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Investing In Small & Mid-Cap Equities: Taking small-caps global

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  • Shenguan Holdings: the perils of incomplete knowledge

Brandes Investment Partners has been managing global small caps since 1997. “It’s a big pond with a lot of fish but very few anglers,” as director of investments Luiz Sauerbronn puts it. 

A quick look at the size of the Mercer global universe relative to its US universe confirms how few those anglers are. Among our featured strategies, the F&C fund is explicitly European; Horizon Kinetics describes its strategy as “US-focused small-cap”, but it is currently almost entirely in North American stocks and has been since 2008. (Brandes is genuinely global, with a huge underweight in the US and its main overweights in Japan and Mexico). 

Global small-caps is tricky for the same reasons it is compelling: management decisions assume an outsized significance within smaller companies, and maintaining genuinely deep relationships with even a few dozen of the 10,000 remotely-scattered names available is a tall order.

“We’ve seen companies that look cheap, superficially, but where we’ve felt there was some cyclical explanation, the accounting wasn’t clear enough, or our access to information wasn’t as good as we’d like,” says Sauerbronn. “In China, there are lots of these examples. It’s important to have the discipline and humility to know what you can or cannot know, and feel able to pass on what may look attractive only on the surface.”

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It is a lesson that Hermes, fairly new to global small-caps and feeling its way at the request of clients anxious to globalise their portfolios, has been learning through 2014. 

 

Until Q3 it held a position in Chinese sausage casings manufacturer Shenguan, bought on an understanding of the barriers to entry to this business learned from Devro and Viscofan in Europe. It also liked the fact that the firm is located in the heart of China’s cattle-slaughtering region and has a fast-growing domestic meat-eating market to play for. Hermes’ analyst had set out to test the thesis, but getting to the headquarters in Wuzhou, 250km outside of Guangzhou, was arduous – and it quickly became clear that communication from management was neither prompt nor transparent. 

“One thing you learn about Asian small-caps is to be wary of what I call ‘the incredible disappearing ROE’,” says head of small and mid-caps Hamish Galpin. “This one fell into that category. We bought it about 18 months ago but started to become uncomfortable when we saw the likes of Devro making more headway in China than Shenguan had been suggesting, and the financial situation deteriorating more rapidly than it should have been, from what the company was telling us.”

Hermes sold just before allegations of fraud and a short-selling attack erupted. Shenguan shares were suspended temporarily in September 2014.

As Galpin reflectes: “Global small-caps needs boots on the ground, because if you don’t meet management you can very quickly get into trouble.”

 

 

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