Financial Mail - Investors Monthly
NO HALF MEASURES
Going long and short on the JSE
“There were a few shares that fell sharply … which highlights the danger of applying a one-reason-fits-all approach to increased levels of debt
As the days shorten and we spend more time indoors, IM felt the need to put out a piece that elicited debate and discussion, whereas previously this time would have been devoted to outdoor pursuits.
The basic idea is to buy (long) a basket of shares that has fallen precipitously, and sell (short) a basket that still appears to be expensive based on prevailing operating, valuation and growth metrics. John Biccard summed it up at a recent Investec presentation: “Buy humility, sell hubris.”
To make it more interesting, an investment bank was approached to see whether an instrument holding the basket of longs and shorts could be put together for investors. Unfortunately, it declined. After the financial crisis of 2008 banks do not like to tie up capital in the pursuit of frivolity.
Second, many do not like to be seen shorting the shares of their clients … at least openly. That may also explain why investment banking analysts seldom put out a sell recommendation on a share.
Finding shares to populate the long basket was easy. There are a plethora of shares trading at less than half their 12-month highs. Extend the time frame to 24 months and the list grows — in number and magnitude of decline.
Most of the shares populating the list had the following common denominators: high levels of debt arising from acquiring assets (foreign, domestic or both; weakening trends in return on invested capital, or ROIC (some to levels well below the company’s cost of capital); and worsening asset turn numbers (balance sheet growth was rising faster than
that of the revenue line).
The investment community must shoulder some of the blame for creating a vicious circle, where consistent earnings growth was rewarded with an ever-expanding p:e multiple, and by definition an ever higher share price. P:e-to-growth (PEG) ratios of 1.75 and above should have been one warning flag, as should the marked deterioration in the quality of balance sheets — neither of which were heeded by many.
Directors, executive or nonexecutive, must also be held accountable. There is no justification for grossly overpaying for assets. Using the moribund state of the domestic economy, the need to externalise balance sheets, the uncertain political landscape and poor economic policies as excuses is trite. If management is uncomfortable retaining cash for future opportunities that offer an appropriate return on capital, rather than destroy shareholder value, return it to shareholders and let them decide what to do with the money.
Corporate governance failures compounded these sins, leading to the worst possible result. EOH is a case in point. It peaked at R178, and is now trading around R10.
There were a few shares that fell sharply for reasons largely unrelated to the above, which highlights the danger of applying a one-reason-fits-all approach to increased levels of debt. Keeping abreast of changing technologies so as to remain relevant and competitive often necessitates borrowing. A substantial investment in a new plant enabling raw material input costs to be better controlled, with a concomitant increase in margins once completed, is another reason to borrow.
At Berkshire Hathaway’s annual meeting with shareholders, Warren Buffett focuses on what they got wrong before moving on to what they got right. I have set that as one guiding principle in helping to select the basket of longs. If one does not acknowledge a problem, the chances of remedying it are slim.
Second, steps must have been implemented to address the failures — be it a change of leadership, strengthened boards, strengthened capital structure, strengthened human capital and improved procedures and controls (governance, financial, risk and compliance).
Now here is the interesting part: the selection of the basket of longs and a brief reason substantiating the selection (depressed price aside):
● Aspen — 43,800c high /9,800c low
● Mediclinic — 21,800c/5,800c
● Nampak — 4,500c/1,000c
● Omnia — 23,900c/4,900c
● Sasfin — 7,500c/3,400c
Prices shown are all-time highs versus the current price
Aspen: Trading on a earnings multiple of 7.4 times trailing, the debt-to-equity ratio remains high (102%) and the company is awaiting one final piece of regulatory approval for the sale of the infant formula business, which will de-gear the balance sheet to more comfortable levels. Cash generation in the second half should improve, reducing debt further. More sales are anticipated as it disposes of assets no longer fitting its revised strategy.
Mediclinic: IM expects an improved operating performance from the United Arab Emirates. The earnings multiple has unwound from 30 times to a more modest 10 times.
Nampak: Trading on a multiple of just 6.5 times. But debt has been reduced to 60% from 75% two years ago. The group is currently under a cautionary for the disposal of the glass business. If consummated, that will have a material impact on debt and relieve the company of an asset it has battled to optimise.
Omnia: Debt has increased to 58% as the group invested in a nitrophosphate plant. But the
“Directors, executive or nonexecutive, must also be held accountable. There is no justification for grossly overpaying for assets
lower input costs arising from this investment will positively affect margins in the agricultural division from the second quarter of next year. Second, it made two sizeable investments — one in an environmentally friendly agricultural business and the other in cleaner petroleum technology. Both will benefit from the group’s distribution footprint and the move to a greener planet.
Sasfin: Trading on an earnings multiple 7.2 times and price-tobook ratio of 0.72. Senior appointments have been made to address a key weakness — deteriorating metrics in the loan book. Improved ratios were evident in the recently released interim results.
Braver investors might also want to consider adding Ascendis Health and EOH. They are trading 86% and 94% below their respective 48-month highs.
Remedial action has been taken in both cases and remains ongoing. In the case of the former, IM awaits the resolution of steps taken to address debt concerns, and in this regard the disposal of Remedica would substantially improve the capital structure. But it would also mean the loss of the group’s jewel.
Moving to the trickier task, that of selecting the basket of shares to fund the long positions. The basis of selection was to search for shares with high double-digit earnings multiples that are delivering single-digit or no growth. In other words, shares with high PEG ratios. Preference was given to shares with high levels of debt where PEG ratios were similar.
The selected basket of shorts: AB InBev: The share is trading on an earnings multiple of 39.6 times. The debt-to-equity ratio is high at 158%. Some key metrics worsened year on year — notably the net profit margin at 8% (14%), inventory turn 4.8 times (5.2) and ROIC 3.2% (4.8%).
Dis-Chem: The share is trading on an earnings multiple of 30 times trailing. Year-on-year headline earnings growth was 6.1%, meaning a PEG ratio of 5. It is an extremely well-run business, but the valuation concerns IM, especially given the constraints on disposable income and a solid competitor in Clicks.
Pepkor Holdings: The share is trading on an earnings multiple of 22.5 times. The group may benefit from consumers shopping down — but an earnings multiple above 20 concerns IM in a retail environment where opportunity for meaningful earnings growth is unlikely, with little sign of it improving in the near future (if anything it may worsen).
Richemont: The share is trading on an earnings multiple of 31.4. Growth was -2% year on year. The unresolved trade war with China has resulted in global trade falling, and the International Monetary Fund recently downgraded growth prospects for 2019 and 2020. This is not a reflection on the quality of management and the business, merely a valuation reservation given the prevailing economic conditions.
“The basis of selection was to search for shares with high double-digit earnings multiples that are delivering single-digit or no growth