Last bite at the cherry

123RF/mixxx83

Another monetary policy committee meeting, another interest rate hike. The prime rate is now 11.75%, more than the average return delivered by the JSE over the past five years even on a total return basis (that is, including dividends).

Before you fetch the pitchforks and torches, I’m well aware that I just took a spot interest rate and compared it with an average return in a different asset class over a period of time. I’m not suggesting that the average return over the past five years would’ve been better in a notice deposit than on the JSE, as interest rates weren’t high enough over the period in question.

I am suggesting that over the near term, a notice deposit (or some other type of yield-focused investment) may give a better outcome than broad exposure to the local equity index. Understanding cycles is important here. In a low-rate cycle, equities tend to do better. Would you like to guess what happens in a high-rate cycle? I have specifically referenced broad exposure, as a successful stock-picking strategy is always the most profitable opportunity of all. If the rewards weren’t lucrative, there wouldn’t be so many people who dedicate their time and intellect trying to pick relative winners and time their entry and exit points. To understand why I’m nervous of broad exposure in South Africa, you need to understand how cash flows into and out of a business, particularly during a time of relatively high inflation and interest rates. This is before we even get into the other pressing issues, such as loadshedding or our government Putin us in the global firing line on a regular basis. Debt providers such as banks get the first bite at the economic cherry of any company. Interest must be paid or life becomes difficult and the bankers slowly start to take over the company. Shareholders get the last bite, which is sometimes large and juicy and sometimes just a sad stem with red stains on it, much like the status of many portfolios in this environment.

Rare beasts

The worst kind of equity cherry in this environment is a company with little or no pricing power. This is dead man walking stuff, with margins disappearing as costs ramp up and sales volumes drop under economic pressures, with no pricing increases to make up for the pain. Companies that produce commodities can easily experience this nightmare if the commodity in question isn’t increasing in price. Local poultry industry, anyone?

If we take a better scenario for shareholders and assume there is sufficient pricing power to at least drive consistent operating margins, we find a scenario where operating profit will grow in line with revenue. In an inflationary environment that’s quite useful, as revenue is probably increasing as general prices go up. Over the top half of the income statement at least, there’ sa good news story for shareholders even if there is no operating leverage (that is, operating margins stayed the same).

We then get to the net interest cost, which has possibly as much as doubled year on year. In many companies, we’ve seen interest costs increase at a much faster rate than prevailing interest rates. This is because as balance sheets have grown, so too have debt levels. Now, for as long as return on assets is higher than the cost of debt, shareholders shouldn’t be upset about the use of debt to fund assets, provided overall debt isn’t at worryingly high levels. This is why companies will still pay dividends while happily taking on more debt to fund the larger balance sheet.

The best way to see this in action is on the statement of cash flows, where you’ll be able to witness the impact on operating cash flow of investment in net working capital. You will also find the movement in borrowings over the period in question. Where debt is manageable, you’ll typically find growth in headline earnings per share (HEPS) at a slower rate than growth in operating profit because of net interest costs. Where debt is problematic, you can find a negative HEPS movement where operating profit increased only modestly.

The winners in this environment are the highly cash-generative businesses extracting operating leverage. They are rare, often overvalued beasts as investors desperately flee to them for perceived safety. A great company that is overvalued is perhaps the best example of how cruel the market can be, with shareholders losing money anyway.

Personally, I’ve reduced my overall equity exposure in favour of yield-focused investments for now.