Expand offshore on pure merit, not for growth at any cost
South African business leaders are demonstrating a heightened taste for expansion offshore. That is because the stagnant economy offers them minimal growth opportunities. Yet they are likely to be well rewarded for growing earnings.
Such growth could be helpful to managers. Is it as likely to be helpful to their shareholders? It depends on how much of their capital or debt incurred on their behalf is employed to pursue earnings growth. Unless the extra cash generated by expansion abroad or domestically can confidently be expected to provide a cash return in excess of the opportunity cost of the extra cash invested (cash in for expected cash out, all discounted to the present with proper allowance for the maintenance and replacement of the assets acquired) the investment should not be made.
One wonders how many offshore acquisitions by South African companies can confidently offer local shareholders positive net present values (NPVs). Why then the near flood of such acquisition activity?
Growing earnings or earnings per share may not be helpful to shareholders if too much capital has been expended to realise growth in earnings.
If managers are incentivised to grow earnings regardless of the extra capital employed to do so, it should not be surprising when managers seek growth wherever it can be found, regardless of how much it costs and whether it destroys wealth for shareholders. The golden rule of finance is NPV strategies should be considered, but negative NPV strategies should be declined, especially if they are being made for “strategic reasons”, which often means there are no “financial reasons” for pursuing it.
A further benefit to managers from expansion offshore will be a more diversified flow of earnings when these include earnings generated independently of their South African operations. Full exposure to South African risk may threaten the survival of a business and thus their own employment prospects.
Executives who diversify earnings on behalf of shareholders are not doing them a favour. Shareholders can do it themselves at a fraction of the cost.
South African institutional portfolios subject to a 25% limit to offshore holdings may have a stronger case for JSE-listed companies investing offshore on their behalf. These companies can raise capital on the JSE on superior terms to those available to them elsewhere. They can benefit from a higher share price by catering to the South African institutional investor.
For the private investor able to invest abroad it makes little sense to pay a premium for access to offshore earnings, dividends or the capital appreciation provided by a JSE listing. The private investor can diversify directly, without exchange control constraints, by investing in the most promising of companies listed offshore.
NEGATIVE NPV STRATEGIES SHOULD BE DECLINED, ESPECIALLY IF THEY ARE BEING MADE FOR ‘STRATEGIC REASONS’
Local companies and managers have created great wealth for shareholders by investing offshore. But such attempts should be made on their own strict investment merits; chasing earnings growth regardless of properly measured returns on the capital at risk is not nearly a good enough reason to go offshore. It would be better to return cash to the shareholders by paying dividends or buying back shares or debt and let shareholders decide how they wish to diversify risks.
Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity. This column included contributions from David Holland, Fractal Value Advisors director and adjunct professor at the University of Cape Town’s Graduate School of Business.