Looking Beyond the Numbers

When analyzing a listed company for investment purposes, its financial statements are obviously a key variable to work through. If you have to ask ‘why’, then I kindly refer to this series of short webinars I did a few years back:

While the two links and their content are far from comprehensive and aspects of them are interpretive and subjective, those that work through them will hopefully conclude–as I have–that company financials are integral in analyzing a listed company for investment purposes (and valuing it).

But are the financials comprehensive?

The short answer is: no.

The long answer and pointers to get around this problem are what follows here.

Why do the ‘numbers’ have their limitations?

Firstly and most relevantly in the South African-context, the numbers could be incorrect or falsified. The reality is that auditors (and even management) have their limitations.

One of the ways to partially mitigate (you can never entirely eliminate) this risk is by seeking third-party or independent verification.

As a fund manager, I spend time meeting management, asking questions, and, importantly, doing so of third-parties. Likewise, I do site visits and even speak to suppliers and customers. With regards to consumer-facing businesses (e.g. retailers, banks & shopping malls), I literally keep my eyes open to see if consumers are using the said services or products and/or in the shops at the tills.

What you are looking for is non-financial data and/or third-party facts that agree with the company-produced financial reports/numbers and lend credibility to their accuracy. Management can distort their financials (because they ultimately control them), but they cannot distort real-world data not produced or handled by them.

Likewise, this approach can sometimes see trends in real-time and, thus, offers a unique leading-edge in perhaps identifying when a company is doing better (or worse) than the market realizes.

This leads me to my second point: financial statement, results and company data is almost always backward looking.

Companies report their financial results after they have happened but investors are only interested in the future results, hence there is a disconnect. While a company’s financial statements create the context of the future (i.e. from what position and point of profitability with what cash flow to utilize) the historical financials are no guaranty of the future results.

Hence, doing your own “primary” research can also offer a key, real-world insight into what you think the future may look like for a certain company.

How do you do ‘primary research’?

I’ve already touched on a number of soft ways that one can do research beyond a company’s financial results, but let me delve into a deeper (but far from comprehensive) range here.

As a general rule, though, the research of any company will benefit from meeting/communicating with management for insights, doing site visits and speaking with customers and suppliers. Even consider Google Trends, checking out HelloPeter and the company’s various social media accounts for followers, likes, customer comments etc.

Getting more specific, though, will require some customization. Your starting point will always be what is the company? Different companies will require or lend themselves to different sources for primary research gathering.

For example, retailers lend themselves to comparison with the retail statistics released by Stats SA (here). Are they doing better or worse than the rest of the market and, if so, why? It is also worth just wandering around the retailers’ shops, seeing how full they are, how many customers are at the tills, what are they buying and do you find yourself buying from them? How do their prices compare on various items against their competitors? How accessible are their shops and so on…

In this way, in my opinion, it appears that Shoprite (SHP) is still trading well while Pick ‘n Pay (PIK) is seeing trading-down from Woolworths (WHL) as high-LSM’s feel pressure but do not want to stoop to shopping at Checkers and OK… Likewise, Spar (SPP) always seems full to me, at least in my little area. I’d be careful of the discretionary retailers, like Truworths (TRU).

When walking around the retailers, keep your eyes open for what’s going on in the rest of the shopping center. This is relevant for building a view on the retail property stocks. How full are they? Are they in good repair or falling apart? Are their store vacancies and, if so, how long have they been vacant? Which shopping centers do you find yourself going to and why?

Once again, anecdotally, I currently see the mid-tier malls are starting to feel immense pressure. I see lots of vacancies popping up in these expensive dinosaurs and few are being filled quickly. The convenience centers (often with Spars in them) appear to be fine while the super-regionals (except Mall of Africa, which seems quite empty!) are holding their own. While many of the retail REITs are reporting softer numbers, I think the numbers are lagging reality and see some nasty impairments, write-downs and even one or three collapsing/forced-bailouts in this sector (see my old notes here for more details: Part 1 and Part 2, which I still think are relevant as generalizations).

Banks and credit-based businesses can likewise be compared with the National Credit Regulator’s own credit market data released (link). Once again, asking the same questions as for retailers. Most of these credit-businesses have a store presence, so while at shopping centers, pop your head in and see if there are customers actually making use of them?

For example, while Capitec (CPI)’s latest loan book growth and provisioning look like a bit of an outlier against the market, if you walk past a Capitec branch (of which there are more and more of them too!), you will notice how busy they often are and how many people of queueing to use their ATMs. This stands in stark contrast to a number of the other banks (most notably, ABSA) where there are almost never queues and some of them are filled with staff (i.e. costs) and few-to-no customers (i.e. revenues).

I can continue with telcos (ask your Uber driver what telco he is using and why?), airlines (which one do you fly? Where are the queues at the airport?), service companies (which ones does your own office use? Keep your eyes open at place for badges on security guards, cleaning staff, and other outsourced services) and so on, but I think you are starting to see the approach to gathering ‘primary data’ and comparing it against company results.

(When you are sick, see who makes the medicine that your doctor prescribes you or which hospital you are referred to? When eating out, consider who owns it and how full the restaurant or fast-food place is? When eating in, who made the ingredients that you are consuming and where did you buy them? And so on…)

Finally, directors of a listed company have a fiduciary duty to reply to investors and potential investors. Do not feel intimidated in dropping them an email with a series of direct questions about their company, industry or competitors. Even if they do not answer you directly, their investor relations should supply some input. You can often get at least a basic IR-email address off their websites.

In the absence of any reply, well, consider that a red flag that goes well beyond the numbers as they obviously do not care for minority shareholders or potential investors.

It is all just shifting the odds in your favour

Investing is always inherently risky. You cannot get away from this but you can try to mitigate it.

In fact, good investing is merely shifting the odds more and more in your favor. Don’t forget, we are all paying the same share price on the stock market but that does not mean that we all have the same perception of the risk or realization of the value/upside.

Knowing that there is a much higher probability that a company is doing well and should keep doing better may make a share that appears fairly-valued or expensive, actually cheap. Likewise, this can shift a stock from what appears to be risky to one that is relatively safe.

People give bargains away all day long on the stock markets because they do not believe that they are bargains at all. If you have done the work–both with the numbers and with the primary research to back them up–then your conviction becomes your greatest single asset here.

That is gold. No. Actually, that is far more valuable than gold.

That is looking beyond the numbers and shifting the odds in your favor.

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How are the facts?

Perhaps read the below in conjunction with reading: Top Ten Small Caps.

This is an exert from the AlphaWealth Prime Small & Mid Cap monthly investor letter for August 2019:

Adcock Ingram Holdings (AIP): FY 19 Results & Bidvest-control Optionality

The domestic, ungeared pharmaceutical and healthcare Group, Adcock Ingram, produced a superb set of FY 19 results showing revenue, profits and HEPS all growing c.+11% y/y while the dividend was hiked +16% y/y. The Group’s BEE structure unwound and Bidvest increased its stake in the Group to a controlling one.

Perhaps more importantly, Bidvest has reversed their view to dispose of their investment in the Group and, after taking control, are talking specifically about “maximising shareholder value”. This could mean a range of synergies and partnerships between the two groups but, if Adcock Ingram’s share price remains depressed, it could also simply mean the buying-out of the minorities (at a nice premium) and delisting of the Group.

ADvTech (ADH): H1:19 Results

The private schooling and tertiary education group, ADvTech, published fair H1:19 results with revenues growing +15% y/y, HEPS rising +28% y/y and, more importantly, learner and student numbers growing.

While the Group’s (high-end) Schooling segment remains under pressure from emigration, the Group’s Tertiary segment (the largest contributor to its profits) remains a star performer and grew strongly during the period.

Clientele (CLI): FY 19 Results

The niche, low-LSM insurer, Clientele, continued to struggle with policy lapses in a constrained consumer environment. Despite that, a H1:19 -26% y/y slip in Diluted HEPS softened to a H2:19 -9% y/y decline. Interestingly and indicating confidence, the Group increased its dividends by +5% y/y (putting the stock on a Dividend Yield of 7.8%) and continues to generate an attractive Return on Equity of 38% and Recurring Return on Embedded Value of  8.3%.

The Group is investing (at the expense of these short-term earnings) in alternative routes to market (currently performing well) and rolling out a mobile app and a loyalty programme (both gaining nice traction). While these results are disappointing, the initiatives make sense and appear to be working while the Group’s longer-term earnings potential remains well above current levels.

Much like Adcock Ingram/Bidvest above, it is worth noting that Clientele’s controlling shareholder cluster (Hollard & its related parties) have increased their stake in the company during the year.

Datatec (DTC): AGM & Update

We attended Datatec’s AGM last week (we were the only external shareholder in the room!) and cast our votes, particularly relating to the continuing material share buy-back programme at the Group.

Perhaps more interestingly, we asked management about the current trading of Logicalis and Westcon International. These informal updates are always valuable to ensure that no curveballs are heading our way.

The Chairman’s comment was that Logicalis continues trading well and Westcon International’s turnaround remains on track. The relatively jovial atmosphere of the AGM seemed to back this sentiment up and we look for another positive set of results out from the Group in due course.

Grindrod (GNDP): H1:19 Results

After unbundling the risky, debt-laden shipping business, Grindrod released a clean set of H1:19 results. Excluding non-core investments (one of them was announced as disposed this week), the Group’s core operations remain profitable, cash generative and ungeared.

This is particularly pleasing for holders of the preference share where we are picking up a relatively safe c.11.2% Dividend Yield.

Both from a preference share perspective and from Grindrod’s operationally-perspective, we continue to wonder how long such a great group with such an expensive capital structure (i.e. the preference shares) can continue to remain listed. Surely these port, freight and terminal assets are attractive to the right buyer? Surely the buying and delisting of the preferences shares make sense to either an external bidder or even an internal capital allocation?

In the meantime, though, we are happy to sit back and pick up our relatively safe 11.2% yield. We are being paid to wait and we are quite good at doing just that with a patient portfolio.

Metrofile Holdings (MFL): Trading Statement

While several prior periods own-goals continue to haunt this filing and document storage group, Metrofile Holdings, the new Financial Director is sweeping wonderfully clean. A prior month’s strategic review is now resulting in non-core business movements and a restructuring of debt into a more tax-efficient position.

The Group published a trading update showing that Normalized HEPS have not worsened from half-year while some impairments are obviously coming through from the strategic review (hence the material drop in EPS).

FY 20E is going to be key for the Group, but operationally they appear sound and the new FD is driving all the right changes. The stock is currently trading at or around the value of its property portfolio and you are getting the rest of the business “free” at this point.

Much like a lot of our portfolio, we wonder how much longer Metrofile will remain listed if its share price does not recover to a more reflective level? In the meantime, though, we continue picking up a c.9% Dividend Yield (forward DY is probably a bit lower) and that gives us the luxury of time and patience.

Sabvest (SVN): H1:19 Results

Diversified investment holding company, Sabvest, published solid results in August 2019 that saw its NAV growing +8% y/y. We are comfortable as to the “tangibleness” of this NAV and, thus, note how materially lower than the Group’s current c.3200cps share price is against this value.

The Group continues to work on collapsing its dual-structure and releasing locked up liquidity into the market. We remain of the view that this is a wonderfully uncorrelated event and should help unlock the share’s large discount to its NAV.

Santova Logistics (SNV): FD Emigration

We are sad to see Santova’s Financial Director, David Edley, handing in his resignation. He and his family are emigrating and, thus, the Group has begun the process to find his successor. We are confident that this is an accurate narrative and do not fear any nefarious things in the background.

Our advice to the Group was to use this as an opportunity to hire in a heavy-hitting, external FD from the industry. The “external” part is important as we think that the Group—like all organisations from time to time—could benefit from a new set of eyes. If this were to happen, we would view it as a positive event.

We want to personally wish David Edley and his family well with their move.

Wescoal Holdings (WSL): Share Buy-back

The junior coal miner, Wescoal Holdings, started a share buy-back and announced the acquisition of R27m worth of its own script during the month. While not very material in quantum, it is symbolic and does edge the Group’s black-ownership percentage higher (quite important for dealing with Eskom SOC).

As always, while a share buy-back in and of itself may not mean much, it does lend weight to our view that the Group’s shares are extremely mispriced and should be viewed as a positive.

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Is this EOH’s “New Dawn”?

Many (many) years ago when I was an equity analyst at Standard Bank, I decided to cover EOH Holdings Ltd (code: EOH). If memory serves me correctly, at this stage EOH’s market cap was only a couple hundred million.

I reached out to the founder-CEO, Asher Bohbot, and organized a meeting. Their financials and website were pretty vague on what they actually did, but their track record was good enough that I thought coverage of the small cap may add value.

I recall sitting in Bohbot’s office and mentioning how I could not find any results presentations on EOH’s website. Could he perhaps send me a copy of these documents?

Asher’s answer surprised me more: “We don’t have any results presentations. You are the first analyst to come see us.

That was music to my ears and I threw myself into covering the stock and, ultimately, I came to the conclusion that the Group was less an IT business and more a service firm that happened to align to IT (think of something like Accenture Plc or, even, some of the financial consulting or audit firms).

Back in those days, I rated EOH Holdings a ‘BUY’. It was cheap, it was growing and it was in the right space at the right time with an invested & highly-competent management team.

What could go wrong?

You could probably find my original EOH coverage and reports somewhere in Standard Bank (and, subsequently at Thebe Stockbroking too). The reports are likely quite embarrassing–I have grown far smarter and far wise with more experience!–but they do eventually arrive at an interesting conclusion: After the share had gone up a couple 100%’s, I eventually downgraded EOH to a ‘SELL’.

This downgrade was largely due to the share’s ever-expanding multiple. At a single-digit Price Earnings (PE), EOH had been cheap. At a hefty double-digit PE, less so… This was due to a large portion of the Group’s growth was bought (i.e. acquisitions made in present or previous years). While acquisitions are great, I do not really want to pay for acquisitive growth. Hence, when the Group’s multiple in the market expanded beyond any point where I could still justify it, I downgraded the stock to a ‘SELL’. That is the nature of the game.

Interestingly, I was also the first analyst to do this (as far as I could tell). I had covered the stock since sub-R1bn market cap and as it began approaching the largest African ICT business, I was–once again–an outlier in my view.

Despite my ‘SELL’ rating on the stock, the stock still went up a couple more 100%’s and I looked like an idiot. That is, unfortunately, also part of the game.

By now, though, I had moved on to AlphaWealth where I had set up a small cap fund–and decided to not invest in EOH–while the market continued to enraptured by the ICT service firm.

I have a couple “contra-indicators” in the market. A few popular commentators who pretend to be astute investors when, in reality, their real business is getting maximum media exposure. When a small cap pops up on these peoples’ radars, then there is a good chance that its growth story is over.

By this stage, all of these commentators were loving EOH.

Its growth story was over.

At around this time, I had also stopped going to the EOH results presentations. Not only were these events too popular (the amount of value embedded in a small cap’s valuation is inversely proportional to the number of attendees at its results presentation), but they were getting vaguer and vaguer with disclosure and the narrative.

Sure, there were witty replies and entertaining comments at these presentations. But when it came to hard, factual detail, it was a complete waste of my time to attend these events and, eventually, I no longer did.

The years went by, the share price’s rise slowed and slowly began to reverse and then things started to come out…

What subsequently happened to EOH Holdings, its share price and what has come to light, is what happened between then and now. I will not revisit nor unpack this other than to make the following two observations:

  1. Many people do not realize that EOH was formed by what was effectively a management buy-out of PG Bison’s IT department (PG Bison is now part of KAP Industrial). As a business that offered a complete IT outsourcing solution, it really was a great little business. What happened subsequently, I believe, is that growth, size and incentive all conspired to drive up the rate of acquisitions and drive down the quality of these acquisitions. At the same time, the complexity of the Group was ratcheting up far beyond the scope of the existing business. The combination of these factors scaling-up across time arrived at a large, messy Group with a sprawling operation and questionable capital allocation and without the systems or control to handle it. I believe that none of this was intentional, just incremental.
  2. The public sector in South Africa is about a third of the entire IT spend in South Africa. Almost all of this public sector IT spend is funnelled through the central SITA (good in theory, bad in practice). That means that there is a gatekeeper who controls a huge pay gate. Irrespective of anything, where there is a sales force that is incentivized to sell IT in South Africa, the temptation is very real for these human beings to get access to this (public sector) pay gate from the gatekeeper in means other than legitimate ones. Unfortunately, that is how human incentive works: if the pay-off is big enough, most peoples’ morals begin to become flexible, irrespective of how many nice, pretty policies a business may have.

Progressively over the years, I believe, that points (1) and (2) combined toxically to arrive at the point where EOH found itself a year or two ago. Allegations were flying around, the share price was collapsing, a major acquisition was reversed, cash flows were weakening, and management and staff churned as the boat looked ready to sink…

This all culminated in three key things happening:

  1. Stephen van Coller was appointed EOH Holdings’ CEO to righten the ship and, hopefully, turn it around.
  2. ENSAfrica was given unfettered access to investigate illegitimate practises the Group may have committed.
  3. Yesterday, the finding of (2) was presented to the market by (1).

Firstly, (3) can be summarized in ENSAfrica report (dated 16 July 2019). I recommend that you read the full interim report over here.

In summary, though, the report found c.R1.2bn of suspicious transactions. The majority of these were committed by a small number of individuals, were in the public sector space (surprise!) and from the ‘EOH Mthombo (Pty) Ltd’ subsidiary.

Importantly, though, do read through the report and find the list of measures, controls and subsequent actions that EOH’s “new” Board has implemented to correct past behaviour and prevent future circumvention of the rules.

“New” Board?

This leads me to point (1) above where Coller has driven a clean sweep across the Group.

Below is EOH’s pre– and post-Board. If you click on the below image to see the detail, you will notice that the last snapshot of the top management of EOH before all this came out is completely gone and an entirely new Board is now running the show:

I believe that this is potentially EOH’s “new dawn”.

I was impressed by Coller’s directness yesterday in unpacking what they found and how they have dealt with it. ENSAfrica’s report was concise in what they found and detailed logical controls and solutions to prevent it happening again. And, the clean sweep of management means that a new guard is driving this process with minimal legacy, minimal ego and maximum efficiency.

Afterall, EOH is a service firm first and an IT firm second. If you change the people and the processes in a service firm, you change the service and arrive at a different outcome.

For the first time in almost five to ten years, I think EOH may be worth looking into again, if only from a qualitative perspective.

Notice how I have not touched on any numbers or valuation metrics above? This is simply because we do not know what the “new” EOH will ultimately look like.

Sure, R1.2bn of suspicious transactions were found, but how much business did that bring in? What future revenue is at risk? What legal contingent liabilities are lurking out there now? What margin or volume of work will EOH win on a level playing field? What proportion of the quality staff are left after the last couple of years versus what proportion of quality staff can they still attract? What extra costs and what margins will all these extra controls and procedures cost the Group? Having sold off a chunk of the Group and in trying to pay down debt, what is left and how much is that worth?

While the above narrative hopefully provides context for what I believe may be a structural improvement in EOH going-forward, the latter numerical, financial and valuation questions are both harder to answer and more pertinent for investors considering their share price.

In reality, I do not know the answers here, but I thought there may be value in providing the narrative.

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Top Ten Small Caps

Exert below is from June 2019 letter to investors (link) where I touch on high-level commentary around our top ten small cap investments. Where applicable, I have inserted links to other articles or resources for further reading:

Datatec Ltd (code: DTC) – Datatec’s turnaround of its Westcon International continues to gain traction in, what we believe, is the build-up to the final sale of this subsidiary and the value-unlocking return of this capital to its shareholders. In the background and equally important, Logicalis continues to grow as a global ICT services group. From our portfolio’s perspective, all this uplift is being generated independently of South Africa and is not dependent on local politics, Eskom or macro-data to drive upside. If anything, a weaker local currency creates more upside in this hard currency play. [LINK]

Hosken Consolidated Investments (code: HCI) – Trading around a thirty percent discount to its listed sum-of-the-parts, HCI continues to steadily unlock value across its diverse portfolio. The recent unbundling of the hotels business from the casino business (Tsogo Sun Hotels from Tsogo Sun Gaming) is yet another step in the right direction. Beyond these listed assets, the Group’s unlisted investments—particularly the investment in Impact Oil & Gas—are increasingly valuable while management’s capital allocation track record provides further comfort. In a way, HCI offers the blue-sky upside of any return to growth in South Africa while giving us the margin of safety of investing in this exposure through a massive holding company discount and on a relatively diverse manner. [LINK]

Coronation Fund Managers (code: CML) – With a share price trading on a historical and, likely, forward dividend yield that is above cash (i.e. > c.5.75%), Coronation offers a uniquely high returning (its Return on Equity is over 50%!) option on either a recovery in Emerging Markets and/or a recovery specifically in South Africa. Preferably both. Given the share’s current below-mean valuation against its Assets Under Management (AUM) and the relative transparency with which we can track its performance (i.e. via its underlying funds), we are being paid to wait in this investment and getting any recovery free.

Adcock Ingram Holdings (code: AIP) – Adcock Ingram is a highly-profitable, well-branded pharmaceutical and healthcare product business with defensive, high-margin underlying, a large and winning public sector underpin and an ungeared balance sheet offering acquisition, dividend and/or share buy-back optionality. More recently, the fast-approaching BEE deal unwind should shift Bidvest (code: BVT) into a controlling position at the Group. This may precede an offer to minorities (at an attractive premium; we estimate a low-end price of c.7500cps) and the ultimate delisting of the stock. Either route we stand to gain on this relatively under-priced, defensive security while earnings a c.3.2% dividend yield. [LINK]

Stor-Age Property REIT (code: SSS) – The self-storage property asset class offers a diversified income (lots of little tenants instead of a few large ones) with real asset underpin (if a tenant does not pay, their stored property can be sold to claw-back rental owed) that is very defensive in nature (consumers tend to cling to their material possessions). Any investment in self-storage has high barriers to entry given that the properties cannot be pre-tenants (i.e. tenants sign before the property is built) and new properties carry speculative risk until enough tenants have been signed to reach break-even. This background coupled with the fact that Stor-Age Property REIT compares attractively against the few global peers that exist on profitability, gearing, qualitative (e.g. internal ManCo) and valuation metrics provide the basis for our investment in what we believe is a defensive and undervalued REIT currently offering a fast-growing 7.4% dividend yield. [LINK]

Master Drilling Group (code: MDI) – A global pioneer with a fleet that is multiples the size of the nearest competition, Master Drilling is not a South African business. Rather, we view it as a global, industrial technology play leading in the field of hard rock and commodity drilling services that should diversify (read: boost drill rig average utilisation) across territories (¾ of their revenues is already ex-South Africa) & commodities, drilling services (read: addition of horizontal and main shaft) and even industry (read: construction, hydro-electric, amongst others). As an absolutely special asset, Master Drilling is the definition of a South African-listed small cap stocks that is not South African and should not be trading on such a low Price Earnings as 7.4x. Our risk is that management and/or private capital agree with our view and delist the stock. Sure, this will likely be at a premium to its current share price, but it will mean that we won’t participate in the Group’s future. [LINK]

Sabvest -N- (code: SVN) – Sabvest is currently trading at a large discount to its majority unlisted and seemingly conservatively valued investment portfolio. We expect the collapse of the -N- and Ord structure into a single share class to boost liquidity and further lower this discount. Indeed, management incentives now include the share’s discount to its own NAV. Finally, the Group’s unlisted portfolio is quite attractive with a very strong Rand Hedge element protecting it. Even after a large investment holding discount and a non-controlling discount (due to the -N- shares), we still estimate that Sabvest -N- shares are trading on a c.37% discount to their fair value. [LINK]

Sirius Real Estate (code: SRE) – Sharing some of the same characteristics that make Stor-Age REIT attractive, Sirius plays exclusively in the German property space. While the Group does have some long-lease, single-tenant properties, the Group’s real edge comes in buying industrial parks with large void (i.e. vacant space that is unlikely to ever be tenanted, and hence is not charged for in a property transaction) and then developing good margin, tenantable smart space (office, industrial, logistics or storage) that the Group then tenants efficiently. The uplift in both rental and value of the property is potentially material while the in-house platform managing the tenanting and leases captures material margin (as opposed using external agents). Lowering our exposure to South Africa while offering a Euro-based, fast-growing yield, Sirius provides growth, diversification and long-term upside to the portfolio in a well-positioned counter.

Wescoal Holdings (code: WSL) – At Wescoal’s current Free Cash Flow (FCF) Yield of c.33%, we are paying for about 3 years of mine life. Once you work through the detail, though, Wescoal has a current average 6-year Life of Mine (LoM) and several longer-life green- and brownfields projects that should add materially to this. There is also a profitable coal trading business that we are getting free. Eskom’s sustainability and the general pressure to “go green” remain risks to the longer-term Group, but given the valuation, we are not paying for this longer-term. Anything beyond ‘Year 3’ is a bonus at this valuation. An argument may be against the Group’s capital allocation, its capex requirements or its rehabilitation provision (note: The Group does continuous rehabilitation as it mines, thus this last argument appears factually incorrect), but the current cash flows are quite real as are management’s intention to launch a material share buy-back programme to return surplus cash flows to shareholders. We are cognizant of the risks of junior (coal) mining but we believe that the rewards far (far) outweigh these risks. In every way imaginable, this is a contrarian investment: a South African junior miner in the coal space. Such compounded negative sentiment often emotionally misprices assets and, hopefully, we stand to gain from this inefficiency. [LINK]

Santova Logistics (code: SNV) – Well-regarded Super Group (code: SPG) recently acquired a local, asset-intensive logistics business on a forward Price Earnings of 8.1x (naturally, this is a lower PE than Super Group’s share’s own PE). This acquisition is roughly the same size as Santova’s market cap. As opposed this 2/3PL business that Super Group acquired, Santova is a 4PL non-asset based, globally-trading (c.60% of earnings outside of South Africa) logistics provider. And Santova is currently trading on a historical PE of only 5.8x. Why? For no reason that we can see. We genuinely believe that Santova is a well-run, globally competitive and sustainably growing logistics service provider. Our risk is that companies like Super Group realize this and—as with a range of our above investments—someone delists it. Yes, we will get a short-term pay-out from such an action, but we will lose the option on the long-term growth that such a business can deliver. [LINK]

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Wescoal: Just Being Given Away…

Wescoal (WSL) released their FY 19 results yesterday showing earnings basically halving off a terrible H2:19 period.

Counterparty risk saw a mining contractor at their largest mine go under and necessitating a change in this service provider. Labour disruptions and above-average rainfall further hurt negative impacted on operations. All of these events cost the Group volumes that operating leverage aggravated towards a halving in the bottom line.

Like I said, H2:19 was a terrible period for Wescoal.

Before I go on, I strongly suggest that you work through the Group’s nicely transparent results presentation over here. It holds a lot of valuable information that I will not go into nor even touch on.

Rather, what I will do is show you what I believe is a mind-blowing reality in the market: Wescoal’s current valuation (&, yes, I do currently still hold it in the AlphaWealth Prime Small & Mid Cap Fund).

Free cash flow is the net cash that a business generates after collecting from debtors, paying creditors and other bills, and spending on any capital items to either keep operations rolling (in the strictest sense) or grow operations (in the expanded sense).

In other words, free cash flow is the single closest true profit that a company actually makes each period. You cannot spend IFRS profits, but you can spend FCF!

In Wescoal’s FY 19 period, its free cash flow can be calculated as follows:

(1) FY 19 cash generated from operationsR462m
(2) Tax paid(R113m)
(3) Finance charges(R33m)
(4) Capex spent (sustaining & expansionary)(R115m)
(1) + (2) + (3) + (4) = (5) Free Cash Flow (FCF)R200m
(6) Wescoal’s market capitalisationR604m
(5) / (6) = FCF Yield33%

You will note a number of things from the above calculation:

  • It ignores acquisitions as one-time items, but it does include internal expansionary capex projects spent during this period. In calculating non-growth-based FCF, one should separate sustaining capex from expansionary capex. I do not do this here.
  • I have not tried to “normalize” or adjust this FCF in any way to take into account steady-state production. This is relevant as H2:19 was an anomaly and FY 20E should arrive at (much higher) steady-state. In other words, a more normal year should see FCF much higher than the above. I have ignored this fact.

These assumptions make the above FCF imperfect, but they do simplify the number of other assumptions that go in. And, in a way, they make it more conservative.

Now what does Wescoal’s current 33% FCF Yield mean?

It means that if Wescoal does nothing differently, carries on operating at this level, pays all its bills, creditors and financiers as per normal and then pays out the rest of its cash as dividends to shareholders, that shareholders will have had their entire capital (assuming that they paid 135cps for WSL shares) returned to them via dividends within c.3 years.

I.e. 33% cash yield x 3 years = 100% of capital returned by the end of Year 3.

Yes, this ignores dividend taxes and a range of other assumptions (both good and bad, as noted above) but I am just keeping it simple here.

Is the 33% FCF Yield for Wescoal good or bad?

Well, if you work through Wescoal’s existing (once again, ignoring their growth projects) portfolio of mines, you find that their Life of Mines (LoM) range from 3 years to 7 years. More importantly, from a portfolio perspective, if you calculate a weighted-average LoM, then Wescoal’s portfolio’s average LoM is c.6 years.

(Yes, VG5, Moabsvelden & Arnot will add materially to the Group’s average LoM, but I am ignoring these here.)

In other words, at the current market price for Wescoal shares with its 33% FCF Yield, you are paying for a 3 year LoM and getting another 3 year LoM free.

Oh, and then as noted above, you are getting all the growth projects free. Oh, and the Coal Trading segment free too. Oh, and, finally, this is also assuming that FY 19E is the best Wescoal can do, yet we all know that H2:19 was quite the anomaly and sustainable profits and cash flows should be higher.

In other words, as far as I can see, Wescoal shares appear to be at an absolute bargain basement pricing. No wonder yesterday the CEO explicitly stated their intention to launch a material share buy-back program.

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What Do Auditors Do & Not Do?

Following all the local corporate failures, the media and many (ill-informed) investors have savagely turned around and blamed the external auditors. While easy–and very human–to blame someone else like an external auditor for fraud, two things have become quite apparent:

  1. Many people do not actually understand what an “external financial audit” is and what an “auditor” does, &
  2. Many people do not understand what an “external financial audit” is not and what an “auditor” does not do.

A lot of journalists fall in the above camp and, likewise, investors that cannot seem to take (at least some) responsibility for their own losses. Perpetuating this misinformed views will needlessly damage the auditing profession and, ultimately, this will damage South Africa and its own financial markets.

Having sufficiently dissed enough people above, let me quickly unpack (1) and then (2) before concluding:

An external auditor is hired by the Board but voted in and out by shareholders. Ultimately, these external financial auditors (and their firms) report to shareholders and the Board does not have the power to remove them. This prevents Boards that have adverse opinions being published against them removing auditors until they find one that will “side” with them (i.e. sign-off their fraud).

In this manner–including a range of rules, laws and safeguards–external auditors should be completely independent of their “clients”, being the company that they are in fact auditing. They report to shareholders. Any impairment (or even the appearance) of this independence is severely dealt with and puts them and their firm(s) at personal risk.

This complex relationship is important to understand and a large portion of the auditing standards and various ethical standards that all auditors (being CA (SA)’s and their trainees) adhere religiously. Not to adhere–or have proof of adhering–would put them at personal legal risk. Note that: personal risk.

Now, amidst this balancing act, external auditors have a singular objective: to ensure that the financial statements of the company that they are auditing comply with the International Financial Reporting Standards (IFRS) and any other relevant rules or legislation (for example, the JSE’s various rules and/or the Public Finance Management Act) in all material respects.

While the adherence to rules is fairly self-explanatory, the aspect of “materiality” is less so.

An auditor considers something “material” if its inclusion (or omission) would change the decisions of the ultimate users of the financial statements.

Most users in the market seem to view financial statements as fact. They are not fact. Rather, a set of financial statement of any company will include a degree of interpretation, guess-work, estimations and may have errors. Unfortunately, business is complicated and large businesses are more so, hence the nature of the accounting beast that is trying to be as accurate as possible, but, when in doubt, at least materially accurate.

How does an auditor ensure the above?

They utilize a large series of tests to check for the validity, accuracy and completeness of a company’s accounting records that feed through to the final financial statements that they then sign off.

Using samples, statistics and a risk-based process–i.e. testing the riskier and larger things more thoroughly than the less-risky and smaller things–they compile evidence that will eventually support their opinion that a company’s financial statements reasonably represent (in all material ways) an accurate reflection of that business.

Sampling and the focus on risk–i.e. materiality–mean that most things are probably (read: hopefully) caught, the client will be told to adjust for it and the quality of the final financials should be much improved. If the client refuses to adjust for material mistakes–even if they are unintentional–then the auditor can issue a qualified audit opinion and highlight these aspects. This does not mean that the company does not produce financial statements, but rather that the end-user of those financial statements needs to be very, very careful in relying on them…

Do yourself a favour: google and find SAA’s latest financial statements. Ignore all the rubbish PR in it and jump straight to the external auditor’s report and read that.

How horrifying is that report? It is the polar opposite of all the wonderful, fist-pumping PR that fills the rest of SAA’s financial statements.

That report is what a qualified audit report looks like. And, almost every single SOE, municipality and Government agency has one of these.

Almost not a single listed company does. (Those two or three that currently have audits pending and/or auditors have identified problems the JSE has highlighted and they are noteworthy due to their rarity on the JSE and not their prevalence i.e. Tongaat Hulett & Choppies right now.)

Just point out this juxtaposing fact. Our local corporates are still generally well-run. Our public sector is still mostly a pile of rubbish. Don’t let the politicians or journalists try to tell you otherwise.

Moving on to (2)!

Do you notice in the above granular unpacking of an external auditor’s role a number of things have not been said?

An auditor’s job is to ensure material correctness, accuracy and validity of financials, and not whether the business is a good or bad one?

While financials are normally compiled on the assumption that a business is a going concern, in reality, this is quite easy for a smart management team to prove irrespective of the underlying realities and risks that they are taking. Also, the future and fortunes can change quickly, especially with large amounts of debt!

Auditors have little chance in picking up large and fast collapses before they happen (albeit, slow train-smashes may be detected and noted in their audit reports). They do try, but not even auditors know what the future is.

Thus, an auditor signing off a set of financials does not really mean that the investors’ money is safe there either. No, that judgment the investor alone will need to make for themselves!

Likewise, auditors are not verifying the quality of the underlying business. They may make very reserved recommendations to management, but they are not running the business. In fact, they are not allowed to be involved in decision-making or operations as that would be a serious conflict of interest.

When businesses are badly run, well, that is all on management.

Probably the most misunderstood aspect of external auditors is that they are not there to detect fraud. They do not test everything. They use sampling and materiality to guide them and can miss plenty, particularly if management is making a serious and coordinated attempt to hide something. And (major) fraud is rarely committed in isolation and almost always with top-level coordination. And those that commit fraud will always try to conceal it because that is the nature of it.

No, external auditing is not forensic auditing. The latter does not work on a sample basis but, rather, check each and every single transaction. This is probably why PwC’s report on Steinhoff is taking so long… The difference between taking a sample of transactions and checking each and everyone for a global, multi-national retailer is gigantic

Hence, forensic auditors work slowly and charge a lot. If listed companies’ only reported forensically audited financial statements, then we would probably be waiting years for a set of financials from any of them and the audit fees alone would wipe out most profits!

Time also makes a set of financials relevant. Too late and no one cares because the world, markets and the underlying business itself has moved on.

Now, if an external auditor stumbles onto fraud then, yes, they do act on it! But, no, they do not focus exclusively on finding it.

I. Cannot. Emphasize. This. Enough.

Investors need to do their own work to decide whether they trust a management team or not. Decide whether there are warning signs in a business or not. And then own their own decisions and their mistakes.

External auditors can protect investors against this, but they are a wide net to cast with many practical holes in it. Thus, auditors should not be exclusively relied on as the first-last-and-final defense against fraud.

In summary, external financial auditors use sampling and materiality to arrive at an evidence-based conclusion that a company’s set of financial statement are or are not valid, accurate and complete (per the various rules, like IFRS, that they need to comply with).

The auditors ultimately report this to the shareholders. If major risks in terms of going concern and/or fraud are found, then this may be communicated too, but these are–broadly-speaking–not the external auditor’s exclusive focus.

No, at some point, investors have to take responsibility for their own decisions to invest.

There are bad Boards out there and rubbish management teams. Avoid these, invest in the good ones, read the audit reports and, with a bit of luck, you will avoid the next Steinhoff, Tongaat Hulett and/or Choppies.

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Tax-Free Savings Accounts: Buy Risk & Sell Time

A Tax-Free Savings Account (TFSA) offers a superb, tax-efficient mechanism to compound long-term investments for South African citizens.

In the below example, I use an assumption of 15% CAGR per annum from a basic South African equity investment and assume that you are paying a marginal tax rate of 45%. I also assume the effective capital gains tax rate is 18%, but in reality, it will probably be higher in the future (Governments tend to hike taxes on rich, especially in countries like South Africa).

Just these basic variables stretched out over 30 years of investment horizon reveal the massive difference between an equity investment made via a TFSA and the same one made in your own name: And the difference is only the tax paid.

Said different, the (legal) avoidance of tax is free upside to you as the investor. And, in the TFSA, the greater risk you take and the longer time period you leave it, the greater the compounding and upside potential and the greater the tax bill you do not have to pay.

Hence, the greater the free upside you gain.

Due to this, I am of the opinion that any astute investor in South Africa should strongly consider making a small cap equity investment fund their core underlying for their TFSA.

In the long-term, small caps outperform large caps (see below figure). Thus, while equity is a great underlying in a TFSA for those with 20+ years to invest, the best underlying is, in fact, the fastest-growing (albeit riskiest) part of the equity markets: small cap equities.

We manage the AlphaWealth Prime Small & Mid Cap Fund that offers exactly this with its TFSA class (Class B2) via our TFSA account (see link here).

Give me a shout if you want more detail on this?

I think the greatest tragedy is when people do not take advantage of the TFSA mechanism. The second greatest tragedy is when banks or other enterprises convince them to invest their TFSA in some low-interest, capital-eating account for the next couple decades.

The TFSA is for sticky, long-term money that should be agnostic as to the cycle or inherent short-term volatility of the underlying. The TFSA is for taking risk over long periods of time.

Don’t sell yourself short here; buy risk and sell time. Invest in small caps via your TFSA!

OK, marketing aside, I really do believe this. At least, consider taking some risk with your TFSA? In the long-term, the greatest risk you can take is no risk at all.

P.S. Below is a chart of S&P 500 Index (converted into ZAR) versus the FTSE/JSE Small Cap Index (also, naturally, in ZAR). Our local small caps do not just beat the “safe” offshore large cap index (including Rand depreciation!), but they completely smash it out of the park. Data is for the entire available period I could get.

Source: Bloomberg (4 June 2019)
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A Range of Follow-ups

Firstly, I apologize for the lack of recent posts on this website. Life and markets have kept me very busy and, unfortunately, my investors come before a blog.

That said, let me take a bit of time to update a range of views I have expressed on this blog elsewhere (with links to original articles that I do encourage you to read for context):

Local Recession: Q1 Certainty & Q2 Likely

On the 4th of June, Stats SA will likely announce South Africa’s Q1:19 GDP print. And it will almost certainly be bad.

I am expecting -2.0% y/y, but it may be a bit worse or a bit better. Either way, I am certain that it will be negative.

Q2:19 is probably also negative when that comes out. So, don’t get a shock in a couple month’s time and do not get shaken out high-conviction equity investments when the coming results seasons has nasty numbers published through. This will probably be true of both this results season and the next, as financial results are always lagging.

I believe that Q3 and Q4 this year should start to see the local recovery that should gain an exciting pace in 2020 and, hopefully, onwards. In fact, twice across the last week I have met with CEO’s who have mentioned seeing “green shoots”…

Time will tell, though, how relevant those are.

My point is that with trough earnings at a trough multiple as fundamentals bottom and begin to improve, now is probably not the time to sell any local equity. If anything, now I would be buying into these lows (slowly & steadily) as your greatest risk is missing out on what may come next.

Retail Apocalypse: Unchanged View

A while ago, I identified the entire retail sector in South Africa as a key sector to avoid with its geared-cousin, retail REITs.

Read the original articles here:

Almost everyone is aware of the pressure that the local retailers and the local property companies are under. Hence, it is a bit gratifying that what I saw coming is now happening.

But, this is not a told-you-so article. It is just re-emphasizing that we are far from out of the (retail) woods, and the knock-on into retail REITs has been quite minimal as of today.

The latter point will almost certainly change, in my opinion. Retailers can evolve and shift online–have a look at the The Foschini Group (code: TFG) latest results–but shopping centers are both geared and inflexible.

Now, the South Africa’s REIT-market is distribution-focused. Hence, if a REIT can create the illusion of growth in its distribution, then the market won’t punish it (or, perhaps, reward it).

But, distributions are partially discretionary as the Board decides them based on their distributable earnings (within REIT rules of minimum pay-out ratios) and the quality of these distributable earnings have been steadily dropping over the course of the last two or three years.

What I mean by the latter statement is two-fold:

  • More and more non-operational once-offs (e.g. profits of selling property, various other “gains”) are being pushed through REITs’ distributable earnings to prop them up. Reverse these, and the picture often looks worse. Do yourself a favour and read these distributable earnings disclosures by the REITs (often buried deep in their notes) first before reading all their “highlights”…
  • “Hidden” subsidies and discounts are being embedded into rentals via non-rental items that can be hidden on REIT balance sheets and not come out of distributable earnings or disclosure on escalations/vacancies. This is a subtle topic of accounting obfuscation and, perhaps, I should write an entire article just on it. An example, many shopping centers are offering to pay for store refurbs themselves if the tenants accept their escalations like normal. Tenants do not care because this effectively lowers their net cash rentals, but REITs account for this transaction quite differently… Think about it.

In conclusion, remain wary of our retailers and remain terrified of our (retail) REITs. The former have structure challenges while the latter have massive gearing, deep inflexibility & are running out of accounting-based obfuscation to hide it.

Hosken Consolidated Investments (code: HCI) – Cheap as Chips…

HCI published their results the other day and they are as solid as ever. If you merely take the Group’s investment in Tsogo Sun (code: TSH) at market price on the JSE, the Group is trading at a c.10% ~ 20% discount to just this!

Add all the rest that I touch on in this article (HCI: Better Than Buffet?) and you can see why HCI remains one of my largest investments.

Not just is it shielded against downside by this discount and the agility of management to create value, but it is also positioned perfectly for any return of domestic growth whatsoever.

Hence, yes, I do still think that HCI is cheap as chips!

Santova (code: SNV): Tough Results, Good Business

Santova published tough results the other day that saw earnings slip a bit. As a growth story, this is frustrating. The Group’s inherent business model as a 4PL is beautiful, but the underlying volumes are still generated by cyclical logistics demand from clients.

In other words, Santova may be a fantastic, capital-lite globally-growing logistics player, but it still just a logistics player and, thus, sensitive to the same pressures that all logistics players are subject too: trade volumes.

Recently, in what I believe is a recessionary South Africa, trade volumes have been bad. And then there is Brexit. And then there are Trade Wars… And so on, all hurting global logistics players.

That said, a bad set of results does not mean that Santova is a bad company. Quite the contrary, I believe, as the Group continues to build out its offering, open up more trade routes (increasingly less reliant on South African trade too!) and bolt-on parallel services (e.g. Santova Express).

Much like HCI above, I remain extremely comfortable holding Santova as a core investment and–at a 6x Price Earnings–I am really not paying much for the access to the potentially exciting, global future embedded here.

When Bad Results Do Indicate a Bad Business

I have made plenty of investment mistakes. Investing is hard, never forget that.

Consolidated Infrastructure Group (code: CIL) is one such investment. As a matter of linear history, read my (original) investment case for them here and then read my subsequent realization that this investment case was wrong and our decision to exit here.

It reflects badly on me, I know. But it is what it is, and self-reflection cannot truly happen without brutal honesty.

Subsequently, CIL has seen a large new shareholder come in, a massive rights issue and, yesterday, published a nasty trading update.

The share is already a fraction (even more so, if you take into account dilution!) of where we sold it (at a loss) and moved on with our lives.

Unfortunately, I don’t see a low-margin, high-risk, pan-African heavy construction business turning any corner any time soon. If anything, they may need another rights issue…

Hence, sometimes bad results are just a symptom of being a bad business and one needs to acknowledge that too.

Likewise, Tongaat Hulett (code: TON) is another of my mistakes, albeit one where we never lost much money and got out a lot sooner (i.e. learning from our CIL mistake!).

Tongaat Hulett is just going from bad to worse, as debt issues and the need for a rights issue is being compounded by potentially irregular accounting and overstatement of profits and balance sheet.

The lesson here is simple: do not hold what you do not want to hold.

Whatever price you originally paid for it is irrelevant and a sunk cost, but continuing holding an investment and rationalizing why when all the warning signs are flashing is potentially very destructive. Small mistakes become big mistakes then, and the latter must be avoided at all costs.

Businesses can always go to zero. Your capital never should.

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CSG Holdings: Is Our Investment Case Still Valid?

If you stand back from the noise, we made an investment into CSG Holdings (code: CSG) due to several concurrent factors that we believed raised the odds in our favour:

  • Quality: CSG Holdings was the second largest staffing business in South Africa and had double the margins and double returns of its larger competitors – I.e. It was a better business.
  • Value & Growth: The entrepreneurial-founders & deeply-invested management team were building out an industrial services and security business that the market was not giving them any credit or value for. Despite this, these businesses collectively contributed more to the Group’s profitability than the old staffing business.
  • Diversification: The Group was broad, diversified and—although exposed to cyclical industries in South Africa—was a (more) defensive way to play the cycle. As the non-staffing side grew faster than the staffing side, this last point would increasingly true over time.

Interestingly, we believe that points (1), (2) and (3) are still valid, albeit the Group is certainly feeling both the macro-economic pressure in South Africa and is finding the building of the services-side more challenging than expected. The latter point is a combination of some mistakes and the fact that it is always easier to build businesses in a growing economy than a static or contracting one.

CSG Holdings put out a negative trading update recently and followed this up with a more detailed operational update earlier this week. Please do read the full operational update here. A concise summary of this news flow is below:

  • The major cyclical sectors that the Group services in South Africa have been under pressure. Even the defensive sectors (e.g. security) that the Group services have been under pressure due to a combination of rising costs (e.g. high fuel price as a large input cost into a patrol fleet) and falling disposable income (e.g. consumers’ ability to absorb security contract inflation). This has put CSG Holdings’ underlying businesses under more pressure than they were a year ago.
  • A fraud was discovered in the one staffing business and has been dealt with, though it has cost the Group during the period.
  • A range of once-off costs hit the Group in H2:19 from bad debts in the construction sector to start-up/expansion/consolidation costs in some new or expanding businesses to some smaller acquisitions under-performing and needing either restructuring or disposal thereof.
  • Earnings will be materially down on last year and, given the above, I would not be surprised for an intangible impairment or two.

Point (1) above is merely the vulgarities of doing business in South Africa over the last year. We do not believe that (1) disproves our investment case noted above. Unfortunately, it does infer that—despite the diversification noted earlier—CSG Holdings is a more cyclical group than we initially anticipated.

The flipside of this increased cyclicality, though, is that if the cycle in South Africa is turning, CSG Holding may actually have more upside potential than a less cyclical business!

Point (2) about fraud is a red-flag, as it points to a weaker control environment than expected. While the fraud appears to have been dealt with and concisely quantified (it is minor R9m in quantum), it does beg a range of questions: who, where, how, and what now?

Unfortunately, given that CSG Holdings is still in a Closed Period, we will only be able to engage openly with management after the Group’s results come out (late-June 2019).

We console ourselves that the fraud was found, dealt-with and it is relatively small (i.e. The exact opposite of what appears to be happening at Steinhoff). Hence, this is likely an isolated issue and we are neutral on this fact (for now).

Moving to point (3), there are few companies in the South African construction sector that are not potentially bad debtors now. Rather than penalizing CSG Holdings for construction sector debtors that go bad, we believe that the blame here lies on us. CSG Holdings’ services the construction sector and, knowing this, we are invested in the stock. Hence, the risk was cognisant and consciously taken by us. Once again pointing at the potential turning of the domestic cycle as an indication that this recent problem may, in fact, prove to be an opportunity in disguise going forward and definitely safer than actually buying a heavy construction stock.

The small disposals, restructurings of some of the businesses to give them a scalable national footprint and the start-up costs from some new (and exciting!) businesses in the Group are all just “growing pains”, thus we are quite comfortable with them. In most instances, they appear to be taking the pain today to build a better business tomorrow, hence the cliché growth profile looking like a “J-curve”.

In summary on point (3), the fact that earnings will be down over this period is neither here nor there. Because the balance sheet still appears comfortably solvent and the Group is almost certainly trading liquidly, the only question worth asking is what the long-term earnings sustainability and growth may look like?

Given the above and conscious of the macro-economy within which CSG Holdings has operated through, we still believe that CSG Holdings will prove to be a good investment. We are controlling our position size (c.3% of the portfolio) and, once the full results come out, we will engage with management thoroughly.

Despite this, the share price is not too far off from the Group’s tangible NAV (should be approaching c.40cps to 45cps by now) that is pretty much unheard of in a profitable services business. A service business’s greatest assets do not lie on their balance sheets (as part of TNAV) and, typically, are their people and their brands.

Let me phrase it this way: At 58cps, CSG Holdings shares are on a small c.45% premium to the Group’s hard, tangible net assets. Even EOH Holdings’ own shares are currently trading at a >600% premium to the tarnished ICT group’s tangible NAV of c.638cps (EOH’s share price is c.2250cps). And CSG Holdings is certainly no EOH Holdings: the Group still has its reputation, brand and other intangibles intact!

(If CSG shares traded at the same premium to TNAV that EOH shares do, then CSG’s share price would be c.240cps!)

While we are not happy with many of the developments noted above, we are cognizant of them and balance this against both the valuation of the share and the Group’s prospects. Hence, we believe that the share price gives us a large margin of safety at its currently depressed valuation with potentially good prospects going forward.

Therefore, we remain invested in CSG Holdings in the AWSM Fund and—especially at this share price!—are particularly excited about potential returns from this investment.

Exert from AlphaWealth Prime Small & Mid Cap Fund’s April 2019 investor letter (link).

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HCI: Better than Buffett?

As an empowered investment company under John Copelyn’s stewardship, Hosken Consolidated Investments (code: HCI) has outperformed both Berkshire Hathaway and PSG (both in ZAR) since the end of the 1999’s (Figure 1). This outperformance of Warren Buffett’s Berkshire Hathaway becomes more pronounced when you consider that Berkshire does not pay dividends but HCI does.

Arguably the best quality hotel, casino and gambling operators in South Africa (and Africa), Tsogo Sun (code: TSH) is controlled by HCI. While there is a balance of risks and rewards in Tsogo, if we assume that the market is pricing Tsogo Sun fairly (Note: There are good arguments about why Tsogo Sun is actually cheap.), then HCI’s market cap is currently trading at a discount to the basic market value of its investment in Tsogo Sun!

(Taking out some debt, ignoring tax and one or two other assumptions, HCI’s market value of its Tsogo Sun investment is approximately R10.6bn or 12500cps. HCI’s own market cap is only R10.3bn with a share price of only c.11500cps!)

Now go and add to this simple sum-of-the-parts the fact that HCI also own a property portfolio worth over R2.8bn, a number of coal mines, a stake in a platinum miner, and controls eMedia (invested in OVHD, eTV and a number of other media assets), Hosken Passenger Logistics (i.e. Golden Arrow Buses), Deneb (industrial, property and consumer good business) and some other minor assets dotted around (even after taking out the debt at the centre).

In other words, HCI is very cheap, despite being high-quality and well-diversified with some rather material, flagship assets.

Recently, though, HCI has become even more attractive due to a part of their investment portfolio that we had previously given zero-value to. This investment we originally wrote-off is now obviously worth a lot. If not billions of Rands.

HCI has been quietly allocating increasing amounts of capital into an (effectively) controlled offshore business, Impact Oil & Gas Ltd (Impact O&G). The business is an oil exploration group out of the UK with interests in a range of potential oil fields and early-stage/exploration-type hydrocarbon assets. This is exactly the type of business that we prefer not to pay for and get for free in an investment like HCI.

Hence, we gave it a zero value and refused to pay for it (despite HCI allocating about R1bn of capital to it).

Interestingly, one of the investments that Impact O&G made was an effective interest of c.5.1% of the Block 11B/12B off the southern coast of South Africa. Yes, this is the self-same field that Total recently announced a major hydrocarbon find at (Total’s press release here). Here is Impact O&G’s own press release.

Block 11B/12B is both a material hydrocarbon discovery for the world and a massive boost for South Africa. Our understanding is that it is also only the first hole drilling into this prospect, thus future holes will likely open-up a much larger total resource.

By various extrapolations and assumptions, we estimate that HCI’s c.2.5% effective interest in Block 11B/12B is worth between R0.8bn to R1.6bn (i.e. between c.+7% to +15% of HCI’s entire market cap tied-up in an asset that we and the market were giving zero value to!). While this rough valuation of an early-stage hydrocarbon asset is probably wrong, the fact is that this single investment by Impact O&G should move the needle in terms of HCI and its investment case.

It is also worth noting that Impact O&G has a range of other investments beyond Block 11B/12B and some of them (at least on paper) appear to be more attractive assets than this find off the coast of South Africa.

Suddenly, we are contemplating if Impact O&G may be worth more than zero. A lot more. Hence, we have gone from finding HCI attractive to finding it very attractive…

In five to fifteen years’ time, HCI could well be a significant oil and gas investment on the JSE. It does not hurt that you also get a nice portfolio of hotels, casinos, gaming, media, property and mines, amongst other things, and all this is managed by a fantastic capital allocator with rigorous oversight and possibly a better track record than Warren Buffett.

Original article published in AlphaWealth Prime Small & Mid Cap Fund’s March 2019 Investor Letter (link).

See my previous article on Hosken Consolidated Investments here: “When Book Value Is Real”

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