Less liquid shares can be riskier at times. Being more difficult to sell, managers may struggle to do so without impacting the price at certain points in the market cycle, or may be restricted in their ability to raise funds from less liquid names. In addition, local small- and mid-cap stocks tend to be more exposed to the South African economy. When it performs poorly, they are hardest hit by weaker levels of profitability as well as negative investor sentiment.
This is part of the reason that small- and mid-cap shares are currently out of favour. They have become a lot cheaper than large-cap shares, which offer greater liquidity and broader geographic exposure.
In other words, the risk premium to invest in these less liquid shares is elevated.
This higher liquidity risk premium means lower valuations, which almost always suggests better long-term returns for investors who can identify mispriced stocks, select carefully and be patient.
A concentrated investment landscape adds to the unpopularity of smaller-cap stocks
The significant concentration in the local asset management industry – one of the most concentrated in the world – is worth noting.
It means that the handful of very large managers can only invest in liquid stocks: at maximum investment size, many mid-cap shares simply don’t move the needle for them.
Offshore investors also focus predominantly on large-cap names, as liquidity is key if you are buying shares from thousands of miles away. In addition, sell-side analysts tend to only research large-cap shares, so many small- and mid-caps are both under-owned and under-researched, which can result in mispricing.
Due to a high liquidity risk premium, PSG Asset Management funds currently have significant small- and mid-cap exposures
PSG Asset Management currently has an overweight position in less liquid small- and mid-cap shares relative to the stock indices, which are very concentrated.
We believe that the current high liquidity risk premium has presented attractive opportunities in this space, with above-average quality small- and mid-cap companies trading at below-average valuations, and arguably on low levels of earnings.
The valuation differential between the FTSE/JSE Top 40 Index and the FTSE/JSE Mid Cap Index based on relative price-to-book ratios (as shown in the graph below) gives an indication of how high the liquidity risk premium is. In 2018, it reached the highest levels of the past 16 years, and it remains elevated.
Over this period, the Mid Cap Index far outperformed the Top 40 Index, by more than four percentage points a year, suggesting that the liquidity risk premium does result in superior returns over long periods of time.
Graph: The liquidity risk premium in South Africa is elevated
Investing in less liquid stocks at the right times can achieve superior returns over the long run
We are not mid-cap managers. In fact, on previous occasions we have had a bias towards large caps. But the current liquidity risk premium provides a high likelihood of achieving above-average long-term returns from quality small- and mid-cap counters, and this is an opportunity we are taking advantage of on behalf of our investors.
While we are conscious of the liquidity trade-off, our process tries to keep liquidity risk to acceptable levels. Among other checks, we account for liquidity in our buy lists and track liquidity constraints across all our funds on both an individual and aggregate basis. The diversified nature of our portfolios – which tend to be fully invested offshore and hold healthy cash balances where mandates allow – provides an additional buffer.