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South Africa

What is our potential?

Last week Lesetja Kganyago, the South African Reserve Bank Governor, announced that they are cutting the repo (lending) rate by 0.25% to help the stressed South African economy. That’s seems too little to give the economy a real boost. But what he said next could give the economy a substantial boost. Mr Kganyago said that government should do its bit by delivering long-promised structural reforms. Only with structural reforms can the potential economic growth be lifted from its current dismal 1.05% to the targeted 3%. There is one obvious question: how is potential economic growth calculated?

The potential economic growth is an estimation at what rate the economy should be able to grow over a long term. Naturally the GDP growth rate can vary. Sometimes it is higher than the potential economic growth rate, although this creates stress factors such as higher inflation. That is not a worry for South Africa though, since we are battling to get the growth rate anywhere near our potential.

This leads us back the most basic question: how is the potential growth rate calculated? The potential growth rate of a country is the population growth plus the productivity growth rate. In South Africa’s case, the population growth rate is 1.2% and the median productivity rate is -0.15%. Therefore, the South African potential growth rate is 1.05%, far below the 3% president Ramaphosa promised and the 4% that the IMF suggest is needed to escape the middle-income trap. While it would be foolish to suggest that the answer to the poor economic prospects is to grow the population (although the Zambian president suggested this), it would be right to look at improving the productivity growth. To do that, as the SARB governor said, we need structural reforms.

Productivity growth is made up of the following: capital stock, human capital and technology.

Take capital stock. South Africa is notoriously incapable of using our natural resources efficiently. We largely missed out on the resource boom between 2003 and 2007, and have not increased our output by much since. In fact, most mines have been forced to retrench workers and close mines over the last 10 years, because it has become so unprofitable to mine here. That is mostly due to increasing electricity and labor cost, hostile government administrators and a muddy system of mining rights allocation. But mining has not been the only sector that is underperforming. Our harbors are expensive and inefficient, therefore operating way below their capabilities. The South African Bureau of Standards (SABS) take too long to approve any new product. It is therefore easier to import new goods than it is to produce them here.

The situation is even worse for human capital. Trade unions are demanding above inflation increases across the board. Our schooling system produces some of the worst results of the OECD. We are constantly ranked worst or in the bottom 5, across many measures. Therefore, our labor force is under-skilled and under-qualified. Employment equity prevents merit-based employment.

The only factor holding up our productivity is technology. Companies have been embracing automation and deploying robots rather than humans. BMW’s new production plant in Pretoria is 95% automated. Banks use of internet banking and mobile banking puts them ahead of their European counterparts. And our mobile operators are constantly coming up with new innovative products and channels of distribution, like the recently announced JV between MTN and Sanlam, to distribute life and funeral insurance products.


So what structural reforms are need in South Africa. The obvious ones are in the education sector, where the level of education needs to be lifted dramatically. Teachers should be trained, monitored and compensated according to their performance. Pupils need to be provided the necessary assistance to achieve top scores. In some cases (especially for the poor households) this might include better pre-school facilities, free meals at school and earlier introduction to e-learning. Employment equity laws should be scrapped in favor of pure merit-based employment. BEE codes should not constantly be changed. Business licenses should be given out quicker. And the awards of mining rights must be transparent, quick and not subject to political interference. There are many more reforms needed. But these would be a good start.

If we manage to increase the potential GDP, it would lead to an automatic increase in GDP. And with a higher GDP, everybody is better off. New companies will look to employ new workers who are then able to send their children to better schools. Tax collections would increase, giving the government more money to spend on the poor, sick and elderly. The upsides are endless, but the politicians just need to do more walking and less talking.

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South Africa

Be careful what you wish for…..

The DA has asked the public prosecutor to investigate if president Ramaphosa lied about a R500 000 donation. The result might hurt the DA most.

When in 2017 the current South African president Cyril Ramaphosa launched his bid to become president of the ANC, the campaing needed to be funded. Since he was up against fierce competition, he needed quiet a bit of it. But since the odds were stacked in his favor to take the top job, money started flowing in from all corners of South Africa. The reasons why individuals and business contributed varied. Some did so because they felt it was their civil duty, some probably just wanted somebody else but another Zuma crony to become president. Some thought it might be best to contribute to buy favors, since it worked to well in the Zuma years of plunder. Needless to say, some donations would spark outrage, in particular one from a company called Bosasa, who donated R500 000. As it turned out, they were exceptionally brash about corrupting individuals to win state contracts.

The official opposition in parliament, the Democratic Alliance (DA) has continued with the same tactics they used to help get rid of the deeply flawed Jacob Zuma and asked the public protector to investigate the donation. She in turn took it upon herself to expand the probe and look at all the donations funneled to the Ramaphosa campaign. The wisdom and motives for this is questionable as the public protectors’ competencies are in doubt. However, if she can proof a case for money laundry, mr Ramaphosa might be impeached. There are more than enough shady characters in the ANC who would like to see him go and return to the kleptomaniac days of the past ten years.

The DA meanwhile would have shot an own goal. They would clearly do better in elections if Ramaphosa manages to get the economy growing again, restore the justice system and improve the basic education. Why? The DA is a liberal movement that doesn’t believe in racial segregation and supports selection on merits. They will do better when the population doesn’t have to fight for their basic services, but rather when the population has got a fair education and understands the possibilities of a well governed economy.

Should mr Ramaphosa be replaced as the president by some other self-serving thug, the lost year under Zuma will continue. Far from improving the basic functions of government, they would only get worse as tenderpreneurs target any state entity that is not yet insolvent. Clearly voters would turn to a more radicalized political party, like the EFF at the expense of the DA.

In doing the right thing, you don’t always achieve the right outcome. Ramaphosa is also the DA’s best bet to bring long term stability and prosperity, so don’t shoot him down.

Categories
South Africa

When really bad news still surprises

South Africa has had a lackluster GDP growth rate for the last few years, hardly ever beating 1% on an annualized basis. The quarterly figures were spread from slightly negative to hardly positive. Disappointing growth rates are the norm. But when the most recent GDP growth rates were released, it sent shiver down the spine of the most hardened pessimists. It came in at -3.4%.

The primary sector fared particularly bad, with agriculture recording negative growth of -13.2% and mining at -10.8%. Manufacturing did not much better at -8.8%. For each one there were reasonable explanations why such a poor result is was recorded. Agriculture slumped because of the substantial growth in the last quarter (7.9%), mining and manufacturing were impacted by the power cuts Eskom had implemented, just to keep SA’s electricity grid from collapsing.

All these excuses miss a very important point. South Africa simply failed to attract enough investments. Local businesses are coy to invest given the mediocre prospects; international investors have a whole host of reasons. We however need them to fund new factories, to finance expansion of existing mines and to build new ones. The government can’t drag the economy out of the hole by themselves since they don’t have the finance to do so. They have too much debt curtesy of Eskom already.  But instead of attracting more businesses to expand their local footprint, we are losing them. AngloGold for example, a gold mining company that in the past might have been described as a national champion decided to sell their last gold mine in South Africa. In fact, South Africa portion of the total foreign direct investment into Africa has shrunk. That means that investors are increasingly more willing to commit capital to countries like Kenya, Ethiopia and Morocco at the expense of South Africa.

Investors will be drawn naturally to environments where three factors are prevalent: the ability to generate a descend return on their capital, stable government with policy certainty, and an operating environment which is welcoming and not hostile. We have none of that. Returns have been poor. Many of the more recent projects of listed companies have a cost of capital that is higher than the return on it. The primary and secondary sectors are burdened with very high electricity prices and increasingly expensive labor. Policy goalposts keep on changing. One need to look no further than BEE accreditation, especially in the capital-intensive mining sector (who really need a long-term policy certainty). Land reform blurred the line of whether land should be classified as an asset or liability.  The operating environment is no better either. The Unions are militant and can be very violent and disruptive even if they only represent a minority of the total work force. Visas for skilled foreigners are hard to get and much of the workforce is under-qualified thanks to the dismal education system they had to endure.

So what to do?

Extremely high unemployment, a poorly educated workforce and a stuttering economy dictates that South Africa needs to attract more foreign capital into their primary and some secondary sectors. That means we need to expand the mining industry, which would suit us well since we have some of the richest resource deposits. Land ownership must be guaranteed by the government, and unions should not be forced upon workforces. Collective bargaining needs to stop. There should be Tax incentives for private individuals setting up new businesses, and red tape should be cut to a bare minimum. If need be, foreign professionals should be granted work visas quickly, as they can contribute not only to the growth of the economy, but also by sharing skills with locals.

The South African governments priority should be to make it as attractive as possible to foreign direct investments. Without foreign capital flooding in, South Africa will have to rely on our own pool of capital, that is both finite and scarce. It is now a time where Ramaphosa need to be bold and make it very clear – we want investments and that is our priority.

Categories
International

Brexit negotiations – what can we learn from them?

The ongoing Bexit negotiations led by Theresa May hold valuable lessons for future negotiations, mostly on how not to do it.

During her time as home secretary she made a name for herself as a prudent and competent operator. Even though she campaigned for the UK to remain within the European Union, surely she would be savvy enough get a good Brexit deal approved by parliament.

Mrs. May entered the negotiations overconfident, mistakenly thinking that the UK was in the stronger negotiations position and drawing red lines that were in her mind non-negotiables.

As a Brexit secretary she chose David Davis, for no other apparent reason than that he was one of the strongest Brexit supporters. But he resigned after only a year in the job, which he never seemed to take seriously in the first place. But he was not the only one to resign from team May – she has had 37 ministers resign (and counting). That is more than any other UK Prime Minister has ever had.

Mrs May stuck to her lines and was uncompromising in her approach. She came up with one deal, that was voted on by the members of parliament a few times, and every time defeated by record margins. Even some of her own executives voted against her. Predictably, she ran out of time, and had to go and beg for more time from the increasingly impatient EU.

So, what can we learn about her disastrous negotiation skills?

Firstly, don’t start the countdown until you have a comprehensive plan. It was up to the UK’S Prime Minister to start the two-year period by triggering article 50. When the UK Brexit negotiators met the European negotiators for the first time, they seemed woefully underprepared. If one has the ability to start the clock, make sure you know exactly what you want to achieve in that time period, with different options at hand should the negotiations become deadlocked.

Secondly, make sure that your whole team sings from the same hymn sheet. As the Prime Minister lay out the objectives of the negotiation, and then come up with a strategy on how to accomplish them. Make sure that you have the buy-in from your closest colleagues, so that they can spread one uniform message with the same objectives in mind. Also select team members you get along with. You don’t need to be friends, but you need to be able to spend countless hours working together. Complex negotiations take time, make sure your team gel and don’t get pre-occupied with infighting.

Thirdly, when you draw lines in the sand (or red lines like Mrs. May referred to) make sure that it is out of a position of strength. More importantly make sure that they are realistic. It didn’t help that Mrs. May chose targets that are only of benefit to the UK, not the Euro area. She completely overestimated the UK’s position of strength and didn’t analyze the alternative.

Forth, be flexible. A trait all great leaders had was to be flexible. Changing your point of         view slightly doesn’t mean that you are not fulfilling your objective. It also shows that you are willing to compromise and work towards a solution. Thus your negotiations partners knows you are working with them, rather than against them, leading to a friendlier working environment which has been proven to yield better results. The trick is to list as many objectives as possible, so that the negotiations don’t get stuck on a few major elements, but that it is a fluid motion of give and take. Theresa May is stubborn, uncompromising and inflexible. That caused her to stumble in the negotiations and be defeated in parliament.

Fifth, make sure that you have the numbers behind you. The conservatives had a small lead in parliament when Article 50 was triggered, but the party was split between strong Brexiteers and “Remainers”. Therefore, Theresa May would need the support of some of the opposition party members of parliament. Instead of reaching out to them, she decided to hold a snap election in which she lost the majority in parliament. The results were a clear indication that the not even the public approved of her work thus far. Yet she still didn’t reach out to the main opposition parties to come up with a deal that would pass parliament. Instead Mrs. May continued to thrash out a deal with the European Union, which when it was finally ready to be voted on was defeated by the biggest margin ever. It is simple math’s. If you don’t have a clear majority in parliament, and you don’t have your whole party behind you, your deal will fail, unless it is a combined effort of all the parties involved.

This also leads me to the last point. If you enter negotiation, make sure that your objectives are the objectives the majority of your team, in this case the British parliament, approves of. Once you have that, it is time to start the clock and negotiate with the opposing party.

The Brexit disaster has been a tragedy that is still playing out. The parliament are making a fool of themselves. The debates remind of a tired yawning soap opera that seems to be never ending. The politicians seem to thrive in endless posturing and biggotting. But I not sure if doing what is best for their community is a high priority.

Categories
South Africa

Brait – not all shareholders are equal

Executives of Brait are bailed out, but they insist it is not at the expense of the other shareholders. Is it?

When Brait morphed from a private equity entity to an investment holding company, the management team leading the change were given the opportunity to buy a 18% stake in the new company. They only had to come up with 20% of the value of the deal, the rest would be vendor financed by Brait itself. The shares would be held in a entity called Fleet. As the share price soared, nobody complained. But since then, the management of Brait has made value destructive decisions. That reflected in the share price, which has come down from more than 160 Rand per share to 24 Rands per share. In the meantime, Brait has refinanced the loan with Standard Bank and FNB. Current the value of the loan is a lot more than the security the banks hold, and Brait has decided to settle it. This is essentially worse than what Carlos Ghosn has been accused of by the Japanese prosecutors, when he convinced Nissans board to take on his personal currency swaps which were under water. But we are not in Japan, we are in South Africa. And here the board of Brait decided to issue a statement that the bail-out does not favor executives!

Besides being highly immoral, one must question the behavior this encourages. The board of directors are the custodians of the invested capital and it is their job to protect it and to grow it. Only they can decide where to invest capital. For that, they get paid astronomical salaries. If the capital allocation turns out to be poor, they should be the ones to take the blame. In Braits case, they were greedy and possibly over-confident to take such a large  loan. Bailing them out when the share price comes tumbling down essentially means that they were able to take a leverage position with unlimited upside, but no downside. Evidently it leads directors to take unnecessary risk without considering the downside.

Brait is unfortunately not a unique case. Pepkor recently bailed out their executives, costing the company a few hundred million Rands, when their Steinhoff shares collapsed. Adept IT is considering issuing new options to their executives (at a lower strike price), because the last few were at such a high strike price that they would not be worth executing any time soon. Off-course, the reason for that is because the share price decreased from more than R15 to R5.11 in about 2 years. There are more examples, a few that are more complex, like the recent change in incentives at Woolworths. Their executives are rewarded on the return on invested capital, which is a prudent measure. But at the same time, they wrote down billions of Rands of their disastrous David Jones acquisition, which was their biggest bet ever. That means that the executive will be measured from a lowered bar, and not from the high water mark before the acquisition was written down. At least going forward, their measure of reward is in line with those of shareholders.

To understand the unfairness of these incentive deals where Managements are offered very lucrative incentives, only to be bailed out when things go bad, it helps to look at an analogy. Imagine that a portfolio manager invest so poorly, that the unit trust he manages constantly loses value. After the value of the fund is down by 70%, the management of the company he works for feel sorry for him and decide to pay him is performance bonus anyways. But because there is not enough income generate by the fund, the investors in the fund have to pay him by sacrificing some of their own invested capital. No doubt this would cause a total loss in confidence in the portfolio manager, the same should happen to managers who only scheme how they can make more money, even at the expense of ordinary shareholders.

It seems it is not only politicians who get rewarded for a poor performance.

Categories
South Africa

Aspen Results – need remedies?

Aspen Holdings, a pharmaceutical company listed on the JSE reported their interim results on Friday. The share price has already lost two thirds of its value since hitting an all-time peak in 2015. Never the less, while Stephen Saad presented the results to analysts and investors, the share price plunged intra-day by a further 50%, ending the day 28% lower. Did the performance really warrant such a drastic move? Or is something else at play?

There was much not to like about Aspens recent results. The headlines point to a worrying picture for a once fast-growing company; net revenue increased by only 1%, EBITDA was down 3%, headline earnings per share were down 9%, and free cash flow per share down by 45%. The borrowings increased drastically from R46bl to R53bl, the cash conversion rate is at an unusual low of only 47%. These are troubling numbers for Aspen shareholders, who are used to see growth in the double digits. Some clearly scrabbled to exit their position, accepting a 50% lower price than the previous day, fearing that in hindsight, that decision might still be a good deal. And all this without going through the details of the presentation.

Aspen used to be the darling of the JSE. Lead by the very entrepreneurial Stephen Saad, Gus Attridge and their team, they grew the company from nowhere in the late 90’s to one of the leading pharma companies in the emerging markets. The company was easy to understand. They produced generic medicine, owned a few over-the-counter brands, manufactured products like eye drops for third parties and distributed branded prescription drugs from GSK. The constant exploration of new opportunities led them to grow internationally, especially in Australia and the emerging markets. The business model stayed the same. The key was to open channels of distribution and then pass through an array of products, from their own generics to branded prescription drugs. They were very successful, which reflected in the Aspen share price. In 2015 it hit a peak of more than R420 per share, trading on a price/earnings multiple of more than 35.

But that’s where the strategy changed slightly. Aspen bought a struggling French manufacturing facility in Notre Dame de Bondeville. It provided a great opportunity to change focus from the increasing price sensitive generics medicine markets to sterile focused brands, primarily producing anesthetics and thrombosis drugs. These are much harder to produce, since the quality consistency is so critical. Aspen needed to invest a lot of capital to increase the capacity to produce at a volume level where they can guarantee uninterrupted supply. That investment is still ongoing, just as the investment to upgrade and increase their production capabilities in South Africa and Germany. The full effect of the increased production capacities will only be seen over the next three years, but to achieve higher volumes one would need to spend a lot of costs upfront. Hence also the higher debt levels.

Besides the big increase in debt, a major concern investor have is that much of the debt is denominated in Euro’s. Given that in their most recent results 38% of their revenue is from the Euro area, this should hardly be surprising. A prudent manager should always match the assets with the liabilities.

Investors are also worried about the delay of the sale of the nutritional business, and the sale itself. They are worried that Aspen is selling their crown jewels to finance their new acquisitions. First the delay of the sale itself. The sale was originally to be concluded within 6 months, and ambitious task given that it is a multinational business. This will now be concluded at the end of May. But the answer to the second question might also give an indication on why the share price has been performing so poorly. Yes, Aspen has done very well out of the nutritional business. But the sale is just the nature of the beast. Aspen is constantly morphing into an increasingly sophisticated business. As they see opportunities that fit with their future strategy, they are not scared at making big commitments. If investors buy Aspen shares they buy into the managements ability to spot opportunities in the Pharmaceutical Industry and extract as much value as possible from it. It is very hard to value such abilities, and it gets increasingly harder as the products become more complicated and niche. It also becomes more difficult for mr Saad to sell the good story to investors, as there are more and more moving parts, each of which are difficult to value. Added to that, the investor must look 3 to 4 years ahead to see the results of their current strategy. That is a hard task for those who, at best, are concerned about the next 6 months. It is anyways easier to follow the crowd instead of dissecting the complicated financial statements.

So what is my take on Aspen shares? I hold Aspen shares and have been holding them for ever. For a long time, I didn’t add any, but with the recent price movement I have. I don’t have a target price, because that would just be an arbitrary number. Instead I focus on 3 point: the managements ability to execute, the downside risk to the current concerns and the managements own skin in the game.

Firstly, they have a very good track record. Even though they did get a few things wrong along the way, like their investment into Venezuela, they got most right. The crucial part is that their ability to manufacture products at the highest international standard, which has been proven repeatedly.

Secondly, the downside risk. Their cash on hand covers their current liabilities payment obligations, which secures them for at least a year. The right time to gear up the balance sheet would be when interest rates are at a historic low. The time seems right to do exactly that. The crucial question is what covenants and what durations the loan agreements have. At an interest cover of 5.6 times and a net debt/ebitda of 3.7 (calculated after the conclusion of the sale of the nutritional business) they don’t seem to be in any immediate danger. The proceeds from the sale of the nutritional business will reduce their debt by 18%.

Another important point to remember is that the new accounting standards also don’t allow them to increase the value of any investments they have made (they can only write them down). That means that if they spot an opportunity where they can create value, that value is never reflected in the balance sheet until the business is sold again. Therefor their balance sheet would always be understated. Given that shares NAV is about R110, any price around that surely presents value. Added to that, on a historic P/E multiple of 7.5, even a company with pedestrian growth looks attractive.

This brings us to the third point: managements skin in the game. Two of the three biggest shareholders are Stephen Saad and Gus Attridge. They were happy to buy more shares in October 2018 at a price just above R155. Mr Saad bought for 93 million Rands worth, and mr Attridge for 15 million Rands. If they were happy to buy shares at R150, surely R110 seems like a bargain?

Categories
International

Economics 100

The world economies are getting ever more sophisticated and inter-reliant. Some countries struggle to grow their economies, while others prosper. Few politicians seem to be able to come up with the right economic policies to achieve long term social goals.  It may help to rewind and look at macro economics in it’s simplest form.

The simplest question one needs to answer is: “How do you create wealth?”

Contrary to some conspiracy theories, wealth is not created out of nothing, it is not some abstract bubble that will burst at some point. To analyse it correctly, one would need to look at the world thousands of years ago. Just imagine a world which is divided into countries. Each country has a human population, and although smart and intelligent, are nothing more than cave dwellers. Each country has two forms of capital. The first are the natural resources. They include everything from the wild crops, to the animals and mineral deposits (such as copper and iron ore). Some countries have got more of the one or the other, but each country has got natural resources. The second form of capital is the human capital. The distinguishing feature between us humans and the rest of the animal kingdom is that we have far superior cognitive abilities, making it possible to think in abstract terms and thus create something not by chance but on purpose.

If the humans decide to gather the seeds of crops growing in the wild and grow them in fields that are easier to cultivate, resulting in higher yields, each human will have more to eat. It is not at the expense of the other humans, thereby making the society as a whole richer. It is the combination of human intellect and the natural resources, that creates a wealthier society. This process is repeated over and over again. They would build man made shelters out of natural stones, and thereby were able to live in areas that previously lacked shelter.

But at some point, the human capital would have reached its physical limit, because a highly intelligent farmer can’t be much more productive than an average farmer. There are only so many hours of sunlight to work the soil, and even though the highly intelligent farmer would be more productive, there is a physical limit on how much earth he can turn in an hour. But the humans then specialised on one activity, because the concentrated knowledge makes them more productive. The highly intelligent human would stop growing crops and rather invent farming tools, which the farmer would use to be even more productive. As a medium of exchange, money is created. The farmer is able to pay for the farming tools because he has a higher crop yield. Since it is more efficient to trade the crops with somebody who needs crops, he would trade the crops for money and give the inventor money for the farming tools. Using money as a medium of exchange is just the most efficient way of trading, and again, the society as a whole benefit and gets wealthier.

Fast forward a few centuries, and the repeated process of using the resources more efficiently generates wide spread wealth. But the constraint to this growth is the ability of using the current countries capital in a more efficient manner. So it would be a function of furthering the human knowledge, and trying to use every incremental increase to somehow make a better use of the countries natural resources.

Enter a third form of capital, namely foreign capital (both as human capital and natural resource capital – or the mean of exchange, i.e. money). With foreign capital the country doesn’t need to wait until they have generated enough surplus capital (i.e. wealth) to, as an example, build a mine. They can do it straight away. This encourages growth beyond the natural ability of a country to grow. It makes the country wealthier and its citizens more prosperous.

So what lessons can the politicians draw?

To grow the economy, the government should always focus on three aspects: Firstly, do the policies encourage further development of human capital? Does our population become more knowledgeable and more intelligent? Secondly, do you encourage companies to use the natural resources in the best possible way? Thirdly, how do we attract the most foreign capital, both human and resources (i.e. money).

Focusing on those three areas will deliver the highest possible economic growth, which in turn will generate more taxes to be spent on the poor.


Categories
International South Africa

Long Term review

As the last post of 2018, I thought of giving a long term review instead of the year in review.

South Africa is in and out of a recession, but that should not come as a surprise to anyone who has looked at the underlying strength of the economy. Has SA reached its growth potential?

Ramaphoria seems like a distant dream, almost a fairy tale on how president Ramaphosa has taken the helm and in one swoop turned the stuttering economy around which his catch phrase “please send me”. His state-of-the-nation address was heralded as the start of a new era, and we can finally, unshackled of constant Zuma cronyism interference, proceed to grow again. With enthusiasm abound, investment banks rushed to upgrade their GDP growth forecast. But only 7 months later, the reality check: we slipped into a recession. While the rest of the world is growing strongly, we don’t. But to anyone, who looked rationally at the underlying capabilities of the South African economy, this should not have come as a surprise.

What might have surprised those number crunchers is how long the party seemed to continue. Looking at the performance of the JSE, as a measure on the strength of the economy, it would seem that South Africa is capable of keeping up with the best Asian Tigers. We would lead the African renaissance, famously proclaimed by the former president, Thabo Mbeki. But the reality is that we have been living on a toxic cocktail of steroids that mask the true performance of the economy, and therefore misguide on the potential for the medium term.

The JSE’s stock exchange index has increased by about 375% over the last 15 years (in Rands). That is a truly spectacular performance, and anybody who invest in shares would have done well. But that was just the index. Looking at the different components of the index, it becomes clear that we have had thee super phases, in addition to one over-arching theme.

Start with the three super phases. Firstly, we have benefitted enormously from the commodity boom of the mid 2000. China consumed almost all commodities quicker than anybody could produce, causing all commodity prices to rally sharply. That was a bonanza for the mines, which was reflected in their share prices. But South Africa had severe export transport constraints, and the throughput of Richards bay coal terminal and Saldana has hardly increased. Our mines were earning more Rands and Cents, but they struggled to push through the increase in volume they would have liked to. So what happened to the mining shares since then? Only the best managed companies managed to keep the share price at some reasonable level, many (especially SA focused mines) however are down more than 80%, a few collapsed totally and are no longer listed.

The second phase was the construction boom, spiced up by the Soccer World cup in 2010. There was a deadline, and plenty of projects had to be completed, almost at any cost. Luckily, the South African government had competent finance ministers and a very efficient tax collecting machine. We could afford it, and for the greatest show on earth, South Africa did deliver. This phase went on for a bit longer, because it partly coincided with the third phase, the retail boom, and the mushrooming of shopping centres. But the music has stopped, and the sector is down about 76% since its heydays. In fact, the share prices of most construction companies are down more than 80%. Well known ones, like Basil Read have gone into business rescue.

The third phase can be described as the retail boom. The index has increased by 325% over the last 8 years but seem to be running out of steam very fast. The start of the run was caused by the sharp increase in social grant beneficiaries. In 1994, about 4 million received social grants, by 2008 it was about 8 million. By 2017, 18 million South Africans received some form of social grants. And they spend it. Companies like Shoprite, Pep and mr Price reported dazzling growth figures.  International retailers like H&M and Zara couldn’t wait to open more stores in South Africa. To turbocharge the trend even more, unsecured lenders were happy to finance the difference between the wants of consumers and their ability to have. But this trend, like the two before, was is not sustainable. Not only is the government constrained by their budget on how much they can expand their social spending, but the boom in the retail figures masked another trend: for the last 8 years, the private sector has been shedding jobs, while the government and state-owned enterprises (SOE’s) have been adding jobs. Overall the unemployment rate, though high, remained relatively constant. In 2016/17, national government spent about 7 out of every 10 Rands on grants and employee compensation. That leaves precious little to spend on project enhancing the competitiveness of our economy, like new highways, schools or hospitals.

And what was the overarching theme of the JSE Index? We have had a few, really big companies doing really well. The JSE is a very concentrated index. If one takes the market capitalisation of the index (the value of all companies listed on the JSE), and then divides it up into three equal “boxes”, then the first box consists of 2 ½ companies, the second of 16 companies and all the other companies (200+) combined would fall into the third box. Clearly, the biggest 10 companies have a far greater influence on the performance of the index than all the other companies combined. Within the top 10, you will find companies like British American Tabaco, Richemont, Naspers, BHP and Glencore. The only thing they have in common is that they hardly earn any money (or in Naspers case – any asset price value) from South Africa. All these companies have been doing well and kept the market at elevated levels, because of their foreign earnings.

So what are the underlying problems of the economy, and is it possible the fix them quickly?

It is complicated. Like the performance of a football team, there are a few quick fixes. But to be consistently winning, the foundation of the team needs to be such that there is a depth of talent. This would give the team the ability to perform well, no matter what challenge is thrown at them. To demonstrate one fundamental problem with getting the South African economy going again, lets look at how the economy developed between 1980 and 2016.

In 1980, manufacturing contributed 22%, mining 21%, agriculture 6% and finance 11%.

In 2016, finance is the biggest sector, contributing 20%, followed by government at 17%. Manufacturing declined to 13%, mining 8% and agriculture only 2%. In other words, the government has shifted the economy from a labour intensive to a skilled based economy. But the schooling and system has not produced more skilled labourers. They are needed in such a skills-based economy, because if you can’t read nor write fluently in English, or compound mathematical equations, you can’t be employed at a bank or as an engineer or similar professions.

According to Stanlib, an investment company, each year there are 1.24 million children starting their school career. By grade 10 there are only 1.11 million scholars. That number gets drastically reduced to 687 000 by the time they write their school leaving exams. Of those, only 270 000 will take the maths exam, and only one in three kids get a mark of 40% or more. So only 89 000 pupils will finish school with a pass in maths of 40% or more, that is a rate of only 7% of those who started school.

The story continues at University. Again, according to Stanlib, only 17% of all students at the public universities will obtain their degree. That is no more than 30 000 graduates each year, far too few to replace the skilled labourers retiring each year. The lack of skilled employees become obvious in all corners of the economy. For example, only 55 municipal technical divisions, out of 257 are headed up by an engineer.

The other fundamental problem of South Africa is that the Unions are too dominant. Their membership has been in decline for years, but they remain just as powerful as before – making up for the lack of new members by using increased violence. Year after year, they have demanded above inflation increases, thereby increasing the unit labour costs. Our average manufacturing wage are now 32 times higher than that of Ethiopia. Not surprisingly, China’s “one road” initiative is focused on countries north of Kenia.

Partly because of the high unit labor costs, industries like manufacturing are increasingly relying on robots (the BMW assembly plant near Pretoria is 95% robotic). Mining are shedding thousands of jobs and closing unprofitable shafts while mothballing marginal mines. Just to underscore the Unions complete lack of business understanding, they have now demanded that trying to keep a company profitable is not a strong enough reason to reduce the workforce. They want to make it even harder to fire employees. An analysis of Impala demonstrates the problem facing South African companies. Over the last ten years, the government got R19 billion, labour R77 billion and the shareholders had a loss of R228 billion (that includes the capital loss of the share price, which is now at levels last seen 20 years ago).

The poor education and the ridged labour laws cause a massively dysfunctional labour market. Out of 37.7 million working aged South Africans, 16.4 million are employed. Roughly half of those pay income tax, because most just don’t earn enough. This causes a tight spot for the South African government. They have hardly any room to raise more taxes. Taking into account World Bank indicators, South African tax-to-GDP ratio at 26% is much higher than the world average of 14.5%. In fact, South Africa has the tenth highest tax-to-GDP ratio in the world.  

Under the Zuma administration, South Africa binged on debt, mostly through guarantees to their state-owned enterprises like Eskom and Transnet. They have reached now a debt ceiling where any further increase would surely convince the rating agencies to downgrade the South African debt to junk status. So where to from here? If the government under Ramaphosa is not able to take on massive amounts of debt and spend it on infrastructure projects, what can they do?

Firstly, they need to recognize that they need the help of investors, most of them foreigners. That means that the environment should be as investor friendly as possible. They would, for example, like to have policy certainty. When they make investments where the payback period is 20 years, they want to be sure that the rules don’t change midway through. The returns that they get from their investment should be attractive enough to convince them to invest into South Africa, and not Argentina, Chile, Vietnam or Portugal. The investment world is fluid, and investors are not limited to invest into South Africa – they can invest where ever they want to.

Secondly, they will have to rebuild the schooling system. It doesn’t help that a child in the rural areas will have a 1 in 100 chance of eventually being able to study, not because of costs, but because of their dismal schooling system. It also doesn’t help that all teachers are paid the same, even though the national average of absenteeism of teachers is 40%. Good teachers need to be paid more, and bad teachers (or absent teachers) need to be fired. Mathematics and English are crucial in today’s world and should be compulsory subjects. The pass rate should be calculated on the number of pupils starting schools each year, and the governments target should be for 80% of those to pass matric. The government should also focus much more on early child development (the first 1000 days), thus making sure that everybody gets the same chances in life.

Thirdly, the state-owned enterprises should be freed of corruption and returned to profitability by a management team that is employed based on their merits, not their political affiliation. The tender processes need to be transparent and accessible to everybody. Their debt levels need to be reduced by raising more capital through a partial listing on the JSE. They could contribute greatly to the economy but should not be an expense to the economy. Since the fiscal policy is a zero-sum equation, spending money on bail outs of the SOE’s means that there is less money available elsewhere, for example education or health.

Lastly, the government need to rebuild many public institutions. The Hawks need to be free of political interference and should have the capacity to investigate complex commercial crimes. Currently they don’t. We need more and better policing. It can’t be that the citizens live in fear of violence and crime. The courts need more capacity to hand down judgements quicker and more consistent. The public prosecutors need to operate free of favour and need to improve their competence. Red tape needs to be drastically reduced, and the government needs to be made leaner, more efficient and free of corruption. These are only some suggestions, but they would go a long way towards building a solid foundation for the economy to grow sustainable into the future, and therefor creating jobs and opportunities for everybody. It would raise the GDP per capita and make a real impact on the life of South Africans. They changes will take time to have an effect, but with a strong leadership, it should be possible. Until then, the economy is fragile. It will largely depend on external influences that it has no control over, such as the level of commodity demand of China, the health of European economies and the level of the Rand. Not only would international investors ignore any possible opportunities in South Africa, but talented South Africans would seek opportunities elsewhere.

Categories
South Africa

Viceroy strikes again

Viceroy, as small research outfit (and short seller) based in America has struck again with a report on Nepi Rockastle, one of the biggest eastern European focused Real Estate Investment Trusts (REIT). The recent merger seems to have been very overpriced, and mainly benefitted a few insiders. The Romanian shopping centres seem to be running at a loss and according to Viceroy the share price in general is very overpriced. They supported their claims by a few detailed Romanian submissions, and although it seems fact based, their claims can and probably will be disputed. Without going into details on who is right and who is wrong, what have we learned by the report?

 

Viceroy gained notoriety because of the particularly well-timed report into Steinhoff almost a year ago. The claims in that report have not yet been proven, we are still waiting for the forensic audit to confirm it in the next few weeks. But the timing, just as the then CEO, Marcus Jooste resigned under a cloud of confusion, was impeccable and contributed to the 90% fall in the share price of Steinhoff. Ever since then, executives have shivered when it was rumored that Viceroy is looking into them. Companies like Aspen have been rumored to be a target, and without any report released the share price has hovered around the lows for a year now. Capitec was a target by Viceroy and the share price did react sharply, but a strong response from Capitec means that the shares recovered. No report of a SA listed company by Viceroy has been proven to be right by independent auditors. Is there anything good about their reports then?

 

I think yes, it is good that they issue their reports. It gets boards of directors and fund managers to be more on their toes and don’t simply rubber-stamp everything. As an investor you should always question everything, and don’t take the information for granted. For far to long have related party transactions been under reported, for far too long have fund managers simply held all of the top 40 shares, and just tried to follow the markets. For far to long have fund managers believed everything management told them. Because all of us stand to lose, if South African shares are avoided by international investors because of a reputation of poor corporate governance and fraud. If we are not able to attract foreign capital, local companies will find it harder to raise extra capital because the current economic circumstances don’t allow individuals to save more. By reducing savings in favor of consumption, the local pool of capital depletes thus making capital more expensive. That is something we can’t afford.

 

Like my father always used to say: Trust is the most important part of business, once it is gone, it is very hard to get back.

Categories
International

Down, …. but out? Surely yes

Theresa May has finally come up with a Brexit plan agreed with the European lead negotiator, but as expected, it is of little value for Britain. Is this the final stroke that will end her disastrous term as prime minister?

 

Theresa May did not back the Brexit campaign. She was in favor of remaining in the  European Union, the worlds biggest economic block. But as David Cameron, the previous prime minister, resigned after the referendum, she put her hand up to lead the nation during these daunting times. She suddenly seemed hellbent on fulfilling the wishes of the population and lead the UK out of the European Union. Since she seemed to be the least bad choice, the Conservative Party voted for her to lead the party. But she never had the full backing of her own party. Mrs. May always seemed to want to please everybody in the party, even though they were bickering among themselves. She lacked a vision and clarity, and although she defined “red lines in the sand” they were hopelessly unrealistic. Throughout the whole process the prime minister vastly overestimated the UK attractiveness and economic power. When she finally presented her deal to her cabinet ministers, they were disappointed.

 

The United Kingdom has in the past produced some of the greatest leaders the world has ever seen, from the military, business and government. But just as they most need to put forward one of their greatest, they instead choose one of their weakest. Great leaders have charisma, they are decisive, have a loyal following, are flexible and able to adjust to changing circumstances and most of all – have a sincere enthusiasm for their cause. Mrs May has none of the above.

 

Predictably, the EU dictates the terms of the exit. Britain is not in a position to state demands, purely because it relies more on the EU than the EU does on Britain. And the EU wants to make it as hard as possible for member states to leave the union. This would act as a deterrent for any other populist politicians to promise paradise outside of the union. After famously stating that “no deal is better than a bad one” it is hard to see how this deal represents a good one for the Brexiteers. None of their promises in the campaign leading up to the referendum have been met.

 

I doubt that the prime minister will manage to convince her own party to back the deal, and that it would be voted down. This will leave Britain with a few options: leave the Union without a deal (disaster), try and hammer out a new deal under a new leadership (won’t happen, there is simply not enough time), call for new elections to get a clearer mandate from the electorate (even worse, because it would surly mean that the far-left socialist, Jeremy Corbyn, who in the past has had a soft spot for violent demonstrations to express his view – would become the prime minister). The last choice would be the only sensible one: hold a new referendum. After all, the first one was based on false promises made by populist self-promoting politicians. Now that the public has got the details of the actual divorce, they are far better informed on what a Brexit would actually entail.

 

That’s is if the public even cares. After two years of constant Brexit bombardment and posturing, they might just be so tired of the topic that they surrender. Besides, they would much rather like politicians to focus on running their communities, their cities and their country again.