Small-cap rally: Time to take profits?


THE Zimbabwe Stock Exchange (ZSE) Small Cap Index was the highlight of the bourse’s 2021 Q1 performance as it picked up 298,72% to 47,352.26 points.

In comparison, the ZSE All Share, Top 10, Top 15 and Mid Cap Indices registered respective quarterly performances of 70,74%, 56,83%, 52,6% and 93,27%. Unifreight Africa’s year-to-date performance of 7,695.7% underpinned the Small Cap Index’s surge, followed by National Tyre Services’ (NTS) 3,559.56% increase in its share price. The penny stock anomaly that largely explained MedTech’s stratospheric performance of 7,500% in 2019 is also attributed to Unifreight’s and NTS’ share price growth.

Penny stocks are listed equities that typically trade for less than a dollar a share.

However, the term is also used for stocks that trade for less than US$5 per share in developed markets. The shares are extremely illiquid, and it can be difficult to price the stocks since price quotations for the shares cannot be easily obtained.

A penny stock anomaly refers to the uniquely high share price volatility associated with penny stocks. Penny stock anomalies are also associated with stock manipulation techniques such as “Pump and Dump”, a form of securities fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price. The recent share price volatility in NYSE-listed GameStop is an example of a pump and dump scheme.

Unifreight Africa is a very illiquid counter with relatively few shares trading as free float. Only 22% of its total shares are not held for strategic reasons (such as controlling ownership) and make up the bulk of the counter’s trades.

Between 2019 and 2020, the country changed currencies and experienced hyperinflation that saw the ZSE’s all-share index recording year-to-date performances of 59,4% and 1,045.8% in 2019 and 2020, respectively.

Over the same period, Unifreight moved by 88,3% in 2019 and only 106,7% in 2020. Since the beginning of 2021, the counter has traded in drips to current levels of ZW$14,50 per share, up from a year-opening price of ZW$0,19 per share. NTS also shares a similar background, albeit slightly more liquid than Unifreight Africa.

NTS has traded an average of 15,067 shares per day between 2015 and 2021 compared to Unifreight’s average of 1,671 shares over the same period. The question in many investors’ mind is, “do the current prices for these two stocks represent the fair value of the underlying businesses?”

A good starting point is the movement of both stocks’ share prices between 2015 and 2021. Using a combination of the Zimbabwe dollar prices, OMIR and official exchange rates, the graph shown illustrates the trend of the respective share prices in US dollars.

Between 2015 and 2017, when the country was dollarized, NTS and Unifreight traded at respective average prices of US1,49c and US1,00c per share. This provides us with a benchmark that gives one an idea of over/undervaluation of these stocks at current price levels.

From the graph above, both stocks have rallied well beyond 2015 — 2017 average price levels. In US dollar terms, NTS currently trades eight times above its 2015 — 2017 average while Unifreight currently trades 17 times above its average. However, before we jump to the conclusion that these stocks have become overvalued, one needs to look at valuation ratios and fundamentals.

The two companies’ sales and net asset value have failed to match the growth in their share prices. Using estimates for the most recent financial year-end, we note that NTS’ revenues declined by 70% in US dollar terms between 2015 and 2020 and its net asset value shed 50% of total value. Over the same period, Unifreight’s revenues fell by 54,6% in real dollars but its net asset value picked up 1,304.8% in value.

None of these companies have registered growth in line with their respective share price performance when using either sales or net asset value as a performance metric. Based on Morgan & Co Research data, NTS’ forward price-to-earnings ratio (PER) of 29,3x looks expensive in comparison to an international peer PER average of 24,7x and a ZSE average of 22,7x. Similarly, Unifreight’s forward PER of 30,1x looks demanding relative to an international peer PER average of 23,3x and the ZSE average.

All in all, the analyses above converge to the conclusion that these stocks are overvalued, and they are priced beyond the levels that can be justified by fundamentals. At these price levels, investors in these counters could benefit by selling out and investing in other stocks that still hold more upside potential relative to their current share prices. We also note that prices of penny stocks in Zimbabwe are sticky-down, that is, they easily move upwards, but they do not move downwards easily, as is the case with Medtech.

We are cognisant of the possibility of yet another case of the penny stock anomaly on the ZSE — Zeco Holdings. Zeco is arguably the most illiquid stock on the ZSE, having traded for a total of 11 days between 2015 and 2021. The stock is currently priced at ZWL0.03c per share and has a market capitalisation of only ZWL13.9m. Zeco recently traded 2,527,380 shares on March 30, 2021, renewing a long-lost interest in the counter among local investors.

Zeco has been posting consecutive losses for over a decade, something that is common in other penny stocks, albeit to a lesser extent. Zeco’s investment thesis is hinged on the resuscitation of the National Railways of Zimbabwe (NRZ).

NRZ has been battling very low and unprofitable capacity utilisation levels of 30% on the back of inadequate capitalisation which, in turn, has limited the available capital that Zeco can tap into. We also note that the business serves the mining and agricultural sector, but there has been stiff competition from other peer companies.

Further, Zeco’s Delward Engineering subsidiary has been losing projects to firms based in China and India. Other smaller units of the business have also been struggling to grow because of strong competition as well as imports.

Despite the business’ poor performance, there remains an opportunity for speculative traders to ride the penny stock anomaly on Zeco’s stock in the same way that they did with Medtech, NTS and Unifreight.

Mtutu is a research analyst at Morgan & Co. — or +263 774 795 854.