Solid research can help bypass hysteria of short-selling periods

• A disciplined, thorough investment process must inform decisions to avert disasters

Activist short sellers have been a prominent feature in stock markets for many years. It is easy to get caught up in the hype when their ideas hit the news, but a disciplined investment process, applied consistently over time, helps to overcome the temptation to pile in (or out) based on the headlines.

In December 2017, an American investment firm, Viceroy Research, published an explosive report on Steinhoff International just as the company announced a delay of its financial results due to accounting irregularities and the immediate departure of its CEO.

The dramatic collapse of Steinhoff’s share price that followed inflicted large losses on shareholders, and Viceroy’s serendipitous timing allowed it to claim a major scalp for activist short sellers.

Trepidation and rumour quickly spread when Viceroy announced shortly thereafter another pending research report on a major listed South African company. This caused large share price declines in Aspen Pharmacare and the Resilient stable of property companies. A report on Capitec Bank triggered a more than 20% share price fall in its aftermath.

However, an investment philosophy that involves proprietary research for every share that is considered for investment in client portfolios leaves fund managers such as Allan Gray well positioned to deal with the fear and speculation caused in an era of increased public activist scrutiny.

Assessing the risk-reward trade-offs and margin of safety is a key consideration of our investment process, which has been refined over many economic cycles but remains dynamic. We are always trying to learn from our mistakes and to make improvements. Responsible investing considerations form an explicit part of the investment process.

The value of this investment philosophy and process can be illustrated using examples of companies that were the subject of recent short-selling rumours:

● There was a massive increase in Steinhoff International’s issued shares, intangible assets, debt and employees as the business grew and made acquisitions. Important shareholder metrics such as return on equity (ROE) and growth in earnings per share (EPS) were, however, uninspiring. ROE declined from 20% in 2007 to only 9% in 2017 and EPS grew by only 17% in euros, or 1.6% per annum.

During this period, Steinhoff went through the full Allan Gray investment process on six occasions. This was in addition to the regular review of company results, news events and management meetings.

Numerous warning signs and inexplicable actions flagged Steinhoff as a high-risk and below-average prospective investment. Disappointingly, in October 2017, with the stock down 40% relative to the market over 18 months, we believed the price was sufficiently low to justify a small (less than 1%) position in client portfolios. Due to the risks, a strict limit was placed on the maximum possible exposure to Steinhoff. Although this didn’t make us feel any better about the outcome, it did help to avoid a bigger loss.

An example demonstrating the value of a robust investment process amid uncertainty and activist short-seller rumours is the Resilient Reit property company. The substantial historical premium of the share price over net asset value (NAV) shows the very high expectations the market held for Resilient. This implied little or no margin of safety for shareholders in the event of any unforeseen events — despite a number of potential risks that were identified during our research process.

This included a cross-shareholding structure between related companies with everchanging holding sizes. The market was also placing a premium on Resilient’s shareholding in other firms already trading on a premium themselves.

Both Resilient and the underlying cross-shareholdings are funded partly by debt, which means the ultimate returns for shareholders are geared more than once, increasing risk. The business model requires continuous and substantial additional capital from the market.

Distributable income was of below-average quality and actual cash flows were below the level of declared dividends.

Resilient derives a substantial portion of its income from sources we classify as of a low or medium quality. Actual cash flows covered 78% of the most recent dividend as “low-quality” sources of income, including the fact that interest earned on loans granted is recognised as income by Resilient, even though it does not receive actual cash.

The actual cash flows of peer companies more closely reflect their distributable income declared as dividends.

With no margin of safety and some material risks identified in the investment research process, Allan Gray holds no exposure to Resilient Reit.

Short-selling activists such as Viceroy perform a useful function by making people more aware of the potential risks in shares such as the two examples shown here. They should hold no fear for the diligent, active fund manager, nor for the rational, disciplined investor. Doing our own work to understand the risks, potential returns and the margin of safety are part of the research effort.

We don’t always get things right, but having a robust process for assessing value and a philosophy that has been proven over long periods allows us to make up our own minds about which shares to avoid and where to take advantage of large short-term share price declines.

The ability to limit or avoid losses from permanent capital destruction, as occurred in the cases of Steinhoff and Resilient, can be as important as finding the next big winner.

DOING OUR OWN WORK TO UNDERSTAND THE RISKS IS PART OF THE RESEARCH EFFORT