Wrapping up 2013, Opening 2014
So 2013's working year is winding down and, if all goes well, from Saturday I will down at the coast. SmallCaps.co.za will be quiet until I am back in early January 2014, so this will be my final post for the year.
Firstly, to hopefully provide some interesting conversation during this quite festive period, I have started a thread at ShareChat.co.za concerning small caps. Specifically, which small cap will be the next Ten Bagger? I am looking forward to your thoughts in this thread, let's see where it goes.
Secondly, with 2013 ending, it is an appropriate time to look back on the year.
What happened in the market over this period?
Well, I think that from a JSE perspective, I can summarize the year in one single graph (click image to enlarge it):
Sources: I-Net Bridge, SmallCaps.co.za workings
The above graph shows the Price Earnings (PE) for the Top 40, Mid Cap and Small Cap indices since 1 January 2013 to the date of this writing. On the right axis it also shows the USD/ZAR exchange rate (the dotted line).
Basically, you can see how the Top 40 (dominated by multi-national Rand-hedges) actually re-rated upwards from a c.15.0x PE to its current 18.8x. As PE is always historical in nature, this is the market pricing in the weakening Rand. Small and mid caps, though, have a far higher (approaching 100%) exposure to the South African economy, thus is it any surprise that these indices did not actually see their PE's re-rate at all? Both indices made decent returns, but the market remains wary of their prospects given the local economic weakness in South Africa (labour challenges, 2014 elections coming up, inflation, soft residential markets, slowing retail sales, etc).
What does this mean for 2014?
Well, the Rand-hedges dominating the Top 40 should see their earnings (when translated into Rands) rise, assuming the Rand remains weak, thus the Top 40 PE coming off slightly to more normalized levels (assuming everything remains the same). Despite some critics, the data out of the USA points to a steady, but slow recovery. This implies that global trade should continue to recover, despite the Eurozone challenges that may pose shorter term volatility. Hence, assuming no curveballs, China looks like its growth rate may stabilise, if not rise. And therefore commodities (and Africa) still look well positioned.
The real question is, is South Africa well positioned?
Markets are discounting machines, predicting the future through their pricing mechanisms. In other words, assuming pricing efficiency in our local market, the fact that the small and mid cap sectors have not re-rated upwards is a sign that the market is not hugely optimistic on South Africa's 2014 prospects, despite an increasingly comfortable global landscape.
I tend to agree and I expect a tough, low- to negative-returns world for the majority of 2014 in the small and mid cap space.Thus, I do think stock picking in this portion of the market has never been more important (hence the Ten Bagger thread...).
I try not to get too macro in my views. I really am a bottom-up stock picker, so I do not want to linger too much on this macro discussion.
Much more importantly, I had a scroll through the articles I published on this site during 2013 and (of those that are still relevant, as some related to current news) here are a list of just a couple of my favourites. If you have not yet read them, perhaps take the time to:
- The Small Cap Trading Cycle Observation: Because of their low liquidity, small cap stocks sometimes have annual (or seasonal) trading patterns. Just an interesting observation that may help you time your entries (and exits) a little better.
- When to sell your small cap investment: The majority of financial literature focuses on selecting and entering investments, but very little looks at when to sell. This article tries to address that.
- Five Things to Look for in a Turnaround: After the last couple years of tough economic conditions, there are many turnaround stories out there that can be invested in. But, which one has the highest odds of succeeding? Here is a list of some key things to look at to increase your odds of selecting the right turnaround investment to back.
- Gold, platinum, construction or poultry?: Currently, these four sectors are among the most beaten down on the JSE. Surely one or more of them holds value and is worth investing in? My answer may surprise you.
- An Investment Challenge for 2014: As investor (and even traders!) we often churn our portfolios too much, so I have put this challenge together (which I will attempt myself) in order to trying build some positive behavioral reinforcement.
- Introduction to Blue Gem Research: I launched a small side project during the year, Blue Gem Research. Please go check it out. Feedback is always welcome.
Finally, I hope you have a wonderful (and safe) festive season and I will see you in the new year! Thank you for all the support, SmallCaps.co.za could not exist if you did not read it.
An Investment Challenge for 2014
I have an interesting little challenge for you to complete during 2014: do not sell a single share.
If you accept this challenge, then you should immediately be considering a number of possibilities: (1) One or more shares in your portfolio may crash, (2) One or more shares in your portfolio may rise phenomenally, and/or (3) You may find better opportunities in the market to stick your capital into. All three (and, in all likelihood, a combination of) scenarios could all trigger the itch to sell a share.
So why is not selling so important?
Ignoring the obvious tax savings (CGT is only triggered on disposal of an asset) and brokerage savings (only triggered on buying or selling a share), there are much more subtle reasons for this challenge.
Firstly, if you accept this challenge, go and have a proper look through your portfolio. While we all drone on and on about "the long term", often we find ourselves managing our portfolios, investments and stock positions in real-time. Real-time is, by its nature, short term. If you are forced to hold the current stocks you own (and any new ones you buy) for a full year before selling, it does force you to evaluate them with a long-term perspective.
You are forced to look at your current portfolio and ask: "Is each one of the companies whose stocks I own worth holding for a year?"
Secondly, this drives you to consider the single most important ratio in the entire global financial market: Risk/return. While a stock that is 5% undervalued right now may sound like a good buying opportunity, is it? A 5% value uplift may not be worth the downside risk that may drag the share price even lower with a time horizon longer than a year.
Making long term investment decisions based on short term share price movements is just plain lunacy.
In other words, a longer time horizon makes you focus less on your entry points and more on the underlying company. After all, the underlying company is what you are actually buying and in the long term fundamentals drive valuations that drive share prices that drive returns... Hence, focusing on the fundamentals for long term investment decisions is logical.
Thirdly, the combination of all of the above is that your investment decisions become far harsher, far more critical and, in all likelihood, better quality. Better quality investment decisions will probably lead to better performance and a richer "Future You".
In conclusion, I am going to try this challenge myself. I have re-evaluated my portfolio and I am comfortable I could hold it for the next ten years, let alone the next twelve months.
That said, things can always change and not selling a single share in 2014 may be a little more challenging than it sounds. I suspect 2014 is going to be quite a volatile year, especially in South Africa. Volatility implies quickly changing price levels that often creates exit itches for market participants.
Even if I (or you) don't succeed in this challenge, it should at least lower my (and your) portfolio churn. Given that "over trading " is one of the greatest erosive factors in long-term returns, lowering portfolio churn can only be a positive.
I will report back on this in a year's time.
What's up with Ellies?
The share price of Ellies (ELI) started this year at 793cps, rallying all the way up to 1000cps before a strong sell-off over the latter half of this year has seen its fall to its current range around 600cps. And this movement is coming from a share price that three years ago was around 200cps.
So Ellies has been a volatile share in both directions, making it a topical stock for small cap investors with some quite vocal proponents for and against it.
So what are the arguments for and against Ellies investment case?
Ellies is really made up of two businesses: the Consumer Goods & Services (CGS) segment and the Infrastructure (Megatron) segment. CGS trades in electronics with a focus on audio-visual as highlighted by its core brand, Elsat, that supplies the majority of satellites in South Africa. Megatron really builds substation for the power infrastructural market in South African and across Africa.
In FY 13, Ellies' CGS won a large portion of Eskom's Residential Mass Roll-out (RMR) Phase 1 that saw it replacing old lights in buildings with energy efficient lights, thus saving the national grid a good amount of power. This contract was once-off, lumpy and quite substantially lifted Ellies' CGS profits during the period. Now CGS is about two thirds of the Group's profits, so this helped Ellies produce a strong FY 13.
The problem is that Eskom's RMR Phase 2 was pulled and its Phase 3 is now (by the sounds of it) off the table for good. So Ellies will have no RMR revenues flowing in FY 14. As RMR revenues flowed during H1:13, this will likely make H1:14 look significantly worse. Add to this that the local consumer is under pressure, therefore CGS's volumes to its predominantly retail client-base may be softer, and you get the argument for a bad FY 14 set of results coming through (or, at least, a bad H1:14).
But then again, if you're investing base only on the next six month's results, well...you're not actually investing, you're actually trading.
The bigger picture is that Ellies' FY 13 results actually saw a weak result from Megatron where its profits dropped 10% due to revenue timing issues. These revenues timing issues are likely to push the revenue to being booked in FY 14, thus this fact (as well as Megatron's strong order book at the end of FY 13) will likely lead to a strong FY 14 for Megatron.
So there are no RMR revenues during FY 14, but the CGS segment is so much more than just an ad hoc Eskom contract or two.
Ellies’ Consumer Goods & Services (CGS) segment is a fully-fledged supplier of select consumer electronics to the local (and some African) retail market(s). A steady expansion of product range has helped the business grow faster than its respective market, taking market share from other players. CGS's revenue has a CAGR of c.13.7% against the relevant retail sales data pointing to a market growth rate of c.1.9%.
OVHD was launched in South Africa during October and the units are sold at c.R1,000 per unit with the retailers able to place a discretionary mark-up thereafter. The take-up of OVHD has apparently been slower than usual, but an adapted marketing campaign is to be launched soon and management remain fairly confident that this will help lift volumes towards the expected 500,000 to 600,000 units per annum mark. Just a steady-state volume of OVHD at these anticipated volumes would add c.50% to Ellies' CGS revenues. And, even better than the once-off Eskom RMR revenues, these OVHD revenues are less lumpy and more annual or operational in nature.
Digital Terrestrial Television (DTT) is also an eventual reality. The world will not wait for South Africa and the 2015 deadline is fast approaching. Sure, so Ellies pre-stocked for DTT and is having to (successfully) move the DTT boxes into Africa to free up working capital. But DTT is not going away and sooner rather than later will be put out into the market. If just 500,000 OVHD units make this much different to Ellies, it is worth lingering on the estimated demand for DTT will be about 11,000,000 units.
And then there is the fact that Ellies's CGS segment has been steadily growing its range of products and, actually, has a very healthy position for the long-term with key relationships into all the big retailers and a comfortable distribution network (including effectively off-book installers who run themselves as SMMEs).
Getting back to what is likely to be a bit of an artificially weak H1:14, if you're investing base purely on the next six month's results, well...then you're not actually investing, you're just trading.
In the longer-term, a bigger risk to Ellies is not volumes or results, it is actually more likely to be financing. When you already have a stretched balance sheet trading in overdraft, how do you finance a working capital intensive business when all its blue sky cylinders all fire at the same time? There is so much blue sky tied up into some many initiatives in Ellies, that the concern of financing all of them is (in my mind) a much greater risk than some soft H1:14 results.
Which Small Cap Asset Manager to Buy
Recently in popular media there have been a number of articles complaining about asset manager, fund manager and unit trust fees. Some of the journalists points are valid, some of the points are bias and some of the points are ill-informed. But, the reality is that despite how expensive these services may appear, they offer a very valuable service that most people (and products) cannot replicate (after taxes, brokerage fees and the opportunity cost of time).
But I am not going to enter that debate. Rather let me suggest that instead of complaining how expense asset managers are, why not just invest directly into asset management businesses?
All the asset (and wealth) management listed on the JSE can be considered small caps (Coronation's market cap of c.R28bn, though, qualifies it as a mid cap), so how do they all measure up?
In the above graph (click on it to open a larger version in a separate window) we can see a strong correlation between both Assets Under Management (AUM) and Price Earnings (PE), which is perfectly logical because asset management's business model has a fair amount of operating leverage in it; as AUM grows the firm enjoys significant returns to scale that make it more profitable.
Not just that, but an asset manager earns revenue off its average AUM for a financial year plus its performance fee, thus a high market rating for an asset manager can be a sign that the market is factoring in a large inflow of AUM, an excellent performance by the asset manager (thus lots of high margin performance fees being earned), or both.
Also, the style of asset manager, its major mandates (i.e. funds), the structuring of fees, and its performance in the market all affect the asset manager's ability to earn revenues off its AUM. For example, passive, index-like and low maintenance mandates (e.g. quant-based) all attract a very low management fee and often next-to-no performance fees, while a highly active, very aggressive mandate would need far more active involvement by a fund manager and thus would attract a much higher management fee with a large weight given towards a generous performance fee.
All of this should be quite logical, but how does it relate to the locally listed asset management stocks?
At a high level, Coronation (CML) stands out as a largest of the independent listed asset managers, but it also is the highest rated in the market with an 18.8x Price Earnings (PE) and an extremely high Market Cap to Assets Under Management (MC/AUM) of 5.8%.
While this implies that the stock is expensive, Coronation has had massive AUM inflows in the last couple months of FY 13. The AUM was mostly retail-related (thus more fickle and riskier, albeit it at a higher margin than institutional money) and if it remains at Coronation for the full FY 14, thus Coronation could get a full twelve months' worth of asset management fees from it (and perhaps performance fees). The market has obviously given Coronation the benefit of the doubt and is pricing this in, along with performance fees and, perhaps even, further AUM inflows during FY 14.
Overall, while Coronation is undoubtedly a well-run business, I think the share price is too fully priced. Unfortunately, the market pricing in all of the above implies downside risk if but one of the variables does not materialise, let alone all three (i.e. average AUM, AUM inflows and performance fees).
On the other end of the scale and around 280x smaller than Coronation, Efficient Group (EFG) is trading relatively low versus its AUM (I've assumed that Efficient's recent acquisition of VIS is unconditional and I've taken into account the increase in Efficient's post-acquisition AUM, shares in issue and market cap accordingly). But, Efficient's PE is way out of sync with the market average to its AUM. This is probably a symptom of the Group's small size limiting its profitability and the market betting that AUM inflows will occur and returns to scale will lift that profitability.
Efficient is really trying to build a broader financial services business, mostly geared towards private clients attracted to the business as a turnkey solution for all their needs. In a way, this is moving Efficient close towards what Peregrine's Citadel does (see later on in this article). These client needs, though, will include asset management.
VIS has not been incorporated into Efficient for a full reporting period, thus I cannot tell what fees the Group will be able to earn off the acquisition (VIS was bought for R72m or c.1.35% of its AUM). I have calculated Efficient's fees in its FY 13 year (i.e. future fees as a % of AUM may differ quite markedly). In this case, Efficient is either very profitable earning double everyone else at 1.9% of AUM (unlikely), or it experienced outflows of AUM towards FY 13 year end (or when its disclosed its AUM with the VIS acquisition). The latter would explain the revenues earned from AUM that was not reported at period end. If this is the case, it bodes badly for FY 14 as average AUM should be lower (excluding VIS's contribution, that is...).
Overall, Efficient is an interesting business, cheap on a MC/AUM-aspect (post-VIS deal) and it comes with a wider wealth management aspect (the rest of the Group). But it really is early days for Efficient and the market is perhaps being too optimistic from a PE-perspective. Smaller asset managers are always more susceptible to outflows than their large competitors, particularly if their funds' performance lag for just a moment. Finally, there is the qualitative fact that the share is just so illiquid that a series of very questionable share dealings by Efficient management basically single-handedly raised the share price from c.105cps in May 2013 to around over 150cps by mid-2013... Actions like these don't make me feel all that comfortable with management.
Then there is the newest listing in this space, Prescient (PCT), which was piecemeal reverse listed over the course of the last two or three years. Prescient includes a stockbrokerage and an administration business, but its core asset management business has historically be quant-base. This reflects in the Group's fees as a percentage of AUM being 0.7% and the low rating against its MC with a MC/AUM of 2.3%. (Prescient's revenue as a % of AUM is the same as Coronation's revenue % of AUM, but my calculations are done on AUM at year-end. Coronation's strong AUM inflows towards the end of FY 13 likely generated very little revenue, thus artificially lowering Coronation's revenue as a % of AUM.)
The reality is that Prescient is trying to evolve from a quant manager to an active manager, thus they are risking AUM outflows from clients who specifically want a quant mandate (with low fees), as opposed an active mandate (with high fees). On a risk adjusted basis, it looks like the market is being fairly neutral about the success of this transition.
Prescient has also attempted to move overseas and made some acquisitive moves which have not panned out very well for the Group. This, though, does distort a number of these ratios and, overall, I think that Prescient is currently probably fairly valued. That said, if both the international expansion starts to gain traction and the transition to a high margin active manager works smoothly, the stock could well be cheap.
Finally, that leaves Peregrine (PGR), which I have liked as a stock for quite a while (Peregrine Holdings Ltd). Peregrine is not just a local and international asset manager, but also holds Citadel (private client wealth business), Peregrine Securities (prime brokerage) and various other interesting assets that all have value, but do not all have AUM.
This latter reason is the reason that Peregrine looks expensive from a MC/AUM perspective, but looks cheap from a PE perspective (because some businesses add quite significantly to its earnings and valuation, but do not have AUM and thus do not add to MC/AUM).
What is interesting to see is that Peregrine actually earns more than its larger competitors off its AUM, being 0.9%, and, in fact, its Stenham subsidiary makes a large portion of the business actually a rand hedge (while admittedly lowering the revenue as % of AUM given that Stenham has a HFOF business that has large AUM and low fees). As an interesting side note, Peregrine has also recently bought into Cannon Asset Management.
Overall, Peregrine earns attractively out of its AUM while not being as highly rated against it as Coronation. The Group also looks cheap against its earnings and has some other other exciting assets in its stable that (as a common theme) all benefit from bullish financial markets.
Now, partly because of its small size, but also because its ratios are so out of line that it would distort the graph, I have not included Purple Capital (PPE) into my above graph. After disinvesting from Voltbet and some restructuring, Purple Capital is essentially a small asset manager (Emperor Asset Management and GT Private Broking) with a stockbrokerage arm (Global Trade).
Purple currently trades at an MC/AUM of 44.7% (largely due to the majority of its underlying valuation leaning towards Global Trader, which as a stockbrokerage has no real AUM) and earned revenue of 19.6% of AUM during FY 13 (once again, distorted by Global Trader). Specifically to Emperor Asset Management, though, the business earned only 0.8% of AUM, which the high fees being generated out of the other two businesses. Purple Capital also has a PE of 88.9x.
In conclusion, don't moan about fund management fees, just invest into the asset management businesses. There is an interesting selection of locally-listed asset management groups on the JSE, all moving in different directions and with a quite a wide range of relative valuations. Efficient Group may be interesting if they manage to get critical mass and sort their management credibility out, while Prescient is on surer footing, but must proving it can transition to an (international) active manager. Coronation has been a shining success story that the market has priced for perfection, while Peregrine is perhaps an overlooked stock that appears more attractively priced.
Great small caps that will probably be bad investments
Great companies can be terrible investments if you pay too much for them.
EOH Holdings (EOH) is a good example of a ICT service firm that consistently produced growing profits backed up by strong cash generation. It is also a stock that has re-rated from an arguably very attractive Price Earnings (PE) of only 9.7x in early 2010 to its currently unattractive PE of 26.6x.
EOH reported FY 13 revenue growth of 40% to R5.1bn (FY 12: R3.6bn), lifting HEPS by 35% to 339cps (FY 12: 253cps). The Group’s growth was once again driven by its Services segment, which saw segmental revenue rise 55%. Software and Infrastructure both grew in the low teens and remain about a third of the Group’s revenue base.
I have attempted to exclude acquisitions made during FY 13 (and those that were not fully consolidated during FY 12 that are fully consolidated in FY 13) in order to get a clearer picture for EOH's core growth rate. Interestingly, I estimate that the Group’s organic growth rate was a reasonable 12% during FY 13 (the ICT market during this period grew roughly 10% in nominal terms or c.4 - 5% in real terms).
So, all in all, yet another good set of results from EOH. But is it worth a 26.6x PE?
Most investors erroneously view EOH as a “tech stock”, while I actually believe that the Group is best considered a service business operating predominantly (but not exclusively) in the ICT sector. For this reason, I think an international comparative for the Group is Accenture Plc.
My DCF model for EOH arrives at a fair value at 4968cps, implying a (generous) PE of 14.7x. This is more or less in line with Accenture’s own PE of 15.6x, with a slight discount for EOH’s smaller size, partially offset by its growth rate.
So, why would an investor pay the current 26.6x PE for EOH stock in the market if they could pay 15.3x PE for the 80x bigger Accenture Plc?
In other words, in the long-term, buying into EOH at these levels is not likely to be a great investment.
Blue Label Telecoms (BLU) is quite an exciting IP-rich business whose Local Distribution segment distributes around half the prepaid airtime in the South Africa (along with a growing basket of other virtual goods), while its International segment offers greenfields optionality into India and Mexico for replicating this business model overseas.
Airtime is really just a functional form of currency backed by telecos networks, thus it is a highly defensive commodity (much like food and water). Also, Blue Label's distribution network in South Africa is of such a scale that the local telecos cannot afford to not deal with the business.
Much like EOH, though, Blue Label has seen its share price rise over the last couple years up from a 9.9x PE to a its current 14.0x PE. This was partially perhaps driven by the recent asymmetrical pricing announcement in the local telecos market, but also over the last couple years been due to a series of good results by the Group.
In Blue Label Telecom’s FY 13 results, revenue rose 2% to R19.0bn (FY 12: R18.7bn), but accelerating growth in the Group’s “agent” revenue (PINless airtime and electricity) artificially hid the real revenue growth (actually closer to 6% in like-for-like terms). The expanding profitability of the Group was obscured by IFRS-dictated HEPS remaining flat at 64.17cps (FY 12: 65.4cps), but in fact, if the prior year’s large once-off payment (in the Group’s Mobile segment) is excluded from the prior year numbers, operational HEPS actually rose by c.17%.
So, all in all, yet another good set of results from Blue Label, but is it worth a 14.0x PE when you can buy Vodacom (VOD) on a 12.7x PE?
My DCF model points to a fair value for Blue Label Telecoms closer to 759cps, implying a PE of 11.8x that would put it much more in line with the local telecos market. Perhaps I am undervaluing the international operations? Perhaps not, it is hard to say with certainty. But, I do think that I would not be paying 900cps or a 14.0x PE for Blue Label Telecos at present.
Another great company is Afrimat (AFT), which has not just weathered the contraction of the local construction sector, but utilised its balance sheet to consolidate the sector at attractive valuations, extract value from these additions to the Group and, actually, evolve from an aggregate player to a geographically diversified open cast miner supplying aggregates, industrial minerals and readymix into the local market.
While the Construction Index has fallen by c.9% over the last three years, Afrimat's share price is actually up 270%! More subtly, Afrimat's share has re-rated from a PE of only 6.9x to its current PE of 14.7x.
This is undoubtedly a good Group constructed and run by a strong management team, but is it worth investing in at these levels?
Afrimat's working capital is actually exceptionally well managed, but the capex requirements of the Group do draw quite heavily on free cash flows. All in all, though, my DCF model points to a reasonable fair value of c.680cps implying a PE of c.7.4x for the share. That is almost 50% lower than where the share price is current trading. Even if I optimistically raise the implied PE to 10.0x, this is still well below where the share is currently trading.
If my fair value pointed to only a few percentage points of over-valuation in Afrimat's share price, it might be forgiven as the market adding management "alpha" to the stock (for example, factoring in the turnaround option value for Afrimat's investment in Infrasors). But my fair value points to just such a large gap between intrinsic value and share price that it is likely that Afrimat will not be such a great investment at these levels.
Finally, Howden (HWN) is a great little engineering business with lots of human capital producing IP that sells into the mining, industrial and related sectors in South Africa (and the world). Although currently small, the Group's initiatives in the "green" market have nice upside, while the Group's international backers have deep pockets and could drive quite a bit of business the Group's way.
The stock, though, has re-rated from a 8.0x PE three years ago to a current PE of 15.4x as the share price rose by 325% over this period!
Once again, working through a DCF model I arrive at a fair value of only 2640cps for Howden, implying a PE of 9.6x for the share. This is quite far below the current share price of 4251cps and, despite being a great business, it makes me doubt that Howden will make a great investment at these levels.
I repeat, great companies can be terrible investments if you pay too much for them.