysts, wary of the regional stock market turmoil, are touting blue chips as safe 'buys', the winner of this year's Hong Kong equity over three years award has a different niche - small caps. Value Partners, which specialises in picking value among small cap stocks, has about US$140 million under management, compared with just $5 million when it opened its doors. Its funds have seen returns of 19 per cent a year since the group was founded in Hong Kong in 1993 by managing director Cheah Cheng-hye, a former investment analyst, and V-Nee Yeh, a merchant banker and scion of the Hong Kong family that controls Hsin Chong Construction Group. When the group - now an outfit with four analysts and six support staff - started, Mr Cheah said the concept of sticking with small caps was looked down on. 'But I found there were amazing opportunities for value investing,' said Mr Cheah, a former financial journalist in Asia. 'The idea is not to treat stocks as pieces of paper but as a conduit to participate in a certain business.' Its benchmark fund is Value Partners A - an open-ended fund with $68.4 million under management that is one of the largest Hong Kong equity funds available. Since its launch in April 1993, the fund has gone up 112.2 per cent, compared with the blue-chip Hang Seng Index that is up 70 per cent. Between January last year and February 19 this year, Value Partners A has managed a 9.3 per cent rise, while the Hang Seng Index is down 19 per cent. Standard & Poor's Micropal rating for the fund, the reason Value Partners won the Hong Kong equity award, is 1.9701. It beat the other top performers, Barclays ASF Hong Kong, which chalked up a ratio of 1.7604, and HSBC GIF Hong Kong, at 1.6811. The award is based on Micropal calculations which take into account the total performance of the fund over three years, plus the level of risk. 'Even in such a bombed-out sector like Hong Kong small caps, this shows that it is possible to do well if you know what you're doing,' Mr Cheah said. Value Partners' investment strategy involves picking out value among the small caps listed on the Hong Kong stock market, in stark contrast with most Hong Kong funds which usually keep more than 50 per cent of their assets in blue chips. 'There are 650 companies listed in Hong Kong, 50 of which are large cap stocks that are well researched and well known,' Mr Cheah said. 'We have the choice of the other 600 smaller companies, where research is not available or is of low quality.' It is a large menu of stocks to choose from, especially as 50 stocks are enough to make a fund diversified to withstand problems. Many of these stocks are ignored, or overlooked, and lie in an 'under-appreciated sector'. 'Small caps are in what is generally a dismal sector, where investors have poor morale,' Mr Cheah said. 'It's good for me. When people are fearful, they are emotional and then they tend to throw away value.' Still, it is a risky business that requires a lot of discipline and research. 'We stress analysis and crunching numbers,' Mr Cheah said. 'We spend whole days visiting companies and reading annual reports and we also have to have the courage to behave the same way whether the market is good or bad.' Choosing small cap stocks that never see much liquidity, despite possessing solid earnings potential, is a risk that requires discipline and a long-term view. 'I'm working with fear,' Mr Cheah said. 'But we try to buy stocks that have a potential for an earnings surprise or restructuring, not just because they are cheap.' But, of course, if a stock was 'cheaper than cheap', say stocks trading at three times price earnings when they deserved to trade at double that, then they were a buy. The secret, Mr Cheah said, was being ahead of the market and other fund managers. 'Our strategy is to buy stocks when they are undervalued, before the fund managers and brokers buy them and when they are overvalued,' he said. 'That's about the stage when taxi drivers buy them and there is lots of research on them' Many so-called boutique fund managers, like Value Partners which specialised in buying a certain type of stock, were now facing financial problems. A few may even collapse or be taken over by bigger institutions, Mr Cheah said. Part of cutting down on risk was in staying away from stocks that were the 'flavour of the month', such as red chips - last year's speculative play.