Finding hidden market gems

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Samantha Pauwels, portfolio manager at Cannon Asset Managers gives investors pointers to finding hidden market gems.

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samIt seems like just last month that the oil price slipped to fresh lows and the expected benefit was widely discussed in local news. Many analysts were anticipating consumers to have more disposable income, companies to benefit from lower input costs and the economy to enjoy higher growth rates from the windfall.

But all that has come and gone and the oil price is back on an upward march. We are already approaching the half year mark and a flood of local companies have reported their earnings. Regardless of the company, many annual or interim statements start off with a blurb along the lines of:

“The first half of 2015 was characterised by extremely challenging trading conditions. High unemployment rates, consumer debt exposure coupled with protracted strike action in various sectors resulted in a further deterioration in the South African economy …”

Indeed, whilst the South African economy is experiencing trying conditions, companies and management teams need to be flexible, agile, competitive and entrepreneurial in tough times as much as in good times. It is these companies that gain market share in challenging times and which we want to own for the long term.

Thankfully, the JSE is home to a number of such companies. You may not hear about them as often as the more popular names, but there are a large number of mid- and small-cap shares that have delivered respectable results even under these “extremely challenging trading conditions”.

The chart below shows the most recent reported headline earnings growth that these companies have generated over the last 12 months, and the companies’ current trailing price to earnings ratio, compared to the market.

Chart 1: Headline Earnings Per Share Growth and Price:Earnings Ratio

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As the analysis reveals there are a surprising number of companies delivering double-digit growth while also trading at relatively low price:earnings multiples compared to the market price:earnings multiple of 19 times. These businesses have managed to deliver solid results, during a period when South Africa’s GDP grew at a disappointing 1.5% in 2014 and an even more sluggish 1.3% quarter-on-quarter, seasonally adjusted and annualised, for the first quarter of 2015.

At a recent results presentation, the CEO of one of these “hidden gem” companies shared an anecdote with investors: he is frequently told by competitors and other company leaders how tough the current environment is and that they miss the “good old days” before 2007/8. In his words, “those were not the good days, those were the luck days.”

A business cycle comprises good (or “lucky”) times and tough times.  Companies that perform well through the business cycle will steadily increase shareholder value and are the ones that investors should own. These management teams adapt and look forward, instead of blaming the poor numbers on factors that are out of their control and which are unlikely to change in the near future.

Warren Buffett said, “We never want to count on the kindness of strangers in order to meet tomorrow’s obligations”. In the same way, we never want companies to bank on changing conditions when the time to do business is now.

There are many opportunities in our country and there are plenty of companies taking advantage of them. By expanding their investment horizon beyond the largest 100 listed shares, investors may well stumble upon a gem that is growing its earnings at double the rate of the market, for half the price!