The Cost & Opportunity of Illiquidity

Foreign capital has been selling our local equity market. To be honest, I think so has local capital. And all of this capital has been flowing offshore.

The consequence has been a steady de-rating in our locally-listed equity valuations, particularly those smaller and more “SA Inc” type stocks.

See here: The Cheapest Equity Sector in the World

Not all stocks feel this exodus of capital the same.

Think of liquidity as a table top with capital being poured from a jug in the center. It always fills up from the center first, likewise it dries from the edges first. If you pour lots of water, the table top fills and spills over the edge. When you pour less water, the center of the table remains wet, but it doesn’t reach the edges of the table top at all.

In other words, the smaller, more marginal and less liquid stocks have “liquidity leverage” where they feel changes in capital flows materially more.

What has the impact been on our small caps?

Huge. The impact has been huge.

In a letter I sent out to investors (download it here), I tracked the relative valuations across Top 40, Mid Cap and Small Cap indices as an (imperfect) indication of the “price of liquidity” in the market.

Here is the key chart:

Both small and mid cap stocks are trading at near all-time high discounts against Top 40 valuations. This implied liquidity premium is miles above average in both cases.

In fact, we can quantify that using the difference between current liquidity premium and the long-term average liquidity premium.

If liquidity (or the appetite for illiquidity) in our domestic market was “normal” then the following instant upsides would appear (via re-rating in valuations upwards) in small and mid cap stocks:

Average DiscountCurrent DiscountImplied Upside
Small Caps-35%-53%+18%
Mid Caps-23%-30%+7%

In other words, if liquidity flowed back into our market (dangerously assuming ceteris paribus), the Mid Cap Index would jump +7% and the Small Cap Index would jump a massive +18%!

I’ve heard arguments that our market is doomed because the foreigners are selling it.

I would argue the opposite. I think that our domestic equity market offers an absolutely unique opportunity right now because the foreigners have sold it down so hard, liquidity has flowed out and the valuations have moved from cheap to ridiculous.

Yes, there are plenty of risks. But this is no different from any other market, especially the other EM markets that everyone loves comparing us to.

The two variables, though, that you can control is what you hold and how much you paid for it. And, the way I see it, if you are going take advantage of the cheapness of our local market, then do so in the part of this market that is the cheapest of the cheap sectors: South African small caps.

While I am completely and unashamedly talking my book here, I do think that this is the opportunity of illiquidity right now. If you are willing to provide liquidity to someone else in the South African small cap space right now, then they are paying you 18% for this privilege. Why not take the money? How often do people offer you an 18% discount in profitable businesses merely for cash?

Facebooktwitterlinkedinby feather

Why is Construction Uninvestable?

Wilson Bayly Holmes-Ovcon (code: WBO) put out a terrible trading update last week indicating that they expected H1:19 HEPS to basically fall to zero (between 80% to 100% down).

WBHO has long been viewed as the quality in the construction sector but, with this announcement, even they appear to have taken a bullet.


Well, construction is incredibly difficult, complex and messy. And you earn almost nothing doing it.

Ignoring the industry’s other operations, building materials and manufacturing businesses, heavy construction businesses tend to generate operating margins of between 1% to 3%.

Why is this a problem?

Well, a construction contract is a risky thing. Not just do you have to price it correctly before you do the work, but you are pricing is against other people with–let’s be honest–the cheapest one winning the work and the rest of the bidders getting nothing.

Oh, and then you have to actually execute the contract correctly, whether or not you priced it correctly. And, given the nature of a construction project, the execution can be incredibly complex and unpredictable.

Thus, a construction contract can quickly turn from an asset into a liability. And, given the slim margins of these contracts in the first place, not only is that easy to do but it can be devasting.

Let me phrase it this way: A heavy construction business running at an operating margin of 1% needs only 1-in-a 100 contracts to go completely wrong for it to lose the operating profits on the rest of the 99 contracts!

Imagine the pressure? You have to get a success ratio of more than 99 in a 100 on incredibly complicated, messy work, or else you are reporting a disaster to shareholders and be wasting your time. Oh, and you still have to actually complete the loss-making contract too.

WBHO’s operating margin averages c.3% over the last five to six years (which, by the way, is miles ahead of most of its competitors who tend to run at 1% operating margins!). Thus, if WBHO completely messes up more than 1-in-33 contracts, they can wipe out their period’s profits.

In WBHO’s trading update, this is exactly what they did in Australia. They mispriced a large contract over there (kudu’s to them for being honest about that mistake with shareholders!) and that single mistake has wiped out the entire H1:19 profits.

Over the years, I’ve come to appreciate the construction sector is (mostly) uninvestable. Not only does the entire sector not earn their actual Cost of Equity, but they have failed to do so locally over a period that includes some rather serious tender collusion practises!

For my sins, we were invested in Consolidated Infrastructure Group (code: CIL). The Group’s construction margins targeted and regularly achieved around 8%+ due to the niche nature of their power-focus. We believed that this insulated them from the above-noted risks, but, in the end, those margins appear to have come from aggressive accounting practices and tailwinds on the back of excessive risk-taking.

We were wrong there and we paid the price. It happens.

But, as noted with even the industry-stalwart, WBHO, we still haven’t found a single other business in this sector that we think is investable.

Until either the number of competitors materially shrinks, the volume of work increases beyond the capacity and/or some level of pricing power appears to compensate the risk being taken, I honestly think that heavy construction is uninvestable.

Facebooktwitterlinkedinby feather

Adcock Ingram: Four Drivers of Upside

Adcock Ingram Holdings (code: AIP) has a rich portfolio of well-branded medicines and healthcare products. The Group manufactures, markets and distributes these products predominantly in private and public sectors in South Africa but also has a reach into African export markets.

You will recognise most—if not all—of the Group’s product range: see the branded portfolio at this link.

Despite being small and low-profile, the Group’s returns compare well globally and make its nearest locally-listed comparative (the much-larger Aspen Pharmacare) look quite poor (Figure 1).

There are several potential drivers of positive return converging in Adcock Ingram right now:

  1. Product & Pricing: About two-thirds of the Group’s products are exposed to Single Exit Pricing (SEP) regulation in South Africa. The recent SEP increase should filter through over the course of the next year, boosting revenues and profits nicely. Likewise, the underlying products are relatively defensive—when you are sick and want something to make you better, do you haggle over price or brand?—and stand to gain from a growing disease burden and population.
  2. Currency: Adcock Ingram relies on imports quite heavily. While the Group tends to hedge on a quarterly to six-month rolling basis, the reality is that a strong Rand boosts the Group’s profits (by lowering its variable costs) quite materially. The current Rand strength lifts the Group’s valuation materially, most of which we do not believe has been reflected in a basically static share price.
  3. Acquisitions & Expansion: The Group has an ungeared balance sheet. It is also highly cash-generative with (as shown above) great RoC. Management has asserted their intention to begin acquiring synergistic businesses. While the domestic market for sizable pharma- and healthcare businesses to add to Adcock Ingram may be limited, the lack of gearing (i.e. safety) of the Group’s balance sheet and its cash-generative returns gives it plenty of capacity to add value with acquisitions or expansionary capex. In the absence of acquisitions, we expect management to return the growing excess capital to shareholders through dividends or share buy-backs. Any outcome would generate shareholders upside and, to be honest, we are agnostic as to how we receive that upside.
  4. Corporate Action: For legacy reasons Bidvest Ltd hold c.38% of Adcock Ingram Holdings Ltd. While Bidvest adds limited value to the Group, its 38% holding constricts the Group’s free float and creates an unnecessary overhang. In Bidvest’s FY 18 financials, the industrial group notes that “Our intention for some time has been to dispose of our holding in this business [Adcock Ingram Holdings Ltd] to appropriate new investors to create a catalyst for South Africa’s first major black-owned health care company. There have been numerous discussions and some exciting prospects, but the funding of this venture is proving challenging in this economic environment.” We expect such a corporate action to generate positive upside in unlocking value for the Group and, naturally, us as shareholders in it too.

Considering all the above upsides embedded in Adcock Ingram, it is even more surprising how relatively cheap the stock is trading against its global comparatives, indices and even the arguably-inferior Aspen Pharmacare (Figure 2):

In other words, while Adcock Ingram is smaller than our comparative global pharma-group and Aspen Pharmacare, it is superior on many other metrics against these comparatives. Size is not perfectly correlated to quality, and Adcock Ingram is a superb, high-quality Group with a range of upside options available to drive forward returns in the stock.

Oh, and it is cheaper than the above-noted comparatives.

Basically, a win-win for investors, as far as we are concerned.

Exert from AlphaWealth Prime Small & Mid Cap Fund’s January 2019 Letter to Investors.

Facebooktwitterlinkedinby feather

Three (More) Lessons from 2018

In hindsight, launching the AlphaWealth Prime Small & Mid Cap Fund just before a near-half-decade de-rating in the domestic small cap market and a subsequent bear market, was not the greatest timing.

But, you don’t get to choose when opportunity knocks on your door. You just have to get on and make the best of it.

On the upside, good funds can be built in bad times as the pressure forces discipline. It also teaches lessons, of which I like to regularly look back and see what we have learnt (for better or worse, our experiences should make us more valuable over time).

For some past lessons (still mostly applicable) see the below articles (for some incomprehensible reason, I appear to really like the number five!):

Following this tradition of looking back and learning lessons (but breaking with the tradition of listing five!), I’ve pencilled three more lessons worth contemplating.

(1) Cash Flows Don’t Lie — Management Does

Not that all management teams that mislead investors actually lie outright. Some do so by omission. Other do so through attitudes of unrealistic optimism (or, rarely, pessimism). Even yet others try to shift focus onto metrics that make them look good and away from metrics and risks that make them look bad.

Some may not be outright lies but they certainly aren’t complete truths either.

Behind every listed stock, there is a business. And a business is just a collection of people working together in agreed manner to a common purpose. Groups of people have stories, and, thus, every listed business has a “narrative”.

Management often unpacks this narrative for investors in results, presentations, interviews and meetings.

But, like with anything in life, sometimes stories are misleading, and reality is either different or it could still happen differently when the story is about the future.

All figures in a company’s financial statements can be fraudulent or misleading. Despite this, the hardest (though not impossible) one to manipulate is that of cash and cash flows through a business.


Simple: other than the accountants, the bankers keep a record of this. Thus, the auditors can simply reconcile the bank statements (collected from the bank and not the company) back to the accounts of the company and see if things appear right or wrong.

The big picture here is that when “narrative” and “facts” diverge, rely on the facts. Not the management. And, in terms of “facts” that are often very revealing, cash flows are among the best.

When cash flows disagree with management, the odds are that cash flows are right.

(2) With Debt, Something Eventually Goes Wrong

Debt is often cheaper than equity. This is especially true for large listed companies and, thus, many of them borrow progressively larger amounts over time to enhance their shareholder returns (so-called “gearing” their Return on Equity).

The problem with debt is two-fold: (1) The more debt you have as a company, the more risk you are inserting onto the company’s balance sheet, & (2) Business is inherent unpredictable and risky and, no matter how great the company, given enough time, eventually something will go wrong somewhere.

And, when (2) happens, then (1) makes the downside and damage all that much worse. Sometimes exponentially so…

Be critical of the financial structure of companies and adjust for the risk of highly-geared businesses and business models.

This lesson becomes particularly true if one or more things is happening:

  • Management teams do not own much (or any) of the shares in the company they are managing: This means that they are borrowing on other peoples‘ behalf. They can then gear the company, hit their short-term targets and earn large bonuses. If anything goes wrong, they can walk away unscathed or, even better, they leave and its another management team’s problem. I.e. The agent-principal problem.
  • Groups are borrowing in safe locations and sending the capital into risky locations: Consider those companies borrowing in South Africa and building in Africa, like Angola, DRC and Congo. If the capital invested in those companies implodes (very possible, if not happening right now), then the Group still has to pay back their South African debts. I.e. Doubling-up on the downside risk.

(3) Many People Hide Laziness Behind “Buffet Quotes”

Time and time again, I encounter people who throw Buffet quotes at me to justify either their (in)actions or what they think I should be doing.

This is not to take anything away from Warren Buffet. He is amazing.

These people are not.

I won’t go into detail here but beware people who hide their laziness behind a barrage of Buffet quotes and witty anecdotes. This is often to obscure the fact that they haven’t done any real research on a stock or an investment.

Even after researching something thoroughly, you can still be wrong. I know from experience, and it hurts, but that is life.

But, at least doing the heavy lifting (meeting management, reading endless sets of financials, talking to players in the industry, doing a site visit or three, and building a financial model and valuation) can shift the odds in your favour that you are making an informed investment decision.

And then you can quote Buffet as much as you want.

With my tongue firmly in my cheek, until then, as Buffet says, “Never invest in a business you cannot understand”.

Facebooktwitterlinkedinby feather

Small Cap Market Liquidity

Following a far-too-brief Ramaphoria, the FTSE/JSE Small Cap Index (J202) collapsed back into the low liquidity trend it started a number of years ago.

Aggravated by a touch of hope at the beginning of 2018, then escalated by Trade Wars, Brexit, QT and finally falling global markets, the liquidity and price-levels continued to suck out of this part of the market.

Here is the chart that shows quite how bad the liquidity in the small cap sector has become:

Not just is South African small cap liquidity below average, it is one standard deviation below average!

I still believe that the small cap market in South Africa is the cheapest equity sector in the world (see here) but the terrible liquidity dynamics are a clear indicator of quite how unpopular this sector has become.

Facebooktwitterlinkedinby feather

Tongaat Hulett: Flying Close to the Sun

Tongaat Hulett (TON) is trading at a fraction of its sugar and starch operations’ replacement cost (estimated between R10bn to R20bn by some, if not more). Assuming Expropriation Without Compensation (EWC) doesn’t render it worthless, the Group is even trading at below its Land portfolio’s value (estimated c.R10bn by some).

But, as I wrote over here: sometimes valuation doesn’t matter as much as you think.

Tongaat Hulett’s Net Debt stood at R7.7bn in its H1:19 results putting its Net Debt:Equity at a high 0.55 on equity of R14bn. Its Operating Profits of R530m barely covered its net finance costs of R430m during this period.

These ratios and balances are all assuming that the Group can successfully extract cash from its Zimbabwean and Mozambique operations, else, those cash flows start to become ring-fenced and worthless to the Group’s South African head office. Likewise, you can start to exclude their profit contributions from the gearing ratios…

The Group did report in H1:19 headroom borrowing facilities of a further R1.8bn left and, probably, may be able to flog some of its land portfolio in fire-sales at discounts for quick cash.

All this would materially easier if three things were not simaltaneously happening:

  1. The Sugar Price was circling the drain (link), making the dominant sugar operations in Tongaat Hulett break-even, at best, and loss-making at worst.
  2. The Group’s capex bill had been rachetting upwards from both replanting of recent drought-devastated cane fields and a R550m sugar refinery in Mozambique. The latter should have been completed by now but the former is a continuing drain on free cash flows that aggrevated the sugar operations’ negative free cash flows at these low spot rates.
  3. The EWC risk in South Africa has pretty much collapsed the Land Segment’s sales, as can be seen in the latest H1:19 period’s sales declining from 68 developable hectares to only 1 developable hectare!

The likelihood of the Group’s H2:19 period generating positive free cash flow is low and the above draws on funding make the Group’s balance sheet particularly risky right now.

Irrespective of profitability, the R1.8bn headroom could disappear very quickly with R0.5bn going into Mozambique (and possibly never coming out), Zimbabwe’s operations failing to expatriate some cash flow, sugar reporting a loss and requiring capex for root-planting…

Suddenly, Tongaat Hulett could find itself flying too close to the sun and may even need a rights issue or some other capital raising mechanism to buy itself time.

It does not help that their old CEO has left and we do not know who the next CEO is going to be.

Far from a certainty and the stock is definitely cheap, but I do see a material risk in this company at this point in the cycle. Sometimes, valuation may not matter as much as some investors think.

Facebooktwitterlinkedinby feather

What Does 2019 Look Like?

There are going to be a plethora of articles out about 2019, thus I will make this short and to the point.

What does 2019 hold for investors?

I have no idea, but there are some thoughts:


Global and domestic politics remain hostile, loud and populist. These are the ingredients to that drive market volatility both domestically and globally.

Given that neither local nor global politics has resolved this year, they and their vicious noise should flow into the next year and, thus, I think we can all expect continued market volatility.

But, if you hold good quality investments, then volatility is simply the market disagreeing with itself on the future value of your investment. This is not the same thing as deciding whether your investment will still exist in the future or not.

If you hold quality, you have time on your side.


I have a simplistic view of the version (because they are never the same) of the cycle that we are currently in.

Following Quantitative Easing’s (QE) inflation of asset prices with little real economic growth, the world’s wealth distribution skewed even more. Large and high-growth companies got rewarded with inflated valuations that index-weighted passive flows boosted even higher, rewarding size with more size.

Value investing lagged as did the real economy and wage growth, while lower and lower interest rates drove increasing warped asset allocations across markets, portfolios and the globe.

This all lead to increasing social frustration that has arrived, politically, at global and domestic populism at exactly the same time that QE becomes Quantitative Tightening (QT).

Thus, what worked for the last decade is unlikely to work for the next one.

QT is sucking out peripheral liquidity (i.e. EM markets; just look at the JSE’s liquidity collapsing over the last year) while boosting DM yield, dropping stock valuations (size is now being penalized) and re-wiring global flows.

While the last decade was one of growth and momentum, I think the next one is likely to be the one of value and quality.

Some people have spent their entire careers investing during the period of QE and do not know a world where the Fed does not prop up markets. The same mind-sets that operated in that world are probably not going to work in the world that we find ourselves today.

Hence, it has never been more important that right now to be valuation sensitive.


Given the diverging high- and low-road scenarios from the USA economy to our own domestic politics and potentially-devastating “land debate”, it is harder and harder to know for certain what country, sector or, even, asset class is likely to do well.

Hence, diversification has probably never been as important.

My starting point for an investment three simple questions:

  1. Is it high quality?
  2. Is it cheap?
  3. Is it different to what I already hold?

If any of the three questions comes back ‘no‘, then it is enough cause to not invest in whatever I am looking at.

Very…Happy New Year

Anyway, in conclusion, this is not an article about what 2019 will be. I have no idea and no else does too.

Rather, this is just a friendly reminder to stick to your strategy. Mine is noted above.

Best of luck out there!

Facebooktwitterlinkedinby feather

Hulamin: Intriguing Valuation Anomaly

Hulamin (HLM) is a domestic semi-fabricator of aluminium rolled and extrusion products (think cans, foils, plates, bars, & a million other products).

Basically, the Group buys aluminium, uses capital, labour and energy (mostly gas, I believe) to convert than aluminium into a wide-range of products (see here) for a lot of global markets (South Africa is only c.47% of the Group’s sales), that makes it a very versatile, exportable and globally competitive business.

I.e. If need-be, Hulamin could probably export its entire production, ironically making it a fair hedge against our own economy.

Given Hulamin’s global playing field, a number of things start to become relevant and are worth checking.

For example, how does Hulamin stack up against other global aluminium semi-fabricators?

The answer: quite well, actually. (My understanding is that every single other aluminium semi-fabricator in the world is protected by subsidies or tariffs, and Hulamin is the only one that operates with none of these benefits in South Africa. Hence, view the below within context.)

Hulamin has averaged a Return on Equity (ROE) of only c.7.5% over the last four years. The ROE hit a high of 10% and low of 4% over this period while five years ago it reported a loss. Likewise, further back, the Group averages a mid-single-digit ROE with quite a volatile bottom-line.

This is a poor track record in a South African context, but Hulamin’s main input cost (aluminium) is priced in USD’s, its sales & product (semi-fabricated, rolled and/or extrusions made from aluminium) is priced in USD’s and, even, its rolling-margin (i.e. its “mark-up) is priced in USD’s.

In other words, Hulamin may be domiciled and physically situated in South Africa, but is it strictly a “South African business”?

Thus, there is a very fair argument that Hulamin’s returns need to be judged against a USD-based cost of capital. Given that Hulamin could quite easily swing its volumes entirely into the export market, this is perhaps not a bad argument and, in this case, a 7.5% USD-based ROE is quite fair (particularly if one starts to assume ZAR weakness going forward).

Interestingly, Hulamin is running at full capacity. How many other South African businesses can say that?

But then where is the upside or growth?

The operations have been run quite conservatively and if you work through the detail you will see that the Group’s management have a well-documented plan to raise volumes from its current 229,000 tons to >250,000 tons (per annum). Likewise, by increasing the use of scrap (aluminium is infinitely recyclable, making it quite a good substitute for plastic in an anti-plastic world), the Group can generate material cost-savings.

Both these very basic initiatives, per my workings, can each basically double the Group’s profits. Combined, they might do well more than that…

At this point, it is worth noting that Hulamin is trading on a 7.1x Price Earnings (PE), and I do expect its coming H2:18 profits to be nicely up due to ZAR weakness (i.e. the stock is on a lower Forward PE). 

Is this cheap or not?

If you work through Hulamin’s H1:18 results you will see the following balances:

  • Inventory (mostly aluminium, partially- and fully-fabricated aluminium product): R2.2bn.
  • Debtors (mostly blue chips): R1.3bn.
  • Creditors: (R1.3bn).
  • Net debt: (R0.3bn).

If one adds these figures up, simple math arrives at a figure of a little over R2.0bn for Hulamin’s net working capital less net debt. Taking that figure and dividing by Hulamin’s issued shares (320m) you arrive a figure of 625cps.

In other words, ignoring Hulamin’s land, buildings, plant and machinery and any potential future profits, if you bought Hulamin and merely liquidated its predominantly USD-based stock, called in its debtors and paid off its debts, you would realize c.625cps per Hulamin share.

Hulamin’s share price is only 430cps.

In other words, you could make almost +50% on your money! (And, that is assuming that the rest of Hulamin is worthless.)

There are rumours that a while ago there was an offer on the table to buy the entirety of Hulamin at c.1400cps a share and there are fresh rumours that there could be another offer hovering in the wings.

While I would put zero value in such rumours (never trade based on vague rumours!), given the global competitiveness of the Group’s operations and the discount to its very-liquid, USD-based net working capital, one can start to see why Hulamin would make a superbly attractive acquisition: taking into account Hulamin’s (current value) land, buildings, plant and net working capital, it would probably take about triple Hulamin’s market cap to build another Hulamin.

Hence, why not just offer a fifty-percent premium-to-double the share price and buy the Group? You’re still probably getting its operations at a discount…

Ironically, trade-wars are likely making an asset like this more valuable: it is neither Chinese nor American. Thus, as an alternative source of supply for either a Chinese or American user of large amounts of aluminium product, this offers a hedge against trade-war outcomes and, potentially, a way around expensive tariffs.

Likewise, anti-plastic and pro-recycling drives in first-world (and, increasingly, third-world) countries are also driving the demand for aluminium. Hence, there is real demand-side led growth for the products that–assuming Hulamin can steadily increase its capacity–can easily gobble up any excess production and, over time, should naturally bolster the Group’s rolling-margin.

I.e. Hulamin has a lot going for it right now.

As the saying goes, “you don’t need to know a person’s exact weight to know if they are fat or not“. Likewise, I don’t need to do a detailed valuation on Hulamin to see that the odds of it being ridiculously undervalued are quite high.

And, while cheap valuations can linger and, indeed, get cheaper, there is an entire world out there that is incentivized to find these opportunities and unlock them. Thus, they typically don’t remain cheap forever.

Note: Hulamin is held in the AlphaWealth Prime Small & Mid Cap Fund.

Facebooktwitterlinkedinby feather

Beat Cash?

Here’s an interesting exercise that I think some of you will get value out of: I’ve filtered the entire market into those stocks that have Dividend Yields greater than the Reserve Bank’s repo rate (6.75%).

Here are the results:

CompanyCodeDividend Yield (%)
NAMPAK 6,5%PNPP19.37%

Filters need to be refined, so I’ve gone through the list and cut out all those stocks that are preference shares, discarded the property stocks and REITs, and, finally, removed Steinhoff (for obvious reasons).

Here are the results:

CompanyCodeDividend Yield (%)

The Dividend Yield used in this filter is historical. Thus, some of these stocks have inflated historical yields because the sustainability of their yields going forward are at risk. Likewise, some have such high yields because they have basically zero liquidity and/or are too small to realistically be a holding in any portfolio of scale.

Hence, I went through this list and cut out all the companies that have their earnings directly related to commodity prices (soft or hard) and I discarded those stocks with a market cap below R1bn.

Here are the results:

CompanyCodeDividend Yield (%)

And, voila, we have a filtered portfolio of relatively stable, profitable and cash generative businesses that are currently paying Dividend Yields greater than our Reserve Bank’s own repo rate!

I would be careful of Alexander Forbes (AFH), Phumelela (PHM) and Novus (NVS), given some arguments about them being in sunset industries, but there are good arguments for the rest of the stocks.

In fact, we hold Metrofile (MFL) and Coronation (CML) in the
AlphaWealth Prime Small & Mid Cap Fund, so they are great investments (as far as I can see). Likewise, we hold Hosken Consolidated Investments (HCI), whose major underlying is Tsogo Sun (TSH), thus I am also quite comfortable with that stock.

In closing, in tough times, dividends are more valuable as both a generator of return and as an indicator of quality (bad companies with questionable futures tend to cut their dividends in tough times). Even better when the stocks are paying investors dividends at a yield above the base-cost of capital in their country!

Think about it: yielding above cash with a free company and capital upside as a bonus?

Worth thinking about…

Post Note: The above filter is built off Profile Media resources. I am not sure why it has not captured everything but, for example, Clientele (CLI) did not appear on this filter. Clientele is trading at a 7.8% Dividend Yield with an R5.4bn market cap and I quite like that one too. See my notes on that stock here.

Facebooktwitterlinkedinby feather

Clientele: Below Embedded Value

Irrespective of financial status or position in society, everyone has a demand for reducing risk in their own and their dependents’ lives. A key mechanism for this is life insurance, but the economics of the traditional life insurance business model has historically dictated little of it ever reached the lower-end of the market (i.e. the so-called low-LSM’s).


Ignoring the subtleties of the insurance model, it costs the same amount of money to write a small insurance contract as it takes to write a big insurance contract. Hence, from an overhead and route-to-market perspective, the lower-valued, low-LSM life insurance market with small policies is far less attractive to target than the higher-LSM markets with larger policies.

Hence, the larger players have historically built direct and broker-driven models into the higher-LSM markets in South Africa and the lower-LSMs have been mostly under-penetrated.

Clientele Ltd (CLI) has been one of the few insurance businesses that have focussed exclusively on this under-penetrated, low-LSM market and, driven out of economic necessity, the Group has cultivated a unique route-to-market that has become quite a robust competitive advantage: Independent Field Advisors (IFA).

Effectively, IFA is a franchisor offering support, education and back-office for community members all over South Africa to sell Clientele’s carefully constructed financial products (the main one being life insurance but by no means the only product).

Out of this arrangement, the franchisor has a route-to-market where costs are largely absorbed by the franchisee, the franchisee builds an annuity business that over time generates them wealth, and the end-client gets access to one or more financial products (i.e. life insurance) that they desperately need.

Despite this advantageous network, how does Clientele compare to its larger peers focussing on the higher-end, more-profitable part of the market?

Here is what perked my interest: Clientele is materially higher margin, better and more profitable than the other life insurers (click on the image to enlarge)!

Add to this interesting observation the fact that the Clientele’s share is trading at an all-time low valuation (figure below).

In fact, the Group’s share price has almost never traded below its Embedded Value (which we believe is quite conservatively constructed ~ work through their integrated report to get comfortable on its inputs).

Interestingly, if you use Clientele’s historical average Price-to-Embedded-Value ratio of 1.2x, you arrive at a fair value of 2335cps for CLI. This is materially higher than it closed last week at 1755cps.

While Capitec (CPI) has launched a life insurance product, we believe that this product is more likely to eat into the traditional, higher-end life insurers’ market share rather than Clientele’s market.

Also, Clientele’s above-average margins allow it far more scope to compete (while remaining profitable) with Capitec than these legacy insurers. Finally, the value of the IFA network should not be discounted from Clientele as a powerful platform in its route-to-market (indeed, Clientele has steadily launched more and more products from this powerful route-to-market).

If Clientele’s product(s) are demanded, they are efficiently priced, managed and delivered and the Group is so inherently profitable, then why has the market marked its share price down so much recently?

Low-LSMs are particularly vulnerable consumers, thus the Group’s underlying is more cyclical than other insurers. Expect policy lapse rates and withdrawals to be rising. This is no secret, though, and can be traced back to soft consumers in South Africa and is more pronounced in our retail stocks.

Likewise, domestic small caps on the JSE are particularly fragile. See this more detailed article here: Cheapest Equity Sector In The World.

Both risks should reverse as South Africa improves, thus I believe that this weakness is transitionary rather than systemic.

Therein lies the upside and, what I suppose, is a contrarian call to get into a tightly-held, high-quality asset at the point of peak pessimism. Hence, I have taken full advantage of the risk aversion in this falling market to build what I believe will be an attractive long-term investment in Clientele in the AlphaWealth Prime Small & Mid Cap Fund.

It does not hurt that Clientele’s share is paying a 7.1% Dividend Yield… If nothing else, one can get a greater-than-cash yielding investment with a free option of SA Inc’s recovery!Facebooktwitterlinkedinby feather