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Mid-cap shares:

unloved but not unlovely

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David Lerche

Chief Investment Officer

Despite evidence that over long time periods, smaller listed companies tend to outperform large ones, mid-cap shares have been rather unloved over the past few years. Not only do natural market forces leave them with a limited pool of potential investors, but the current state of our economy doesn’t inspire confidence in their business prospects. In our view, mid-caps will again emerge from the doldrums – and the balance of risks when investing in these stocks may well now be positive.

There are over 160 companies with market capitalisations above R2 billion listed on the JSE – yet the market focus is primarily on the largest 40 of these. Of the JSE’s total market cap of R12.5 trillion, around R1.4 trillion is to be found in the FTSE/JSE Mid Cap Index – the next 60 largest companies outside the Top 40 Index. This includes several high-quality companies.

Over the past 10 and 20 years, the Mid Cap Index has delivered annualised total returns of 14.8% and 17.7% respectively, ahead of the Top 40 Index’s 13.8% and 12.4%. Over the past year, however, mid-cap stocks have struggled, returning a negative 9.5%.

Given the rise of passive strategies and the lower liquidity of smaller listed companies, natural market forces haven’t been kind to them over the past few years. South Africa’s largest passive investment products, including the Satrix 40 ETF, invest only in Top 40 Index companies, which leaves smaller entities with a narrower pool of potential investors.


South Africa’s smaller companies by their nature have lower liquidity. For example, the 50th to the 55th largest companies on the JSE by market cap have an average daily liquidity of R130 million, about a tenth of that of the largest five, while the 100th to 105th largest stocks average only R8 million per day of trade.

Even the more flexible emerging-market-focused international unit trust managers tend to have a minimum liquidity requirement of US$1 million per day, as well as a US$1 billion minimum market capitalisation requirement. This excludes over half the companies on the main board of the JSE, including well-known names such as Adcock Ingram, Nampak and Harmony Gold.

All this of course has nothing to do with the actual business operations of South Africa’s smaller listed entities. However, less competition among investors serves to reduce the valuations to more attractive levels. Valuations for the Mid Cap Index have declined to 2011 levels, with the index as a whole trading at 10 times forward earnings, well below the 2015 peak of 16 times.

As Benjamin Graham, the father of value investing, noted: ‘In the short run, the market is like a voting machine … but in the long run, it is a weighing machine.’ While the above-mentioned factors do limit the number of shorter-term votes, over the longer term, we expect the weight of the truth will prevail.


Numerous global studies, the most famous of which was conducted by Fama and French back in 1993, show that over long time periods, smaller companies tend to outperform larger ones. Essentially, larger companies are more mature and often have market-leading positions, leaving limited room for growth ahead of the economy, while small firms have space to grow and disrupt.

The problem for the JSE’s smaller listed entities, which are generally South Africa-focused, is that this country’s anaemic economic growth has hampered earnings growth and in many cases caused profits to decline through 2018.

In general, this segment of the market requires a healthy local economy to do well. With the current poor state of the economy, the prospects of many businesses don’t appear too rosy. Accordingly, the market is valuing these companies based on bottom-of-the-cycle earnings.

Both South Africans and their businesses have shown great resilience and innovation over decades, and have come through previous difficult periods remarkably well. In our view, they will again emerge from the current difficult situation.

As the South African economy recovers over the coming years, we expect company earnings to follow suit. While the ride is unlikely to be smooth, the combination of undemanding multiples and depressed earnings means that the balance of risks when investing in our country’s less-visible companies may well now be positive.

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