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.

Categories
International

Democrats – targeting the boogieman

As the Americans go to the poll today to vote for a new house of representatives and a few senate seats, they have the chance to change the path of current politics. The Republicans have a slim majority in both houses. If the Democrats win either of them, their win would have been because of a rise in the “anti-Trump” vote, rather than a vote for the Democrats. These days Democrats are united because of a common boogieman, Donald Trump, rather than a common ideology.

 

Gone are the days of true liberal leaders who could unite the followers behind a shared vision on how a better future would look like. Leaders who don’t try and win votes by discrediting each other but by convincing you with their argument on how to build a society that you can be proud of. And with such a lack of clarity of what they stand for, it will be very hard to beat a showmaster like Trump. It would be even more difficult to come up with new policies that would convince the electorate to vote for them at the next elections.

 

We in South Africa have a similar scenario. With Zuma removed, the EFF and the DA are struggling to define themselves. Their political visions are confused, and their purpose faded. Who should the voters vote for if they don’t get a coherent message? Not one about removing an chauvinistic, polarizing and corrupt fool, but a idea about what you as a party would do different, to make the lives of your fellow citizens better. It seems like the only leaders in politics these days are populists who win on a message of fear and hate. What a sad state of affairs.

Categories
South Africa

Investing in turbulent times

October has thus far been one of the worst months for equity investors in the past few years. Lots of people have asked me how to invest in these times, here are my thoughts.

The market is on a rollercoaster. The tech-heavy NASDAQ is heading towards another week of declines, the S&P 500 has had more down-days than up-days this month. The effect of the negative sentiment is even greater on the South African markets. The JSE All Share Index is down from a high of 61 684 points to a current low of 50 877 points. That is very close to bear market territory. Yet the base case seems to be that this is still a correction in a bull run, rather than the start of a bear market. Everybody points to the strength of the US economy, a feature that president Trump takes full credit for. I don’t agree. I would be very cautious. In the fund I manage, I have been selling equity in June and early September. I have never had this much cash.

There are a few reasons for my pessimistic view on the future short-term prospects of the share market. Many originate in the USA .

We have had almost a ten-year bull run since the end of the great recession of 2008. The recovery from the second most severe downturn in the last 100 years has been shallow, but because of that, it lasted very long. Companies now record record profits, mostly aided by un-natural low interest rates. Since Trump was elected president of America, the economic growth accelerated even more, topping 4% on an annualized basis. The unemployment rate is at a very  low level,. The share price valuations reflected such optimism. Not since the dot.com bubble, when valuation of a business plan written on a napkin was worth U$100 million, has the Shiller’s P/E ratio reach such lofty levels.

The problem though is that the last spurt of growth was caused mainly by the Tax cuts imposed by Trump. I am not against the Tax cuts, but using it now leaves the president with one less tool should the economy slow down. You would want to have some powder dry, because open economies do have natural cycles.

Then come the tariffs. The first salvo was aimed at almost all aluminum and steel producers outside of the US, friend or foe. The problems are twofold. The first is that if the biggest consumer imposes tariffs, other big consumers of the metals need to follow suit or fear of getting the surplus glut dumped onto their market. The marginal cost of finished steel and aluminum are the transport and storage costs. The second issue with tariffs on steel and aluminum is that they are also mostly input costs for other goods such as cars or buildings. The knock-on effect on prices is far greater than tariffs on finished products. US producers would have also increased their prices to reach import parity and as such, almost everything – from cars to houses to beer cans get more expensive, and somebody will have to pay for it. Initially the producers would absorb some of the costs, lowering their profit margins. But eventually the consumer will need to pay more for their goods.

In an effort to “make the USA great again”, president Trump started a trade war with China. His reasons are debatable, but the economic impact is underestimated. Gone are the days where the Chinese only imports were cheap cloths and plastic goods. These days, much of the imports are sophisticated electric and mechanical machinery, often used in the production of other goods. Thus this supply chain is very difficult to replace overnight, let alone get American companies to take over the slack. Therefore, all that would happen is that in the short-term consumer prices will increase. And as anybody who has done economics 101, if prices increase, quantity demanded decreases. One can see it already in for example the new home sales or vehicles sales, both of which are significantly off their highs.

Because of the reasons mentioned above, demand for goods will decrease as prices rise. Therefore companies will not reap in as much profit as they have before. Profit growth will certainly slow. The share prices in September did not reflect that.

They are more reasonable now, but I do think that we have more to go before we reach a bottom. There are two main reasons for it. Firstly, markets always over and under shoot. Secondly, we have recently seen a few times markets that closed lower a couple days in a row, followed by a massive up day. The rallies tended to fade, and the next day Asia opened weaker again. That shows clearly that there is no more the glut of money waiting on the side just waiting to enter the market.

So why does that affect us? Simply put: If America sneezes, the rest of the world catches a cold. Since they are by far the biggest market, they will have an influence over the direction of the JSE. The tricky part is how to position yourself as an equity investor, because if history is a lesson, the Rand US Dollar exchange rate will weaken.

I took a dim view on South Africa, because we have structural problems that need to be addressed before we grow at 4%+. Thus I am underweight SA focused companies. Most of the selling I did recently were such companies that mainly serve SA. That portion is now held in cash. As before, I am overweight defensive Rand hedges such as BAT. Yes in general their shares would also go down in a bear market, but since I expect the exchange rate to weaken, it would absorb some of the losses and protect the value of the investment.

(please note that this is from a South African standpoint, it differs depending on where you live. Always consult with your own investment professional before you make any investment decisions)

Categories
Namibia South Africa

Good for headlines or good for growth

Two stories were released at the weekend that should boost investments in two neighboring countries, one is little more than window dressing while the other will have actual and fairly quick impact.

 

South African president, Cyril Ramaphosa took to the streets on Saturday to celebrate a commitment of companies to invest R290bn over the next ten years. This was largely achieved by his star-studded investment envoys who have been traveling the globe, trying to lure more investments to SA. While they were rightfully celebrating the milestone in the streets in Soweto, Tom Alweendo, the Namibian mining minister announced that they will scrap a rule that requires mining companies to have at least 20% of their shares in the hands of previously disadvantaged Namibians.

 

While Ramaphosa’s achievement sounds good, Alweendo’s amendment to the ownership requirements will have a much bigger impact. To see why, one needs to analyze the numbers. The investment pledge is spread over 10 years. It is not clear if they are new investments, or if capex already planned anyways is included. Industries such as mining, real estate development, manufacturing, energy and communications will have a steady stream of capital expenditure that is needed just to stay competitive. Is this counted as new investment? And even though R290bl sounds big, if one compares it to the R200bl that was invested into the renewable energy sector between 2011 and 2016, Ramaphosa’s announcement sounds modest. Bloomberg, a financial data provider, estimates that there was another R550bl investment planned into the renewables energy sector of South Africa between 2016 and 2020. Hopefully the joyful celebrations in the streets of Soweto don’t cause the government to their eyes off the ball, because there is lots more to do to turn around the ailing economy.

 

Contrast that with the Namibian announcement. That’s will have an immediate impact, because the mining companies’ rate of return will increase by owning 100% instead of 80%. That’s will make new investments a lot more attractive. It also shows that the government is serious about becoming more business friendly, a seldom feat in Africa. I do think that the impact of minister Alweendo’s decision is far greater than that of Ramaphosa, and should be a bigger reason to celebrate.

Categories
International

The merits of Capital Gains Tax

Taxing a gain that wasn’t there

The idea behind the capital gains tax is simple: tax any gains on the increased value of capital, as the increase of capital was due to a better performing economy. Whether the capital is in the form of shares or property value, it has benefited from a growing economy, and therefor the value of the capital has risen. The taxes would fall disproportionately onto the rich because they have the excess capital to invest. That sounds like a just idea, but is it?

 

Like so many other countries, South Africa fell over their feet to implement capital gains tax. After all, it would raise more money, which the government could use to fund their social upliftment programs and infrastructure spending. They have raised over R100bl since it was introduced in 2001. During the boom years, there was not much pushback, as it only seemed fair that the capital, that was invested in the South African economy, benefited from the strong growth. As governments invest more into public goods, such as roads, schools and hospitals, private capital benefits by being in the vicinity of it.

 

But now in leaner years, one should question the merits of Capital Gains Tax. The problem is that it is calculated on the nominal value of the increase (the nominal value includes inflation). In countries like the USA or Europe, this is not much of a problem, because their inflation rate is about 1-2%. Our inflation rate is three times higher at about 6%, but our economic growth is much lower than that in the West. The increase is capital value is almost all due to inflation. Why should the investor pay a tax on a gain that has not really been a gain at a ll. In-fact, when there is a recession but high inflation, the capital value might go up, but in real terms the value of the investment has decreased. Yet, you would have to pay tax on that. Is that a fair system?

Categories
South Africa

The land debate is clear …. or is it?

After a two-day policy huddle, the ANC announced that they have decided to proceed with changing the constitution to be able to expropriate land without compensation.

When Ramaphosa took over as president of the ANC, and a few months later as president of South Africa, he was dealt a weak hand. The party is divided between populists and traditionalist. Some care to continue the legacy of Nelson Mandela, to build an all-inclusive South Africa where everybody gets the same opportunity to work and create wealth. Others only care about enriching themselves, while some just care about winning the next election. After all, a politician is one of the best paid jobs in South Africa. Ramaphosa’ s first task would be to unite everybody within the ANC ahead of the next elections. That requires compromises, but surely none as great as giving in to populist policies that are sure to backfire. Sadly, that is exactly what he has done.

A commission was established to investigate the possibility of amending the constitution to allow expropriation of land without compensation. They are currently busy holding public hearings, where citizens can express their views. But before they are able to compile their report, or even finish the public hearing, the ANC, under the leadership of Ramaphosa, decided to amend the constitution, which makes the commission pointless. But that will be the least of their worries.

As a typical trait of modern times, the campaign has been fed by misleading information. According to the economist Johann Bornman, more than half of all farm land in the three most fertile provinces is currently already owned by black farmers. The Ingonyama Trust, whose sole trustee is the Zulu king, owns 3 million hectares, about the size of Belgium, making him the biggest landowner. Much of the rest is owned by companies such as Sappi and Ilovo.  The three provinces with the lowest share of black ownership are the Western Cape, Northern Cape and Freestate, probably because most of the land is semi-desert making farming extremely difficult.

Through the ongoing re-distribution program, the government has already acquired vast amounts of land, on a willing seller willing buyer basis. Many emerging farmers could have been given land (which is just sitting idle now) were it not for the governments incompetence.

What many attendees of the public hearing seem to be focusing on though is urban land, rather than farm land. That makes sense. As South Africans became richer over the last 20 years, more have been drawn from the rural areas to the cities. This is a worldwide phenomenon.

No country has ever become richer by getting more people to take up farming.

A side effect is that there is an enormous pressure on urban land. Government is making progress though. According to the Race Relation Institute, a think tank, there are 10 new low-cost houses built for every informal shack erected. That is the inverse of what happened 15 years ago. But the pressure on housing is relentless, as evident by companies like Calergo M3, a low-cost housing developer. They just reported that they have had delays in delivery of units because of illegal occupants tried to “hijack” the units before they were finished.

The real problems are less obvious though. A move to take away land without compensation puts the whole banking system at risk. Banks lend out money and take the asset as security. The size of the loans are determined by the banks ability to recover the money in a fire sale, should the borrower default. If the bank can’t be sure that the applicant will always be the owner of the land, they will simply not lend any money at all. And if some of the banks current assets held as security are repossessed by the government, they will need to shore up their capital ratios to cater for the increase in non-performing loans. Simply put: banks will stop lending out money, and the money that do get lent out will be done at a higher interest rate. This would not only affect farmers, but everybody.

Secondly, white farmers would surely not be in a rush to invest in their farm if they can’t be sure that they will always own the land. This is already happening, as the debate continues. This not only affects our food security but puts thousands of seasonal workers at risk.

Thirdly, this change in constitution does nothing to shore up the confidence of international investors. They would rather invest their money in an environment where they can be sure that the rules they signed up to will stay throughout their investment. Have we not learned the effects of the constant changing of the mining charter? Foreign investment into our mining industry has almost dried up, declining sharply since 2003, through the biggest commodity boom the world has ever seen. Is the ANC willing to do the same to farming, just to counter the populists?

Lastly, it is a very highly charged moral issue. White settlers arrived in 1652, 50 years after the first Europeans settled in the USA. That is 150 years before the great Zulu king, Shaka Zulu took the reign, and expanded his territory dramatically. To which point in history would the government like to turn the clock back to? Besides that, most land has been bought by the present owners, no matter if they are black or white. Should they suffer from consequences from actions taken centuries ago? It can’t be denied that under the apartheid system there have been all sorts of dubious deal done (like the “rent” of the land on which the Wild Coast Sun casino is built), but that should be addressed through the ongoing land reform, where claimants can either get the government to buy back the land and give it to the rightful claimants or pay them a compensation.

The stakes are very high. The economy will not be limping along as it is now, but another recession will be much more likely.