Boll­worms and share prices

For­get about the PE – check whether banks are go­ing to start lend­ing com­pa­nies money again

Finweek English Edition - - Companies & Markets -

YEARS AGO we had a small cit­rus farm near Mooinooi in North West prov­ince. Mooinooi lies be­tween lo­cal platinum mines. The town and its golf course be­long to Lon­min. We pro­duced or­anges for the Ma­galies­berg Cit­rus Co-op. They ex­tracted the juice from the or­anges and are still the jui­ce­pro­cess­ing com­pany in South Africa that pay the best prices to their pro­duc­ers. One week­end – it was early in Septem­ber or Oc­to­ber – I was walk­ing through the or­chard and no­ticed a small, fresh hole in one of the juicy or­anges. It looked as if one of the neigh­bour­hood’s mis­chievous youngsters had taken a shot at it with a pel­let gun. And, in­deed, on the other side of the or­ange was an­other hole where the pel­let had ex­ited. For a while I pon­dered the ques­tion of who the per­pe­tra­tor of the deed could be. But then I saw an­other or­ange with the same two holes. Then an­other, and an­other and, later, al­most the en­tire or­chard. Then, of course, I re­alised there was some­thing more go­ing on here than a boy armed with a pel­let gun.

I col­lected a few of the or­anges and drove to my neigh­bour. He was sit­ting on his stoep in a mood of de­pres­sion and said just one word when I showed him my or­anges: “Boll­worm.” He went on to tell me that we weren’t al­lowed to sell those or­anges to the co-op and that I had to pre­pare my­self to write off half my crop.

He said he was go­ing to spray his or­chards from the air with in­sec­ti­cide the fol­low­ing week and that that should stop the plague. The good news was that the boll­worms don’t harm the trees in any way. They also eat some of the ex­cess buds, which en­sures a bet­ter crop the fol­low­ing year.

But why the two holes in the or­anges? I won­dered. That’s where the boll­worm en­ters and leaves. The juice was quite OK, he as­sured me, but the co-op wasn’t al­lowed to process it. Be­cause we pro­duce cit­rus juice, not worm juice, con­tin­ued my neigh­bour, who was also a di­rec­tor of the co-op.

I sim­ply had to ac­cept the sit­u­a­tion. All I could do was squeeze out the juice of some of the or­anges for our own use.

Let me try to ex­plain what boll­worms and or­anges with two holes have to do with share prices. First, the boll­worms didn’t dam­age the trees in any way. They weren’t stem­bor­ers de­stroy­ing the en­tire or­chard.

The plague ended by it­self even a week be­fore the air­craft ar­rived to spray the or­chards. Though our crop was cut by a half, the fol­low­ing year’s bumper crop nearly made up for that loss. How­ever, the most im­por­tant thing was that the prices of cit­rus farms in the Mooinooi area didn’t fall at all as a re­sult of the boll­worm hav­ing de­stroyed half of one year’s crop. In fact, prices kept ris­ing, es­pe­cially when my friend Hans, man­ager of the Ma­galies­berg Cit­rus Co-op, man­aged to ex­tract more juice from or­anges ev­ery year and sold it for in­creas­ingly bet­ter prices.

How­ever, if the Mooinooi cit­rus farms had been listed shares, an­nounc­ing a 50% fall in turnover – not to men­tion the loss of profit – their share prices would have fallen by 25%, 50% or per­haps even 75%. Peo­ple who in­vest in shares are a sus­pi­cious bunch. They just don’t be­lieve that it’s boll­worms that are only eat­ing up this year’s crop (profit). Or per­haps two years’ profit.

In­vestors cur­rently don’t only be­lieve that Cater­pil­lar’s cur­rent sales are bad. No, they think there’s a stem-borer go­ing to de­stroy the en­tire or­chard and that’s why the price of this old big gun – which has been pro­duc­ing yel­low trac­tors for many years – is be­ing marked sharply down. There are many sim­i­lar ex­am­ples on the JSE.

Why are in­vestors so sus­pi­cious of a com­pany that has a year or two of hard­ship while the prices of cit­rus farms don’t fall when boll­worms de­stroy one year’s profit?

Con­fi­dence – or rather, a lack of con­fi­dence – in the over­paid man­agers is one rea­son. But the most im­por­tant rea­son for the lack of con­fi­dence is debt.

The busi­ness world out there is much harsher than Hans, the man­ager of Ma­galies­berg Cit­rus. In this cur­rent un­cer­tain cli­mate if a com­pany records a ma­jor loss be­cause con­sumers sud­denly buy less – not be­cause it has a use­less prod­uct (like Gen­eral Motors) but be­cause con­sumers have a bee in their bon­net about some­thing or banks don’t want to give any more credit – in­vestors in the shares also sud­denly take fright. They look at the half crop de­stroyed by the boll­worms and won­der whether the com­pany has suf­fi­cient funds to pay the in­ter­est on its debt. That’s called the com­pany’s abil­ity to ser­vice its debt.

If it looks as if the com­pany is go­ing to come short and may have to bor­row money, in­vestors dis­ap­pear in a flash, be­cause they know the banks aren’t keen to lend new money. Sud­denly, the busi­ness starts fal­ter­ing. The cit­rus farmer can no longer bor­row money to tend his trees be­cause the boll­worms have de­stroyed half of one year’s crop. The trees are ne­glected and die off. And that’s the end of the farm.

The al­most in­no­cent boll­worms, which eat two holes in a nice ripe or­ange be­fore they be­come larva and later turn into moths and fly away, have sud­denly de­stroyed an en­tire or­chard. That’s un­for­tu­nately what’s cur­rently hap­pen­ing in the busi­ness world, be­cause there’s no longer any con­fi­dence.

There are plenty of op­por­tu­ni­ties here for in­vestors in or­di­nary shares. Look for shares whose prices have fallen sharply as a re­sult of boll­worms hav­ing eaten one year’s crop. There are lots of them. For­get about things like earn­ings mul­ti­ples and div­i­dend yields. Look at how much short-term debt the com­pany has and whether it can ser­vice that debt. In a nut­shell: Will the banks lend them money again? If the com­pany has money in the bank, it will still be in busi­ness next year, re­gard­less of the boll­worms.

Sell that cit­rus farm whose price hasn’t fallen and buy those shares.

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