A Collective of Nopes: First Edition.

“To have a great idea, have a lot of them.”

– Thomas Edison

Given the myriad of companies available for purchase by investors, and the myriad of investors looking to purchase them, the astute investor must almost always put in some serious legwork to find a bargain.

This legwork can be reduced by creating structural advantages for yourself. These advantages can be anything from where you look to the method you use to search for bargains. Typically, the more eyes watching a company, the more efficient its pricing becomes. Three methods we use of creating these advantages are below:

  1. Operating with the very small amount of capital that we are, we are not as constrained by liquidity and institutional imperatives as are the larger capital allocators. We can leverage this by searching in the small- and micro-cap sectors of the South African market (an often-under-researched market globally).
  2. We are shameless cloners. A core component of our search for bargains involves researching the positions of respected South African hedge funds as starting points for our hunt.
  3. We take advantage of special situations (such as spinoffs and arbitrage mergers) as these are often sources of price dislocations.

The combination of these allows us to narrow down the target universe for bargains. Nevertheless, most of what we do still consists of just trying to “turn over the most rocks”.

Hence, this article outlines some of the rocks we turned over and passed on, as well as a brief reason on why we passed on them. Because of the legwork required to turn over a host of rocks, we try to pass on companies as quickly as possible.

Below are a couple of companies we have passed on in the last couple months.

Curro Holdings (COH)

A tough pass from us. Initially appealing, given the extensive need for education facilities in South Africa and the appealing economics of the business, however a closer look into the capital allocation by Curro’s management has made it a reluctant no from our side.

  • Pros: Predictable revenue and exponentially increasing earnings as schools mature after initial capital outlay. According to Curro’s most recent AGM, if they stopped acquiring or developing new schools today and just let their current school base reach maturity, revenue would grow 70% but earnings would grow by 351% (without factoring in annual price increases which are slightly above inflation).
  • Cons: High leverage required to fund further growth/school development (as expected from an education company). Management has to-date achieved returns of between 0 and 5% on equity, assets and invested capital. These are all below the weighted average cost of capital which has averaged 8.3% over the past 10 years, with 2019 ending at 11.96%.

Per small cap fund manager Kieth MchLachlan: “Curro’s current returns are too low to justify the capital it is deploying. In fact, its returns are even lower than its cost of debt and, thus, the more Curro builds, the more shareholder value the Group destroys.”. This combined with the large amount of leverage makes it a pass for us.

The Lewis Group (LEW)

Another hard pass. Although undervalued on almost all possible accounts, this is a stock we will not want to hold for very long, again due to the very low returns achieved by management. We expect a brief rebound in prices in the short term, but how much and over what time-period we do not know, nor are we interested.

  • Pros: Trading at very depressed prices (PE: 3.47; PB: 0.22; PS: 0.28) despite sitting in a comfortable financial position and having reduced debt levels significantly in the last 3 years. It has good cash flow levels and strong current earnings yields. While credit regulations are increasingly stringent for lower LSM targeting companies, courts have repeatedly judged favorably for Lewis in both credit and competition-based litigation suits.
  • Cons: Declining margins and revenue are indicative of a shrinking or non-existent “moat”. Further, paltry (and decreasing) returns on equity and assets indicate a subpar allocative ability of management.

Ultimately, despite a strong cash position and enticing valuations. the financials here do not indicate a company growing from strength to strength. South African equities offer many a bargain for the diligent seeker, particularly in the wake of COVID-19. However, in the often-quoted wise words of Charlie Munger: “A great business at a fair price is superior to a fair business at a great price”.

Old Mutual Limited (OMU)

We keep a file for companies labelled “Too Hard”. This company went almost directly into our “too hard” box. While it looks undervalued on most accounts (PE: 5.74; PS: 0.3 and PB: 0.71, all well below average for both industry and history), the group structure is – like most banks – very complex and we were not able to understand the operations easily enough.

  • Pros: The company is incredibly cheap both relatively and historically. It has a very high dividend yield of around 10% at current valuations and has been a consistent stalwart in the industry for decades.
  • Cons: The complexity of the business operations immediately flagged that it was unlikely to be of interest. Its returns have been below industry average and it is competing with some of the best financial sector players in the world, both in its banking and insurance operations. Finally, the abrupt sacking of ex-CEO Peter Moyo has caused a legal battle which we are not interested in fighting.

We can conclude here exactly as we did above with the Lewis Group. Some companies are cheap not because they are bargains or overlooked, but simply because they are not worth much.

Rand Merchant Investments (RMI)

RMI is the holding company of all of Rand Merchant Bank’s insurance operations (including investments in Discovery, MMI Holdings, and OUTsurance). It’s a high-quality company, which is trading at a discount usual valuation averages, holding high-quality companies, so we are obviously very interested. We began looking into this company as COVID-19 began to take effect, and while the price began to drop to more enticing levels, we were also wary of the effects that COVID-19 will have on insurance pay-outs and underwriting. Historically, insurance companies have outperformed fantastically post-disaster, but as we are unable to determine the cash flow going forward, we will have to pass.

  • Pros: The company has grown revenue and profit steadily since 2011, is extremely cash generative, has almost no gearing, and stables one of our favourite companies: Discovery (DSY).
  • Cons: Its steep price relative to peers and, much like Curro above, the returns it generates have been outweighed by its cost of capital for the last five years. In short, the company was not adding enough value to justify its expenses.

We will keep an eye on RMI going forward, and should it drop sufficiently in price we may look more seriously into it. The only inhibitor to Discovery currently for us is its price, something we may be able to circumvent should we go via RMI. That day is likely far into the future, if ever.

African Rainbow Minerals (ARI)

African Rainbow Minerals has come up frequently in our research in both Afrimat’s case and AIL’s case. When we first began researching it, it was prior to COVID’s effect on the share price, and we watched expectantly as the share price fell when the virus hit the mining industry. As a renown BBBEE player in an industry which interacts frequently with unions and the public sector, ARM had an interesting appeal.

  • Pros: The share price dropped below what we considered intrinsic value due to COVID. Also, the company’s BBBEE status and diverse product offering hedge it against both union/government intervention and currency fluctuations. Finally the commodity cycle is nearing its lower trough (cf. Afrimat) and mining stocks are leveraged commodity bets.
  • Cons: The company has a high Beneish M-score, making it a possible accountancy manipulator. It also competes in a commoditized industry with stiff competition from other major miners like Impala or Anglo American. Finally, the company is extremely diversified across commodities and, while this has a hedging effect, also makes it complex to evaluate and we were unable to easily approximate intrinsic value.

We like this company but are not comfortable investing in it until we understand the mining industry well enough to approximate its future cash flows and until we are able to clearly understand the accounting.

Woolworths (WHL)

Having fallen on hard times, the once-off JSE darling Woolworths is a company whose product we love. Their share price depreciation has made room for a possible turnaround story should management be capable of restoring earnings to their 2017 levels.

  • Pros: The company is trading at historically low levels and it is likely that any regression to the mean in performance will cause a multiple revaluation. The company has shown good historical returns, has a strong brand and is the dominant player in the upper retail market. And it has stable margins significantly higher than its competitors.
  • Cons: The poor performance of recent years has largely been due to a terrible acquisition spree of Australian companies all of which are causing a large drag on performance and all of which were purchased at very expensive prices. These have caused the company to leverage extensively and it likely to underperform because of this for a while. The large debt on the balance sheet makes the company very susceptible to a global recession brought on by COVID.

We have a strong aversion to leveraged companies, and unfortunately Woolworth’s management have not inspired confidence with their Australian acquisitions. That said, we still like the company, and at a lower price (around R25/share) we may be interested. The current valuation of the Australian acquisitions is virtually nil, and the company is priced as such. Any turnaround in these subsidiaries will likely yield an exponentially improved market price, but for now their drag on the performance of the group is such that we still believe it is overvalued.

Trencor (TRE; Special situation)

Recently, Trencor announced that it would be liquidating its assets (majority cash with a 48% stake in US-based Textainer) and distributing the proceeds to shareholders. Investors can expect three dividends, with the final being paid out latest December 2024. It is a simple liquidation proceeding and the company is holding cash as warranty for assets liquidated to Textainer. As the Textainer unbundling is complete, the company is a cash shell on the JSE.

  • Pros: The company was trading at R7.17 per share with an NAV of R12.18 per share. This offered a 70% upside. The first dividend was paid out on 15 June 2020 at R2.81 per share after liquidating the Textainer shares and the second will be paid at R1.80 per share after the expiry of the warranty. Effectively, after the second dividend we will be paying R2.54 for R7.57
  • Cons: We have no idea when the final dividend will be paid out. There have also been complications with the trust the company owns (in which assets are stored) whereby the trustees asked for an absurd indemnity of $350m (which was negotiated down to $62m). The fact that the trustee’s required this indemnity is not understandable. The trust is based in Lichtenstein and we have no knowledge of Lichtenstinian regulations.

All-in-all, this is a classic Benjamin Graham net-net combined with a special liquidation situation. We are interested, but as yet are saying no until the issue with the trustees makes more sense. We also are wary of not knowing when the latest dividend will be paid out as, when factoring for tax and liquidation costs, we are not able to determine what the final CAGR would be on the investment.

If anyone with special Lichtenstinian knowledge could clarify for us, that would be wonderful because there is (un)certain money to be made here.

EOH (EOH)

Another one-time darling, EOH fell from high heights when the corruption and fraud in its management came to light. It has been a competitor of Alviva, Alaris, AdaptIT, ISA and even Cartrack at points – so broad was the scope of its operations. Being a large cap that tanked, we were interested in the possible turnaround story and had a cursory look.

  • Pros: A new CEO has come in and is rigorously chopping heads and trying to clean up the company, he has changed the business model from a serial acquirer to a corporate and efficient company based on organic growth. This is usually how a turnaround starts. It is an established name in the industry, has ingrained itself into the IT systems of most of its clients and still has a robust operational framework in place. It is also astoundingly cheap, trading at an EV-to-Revenue of 0.1.
  • Cons: The above are just about the only pros the company has going for it. Sometimes cheap companies are cheap because they are really appalling companies. Its net current asset value and net-net working capital are both well into the negatives, making it unlikely to be a Graham-esque candidate. While still solvent, it is deep in distress. The margins and returns are both in the negatives and the damage to the brand is going to be hard to undo.

In summary, we are looking for a wonderful company at a fair price that provides us a lopsided bet. While there is genuine potential for a turnaround in EOH, we are going to be keeping our distance as to invest would require us to put too much faith in the management of a company with a history of corruption.

Stor-Age Property REIT (SSS)

Storage properties are typically a defensive asset class – during a recession (when people lose jobs) they downsize, but because they are hoarders, they cannot give up their beloved items, so they store them in a low-cost facility. Because of this, unlike most REITs, Stor-Age is not subject to key-client risk. It also has a lot going for it in an economic sense.

  • Pros: The company generates about a third of its revenue from the UK, hedging it from the ZAR depreciation. As mentioned, it provides investors with a niche asset class uncorrelated with regular equity. Storage property requires low maintenance costs and has high capex and geographical barriers to entry. The company has consistently been increasing the dividend, carries decent franchise value, has a solid development pipeline and has shown impressive growth over the last few years.
  • Cons: The price has all of the above baked into it. A back-of-the-envelope DCF places the intrinsic value around R15/share (currently R14.25); the share trades around 20% higher than its NAV (which we are unable to evaluate given the diverse locations of their property base) and is trading at a PE of 53.77.

While Stor-Age looks like a good company, it is unlikely to be a great investment over the next few years. It will have to grow at a significantly faster rate than already expected (which it may do, considering the opportunities available and the onset of COVID causing a recession) to make the investment worthwhile. Essentially, we are not going to look too much further just yet, as the company is still too expensive, and the market is expecting too much growth for us to feel comfortable. Again though, this is a good company and we will keep our eye on it.

And lastly,

ADvTECH (ADH)

We wrote quite extensively on ADvTECH in our article on Stadio and the prospects of private tertiary education in South Africa. In summary, there is a ridiculous amount of demand for private education in South Africa and there are only two real players in the space: Curro above, (who later spun-off Stadio Holdings) and ADvTECH.

  • Pros: ADvTECH has a lot of good things going for it. Its tertiary education segment has experienced rapid growth (38% 5-Year CAGR) and is well positioned for the future. It is cheaply priced (8.4x PE with a median of 19.78x); generates very competitive returns on equity and assets; has consistently increased profit and is diversified across sub-Saharan Africa.
  • Cons: Its tertiary segment is weighed down by the schooling segment, which has misjudged the market and has overpriced itself. It has been very aggressively acquiring new land, companies and developments and is consequently carrying a significant amount of debt. Despite being more established, it has not progressed through its J-curve as expected and has not achieved the economies of scale or generated the returns promised to shareholders.

If ADvTECH were to unbundle its tertiary education component, we would be very seriously interested, but for now, its school segment is a drag on performance. The company seems to continuously seek growth rather than return value to shareholders. While it is good to grow the asset base, at some point the investment needs to translate into shareholder value, either through dividends or through an appreciating share price. Since 2017, ADvTECH has done neither.


In a nutshell, our unsolicited advice to South African investors is this:

  1. Avoid companies which rush into foreign acquisitions (e.g. Woolworths, Mediclinic, Netcare, Truworths and Brait).
  2. Avoid companies with confusing financial statements (e.g. Steinhoff and Tongaat).
  3. Avoid the value traps of companies whose ability to return capital is not far more than the cost at which it uses it (e.g. ADvTECH, Curro and RMI).

All said though, hindsight bias is a real thing and its much easier to use examples we passed on (like EOH, Woolies, Curro and ADvTECH) who were once darlings and are now sidelined.

One thought on “A Collective of Nopes: First Edition.

  1. Hi JD, Really enjoy your no nonsense approach with no “holy cows” – having tested the waters there must be some good companies waiting for you to unleash – holding my breath. GP

    Like

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