<strong>By: Samantha Steyn, Chief Investment Officer, Cannon Asset Managers</strong>Author and investor Jim Slater states of large-cap companies, “elephants don’t gallop”. And as history shows us (see Chart 1) mid- and small-cap companies have enjoyed superior growth over the long term.<strong>Chart 1: FTSE/JSE Mid-Cap and Small-Cap Performance, 1995-2018 </strong><img class="aligncenter wp-image-138024 size-full" src="https://www.cover.co.za/wp-content/uploads/2019/03/Mid-cap-small-cap-performance.png" alt="" width="589" height="211" />However, while the past three years have been tough on local equity investors, they have been particularly hard on mid- and small-cap shareholders; and 2018 was particularly bruising. The general disinterest in smaller companies has been evident over the past three years, as can be seen in Chart 2 below. It’s clear that mid- and small-cap performance has been overwhelmingly negative since 2016, which begs the question: Can we expect the same in 2019?<strong>Chart 2: Market Performance (Three Years to December 2018)</strong><img class="aligncenter wp-image-138023 size-full" src="https://www.cover.co.za/wp-content/uploads/2019/03/Market-performance.png" alt="" width="526" height="212" />Source: Iress, Cannon Asset Managers (2018)However, before we consider return prospects, we should first address the elephant in the room: the issue of benchmarks and outperforming them. The overwhelming majority of investors are primarily concerned with outperforming the market. But this isn’t necessarily the best target to aim for – after all, would you be happy to accept a loss on your portfolio as long as the aggregate market performance was worse?Probably not. While outperforming the market might sound acceptable, it means that you would be lowering a critical measure of investment performance, namely absolute financial wealth (rather than relative wealth).Having said this, if your primary goal remains to beat the market (even if that simply means not performing worse than an index), then we believe that one of your best courses of action would be to invest away from the stocks that make up “the market index”. This makes a specific case for mid- and small-cap shares.Chart 3 below helps to illustrate this point by showing that, while the mid- and small-cap sectors tend to experience greater volatility than the broader market, these shares have historically outperformed larger companies over time.However, dipping in and out of mid- and small-caps is more likely to yield severe losses due to their volatility. So, while future performance is not guaranteed, by riding out the noise an investors’ patience and commitment can also be greatly rewarded in the long run.<strong>Chart 3: History as a Guide</strong><img class="aligncenter wp-image-138022 size-large" src="https://www.cover.co.za/wp-content/uploads/2019/03/History-as-a-guide-600x309.png" alt="" width="600" height="309" />Source: Adrian Saville &amp; Andrew Dittberner, Cannon Asset Managers (2016) JSE 1993-2013LG: Large Growth Companies, LGARP: Large Growth Companies at a reasonable price, MG: Mid-Sized Growth Companies, MGARP: Mid-Sized Growth Companies at a reasonable price, SG: Small Growth Companies, SGARP: Small-Sized Growth Companies at a reasonable price, LV: Large Value Companies, MV: Mid-Sized Value Companies, SV: Small Value CompaniesStructurally, most large investment houses are unable to invest in this part of the market due to their size. They can’t acquire a large enough stake in a small-cap business to make enough difference to their large fund – and they are therefore compelled to invest in larger-cap stocks. As a result, in large investment funds, a significant portion of the portfolio is concentrated in a few large companies. The result is that investors in these large funds miss 90% of the opportunities available on the Johannesburg Stock Exchange (JSE).That aside, mid- and small-cap stocks have had a somewhat checkered history leading to some skepticism directed towards the sector. In 1998/9, a surge in small cap listings (mainly IT and financial companies) lit investor sentiment in these stocks. Several small cap unit trusts were launched, and new stock listings were often greatly oversubscribed – market veterans will recall names such as Q Data, Sweets from Heaven and Usko. A bust followed the boom and many of the businesses delisted within five years. A boom in listings in the construction sector saw this part of the market peak in late 2007, only to unravel two years later. Rinse and repeat.The most significant driver of a share’s price is its earnings and the earnings of mid- and small-cap companies are more volatile than larger, diversified companies. When investor appetite for risk is rising, small cap stocks tend to see significant inflows. By contrast, we are coming out of a risk-averse period in local markets, and the mid- and small-cap sector has seen outflows leading to keen multiples.With valuations at an all-time low in this sector of the market, we are seeing an uptick in activity with management either increasing stakes in their companies through share buy-backs, looking to take out minority shareholders, or an increase in corporate merger and acquisition activity. Witness the recent offers for Cargo Carriers, Clover, Howden, Torre, Interwaste and Verimark. We view this as a positive signal that South African mid- and small-cap shares may be reaching trough valuations: they have historically, staged spectacular comebacks from such depressed levels.Despite the current tough environment, the companies that Cannon Asset Managers invests in are profitable, dividend paying with healthy cash flows and decent returns on equity. Price-earnings multiples are undemanding at current levels, to the extent that all that is needed is a modest re-rating to the long-term average to make mid- and small-caps a great investment – without depending on significant increases in earnings. Given the low multiples, we also believe the risk of capital loss is lower when compared to higher-rated counterparts, which means that the margin of safety is particularly high.Finally, size and value are powerful ingredients in predicting excess returns, but it is worth noting that they require a third – and arguably more powerful – ingredient: time. For investors who take a longer-term view (those with at least a 5-year time horizon), the small- and mid-cap stocks on the JSE offer an extremely attractive investment opportunity. For instance, investors can access mid- and small-cap stocks through the Cannon Asset Managers’ Mid &amp; Small-Cap H4 Fund on a price-earnings ratio of eight times, which represents a 50% discount to the All Share Index (ALSI) of 16.9 times.<img class="aligncenter wp-image-138025 size-large" src="https://www.cover.co.za/wp-content/uploads/2019/03/Screenshot-2019-03-11-at-15.42.36-600x171.png" alt="" width="600" height="171" />Source: Cannon Asset Managers, Iress (2018)Within the Fund are well-known names such as Telkom, Clover and Clientele; as well as lesser known names, the hidden gems that often prove to offer the most valuable returns. Indequity is a great example. This niche, short-term insurer focuses on professionals and affluent private clients. It is a well-run business on a five times price-earnings multiple with a 6.7% dividend yield and the group currently has more cash on the balance sheet than its market cap.OneLogix is another jewel. This superbly run logistics company, managed under the steady hand of Ian Lourens, continues to deliver solid results. Despite the tough macro environment, the group has been able to diversify revenue streams and increase efficiencies, resulting in an impressive 22% compounded annual growth in net asset value. Both of these businesses are repurchasing their own shares in the market, as there is no better business to buy than your own, especially when it is trading at a discount.Investors often accept an all-or-nothing approach, which need not be the case. While we understand the inherent risks such as liquidity and volatility, it is worth considering allocating a portion of your assets to this part of the market. If history serves as any guide, investors will be handsomely rewarded.