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RE:CM investment insights |
I keep an eye out for RE:CM & Allan Gray's quarterly reports - these are the high quality publicly available investment research documents. Any aspiring investor should make them part of their regular reading.
"Corporate profit margins are very high while corporate tax rates and dividend cover for the highest yielding stocks are very low. This implies that, from an absolute capital preservation perspective, a maximum yield strategy is very risky right now."
Have been allocating capital to inter alia Anglo American & Anglo American Platinum, disinvesting from inter alia Old Mutual, Harmony Gold & Discovery Holdings. "We are concerned about the state of some of the markets in which AA does business (notably the iron ore market, where we believe profitability is currently far higher than normal, sustainable levels). But when we apply realistic long-term commodity prices & profit margins to each line of business, we derive earnings levels for the group that supports an intrinsic value well above the current share price."
Telkom: "Another concern has been the amount of capital expenditure being incurred on the mobile business. We are doubtful that the company will earn economic returns on the amount of expenditure that they are currently incurring. While Telkom is still a top 10 holding, we have sold some shares after we revised our investment case & our best estimate of fair value".
RECM's view is that "the excessive leverage in markets that was the source of economic problems in 2008 has not disappeared; it has merely moved from private to public hands...Instead of banks defaulting & heading for bankruptcy, we now have countries on the verge of default & bankruptcy."
Their view is that the SA equity market is overvalued.
In their SA portfolio they "have an increasing weighting towards cyclical stocks such as mining companies; as well as a continued high exposure to companies that operate in the tourism & hospitality sector." They have very little exposure retail & bank stocks - they "have high prices relative to their intrinsic value, and face the most competition over the next 10 years." They view the US dollar as "one of the most undervalued currencies worldwide".
Like Allan Gray, RECM are "not finding widespread value in the South Africa stock market". I tend to agree, and even find the platinum miners (which both Allan Gray & RECM like) too risky. Most of the shares I'm finding value in, are too illiquid for Allan Gray & even RECM to be staking out positions in.
"Our current view on markets is that they continue to face tremendous headwinds. In developed markets there is too much debt in the system & deleveraging needs to take place...Fortunately, the prices of many good quality assets in these markets already reflect the difficult times we are facing."
Emerging markets "are all in a much better fiscal & monetary position" than developed markets, but their "economic fortures are closely linked to those of the developed market. In addition, their strengths are widely recognised & priced into their securities."
"Our sense is that the price of capital in China - effectively free - is distorting economic activity there. We believe there is significant investment risk in assets exposed to the theme of 'Chinese growth'".
In the Global Flexible Fund RECM have been allocating to Amplats, Microsoft, Carrefour, the Vodafone Group and Berkshire Hathaway Class A. They sold completely out of Tiger Brands, and also sold Wellpoint, J&J, Tokyo Gas & Discovery.
Both Allan Gray & RECM are finding value in platinum shares (I'm not, see next paragraph!). Allan Gray have Impala Platinum in their top 10, whilst RECM's largest purchase by value over the last quarter was Amplats, a "cheap and high quality South African investment idea, somewhat of a rare occurrence over the past 18 months" (they've also purchased some Lonmin). This contrasts with Allan Gray who "regard Impala Platinum & some of the juniors as more attractive long-term investments than Amplats at current prices."
I personally am more wary. Whilst these platinum mines look cheap when I peer into the rear-view mirror, there's significant risks on the road ahead. You see, autocatalysts represent about half the demand for platinum. There's a risk of (1) in the medium term platinum usage in autocatalysts being replaced by palladium, which whilst mined by the same players, is cheaper, (2) in the long term as oil prices rise electric vehicles enjoying increasing usage, supplanting the need for autocatalysts. It is possible that other uses for platinum come into being, like their use in fuel cells, but I don't like betting on this uncertainty. As mentioned in my summary of the Allan Gray quarterly report, I personally am not increasing my exposure to platinum.
RECM also "sold some of Harmony Gold during the period. With the rand gold price reaching all-time highs late in 2011, Harmony's share price was impacted positively." RECM reduced their Flexible Equity Fund's exposure to Harmony (although it remains a top 10 holding). I personally sold completely out of my gold shares in the 4th quarter of 2011 (this is not to say that gold shares aren't going to do well, but rather that it felt like it was becoming a gamble rather than a rational decision to remain invested).
"Failure to secure adequate distribution challens prior to launching such a critical product (8ta) to the market (and spending the amount of marketing money that Telkom has) seems odd to us. We have revisited the Telkom investment case, and based on this, have revised our estimate of intrinsic value downwards. This has resulted in some selling of Telkom shares in the Fund, but based on the price to (revised) fair value relationship, it is still a holding in the Fund."
"Old Mutual has been a feature of RECM client funds since the latter part of 2008" (and is also this author's largest personal holding!). The sale of (most of) Skandia "caught the attention of the market, which marked up Old Mutual's share price substantially...Management appears to be doing a good job of realising that value for shareholders." The question with Old Mutual, is now when to sell out. I personally, want to be completely sold out if it hits 95% of embedded value, and will probably start selling at a lower price than that (especially if better opportunities present themselves). I estimate embedded value of Old Mutual to be about R25 (at the time of writing).
They show how the FTSE JSE All Share Index's Price/Book ratio is nearly a standard deviation above the average since 1980, whilst the Nikkei Exchange's Price/Book ratio is more than a standard deviation below its historic average. "We continue to be very optimistic about the prospects for investment returns from Japan." Portugal, Italy and Greece all have price/book ratios more than a standard deviation below their long-term averages - "This leads us to believe that the unpopularity of these markets coupled with their apparent undervaluation and lack of cyclical leverage may offer an attractive hunting ground for cheap and unpopular businesses."
They have no iron ore exposure as they feel that "the current rate of demand (for iron ore) is not sustainable over the longer term", discussing a risk of a drop in demand from China, and believe a 10% drop in demand would leave demand at a 'normal' level (ät "the 90th centile production cost of about $55 per ton"). They also feel there are risks on the supply side, as a result of increases in iron ore supply in 2014. "At a 'normal' iron ore price of $55 per ton (Ed: as opposed to current prices of some $150 per ton), a 'normal' R/$ exchange rate of R8.50, current production and 35% 'normal' operating margin, we can estimate Kumba's normal earning power to be about R13.45 per share (Ed: which contrasts with current earnings per share of R52.62). This equotes to a current, normalised P/E of 35 - very different from the indicated P/E of 9." This caution is in line with advice provided by Deutsche Bank's Long Term Asset Return Study - "Commodities have become very expensive...long-term investors have to be very careful with commodities, especially Gold".
Great minds think alike. It's interesting that both RE:CM and another manager we rate, Contrarius, are finding value in Microsoft.
What RE:CM say about Microsoft |
What Contrarius say about Microsoft |
"High returns on capital", as once developed the incremental cost to produce another unit of software is near zero. |
"From financial year 2000 to 2010, revenue grew 170% (in the first nine months of financial year 2011 |
"High barriers to protect those returns from competition." (high spend on R&D, high spend on marketing, army of programmers who've built up familiarity with its platform). |
"Microsoft's share of operating systems is estimated at 80% to 90%. Microsoft Office market share has been estimated at over 90%, despite comparable products being available for free." |
Failure to capitalise on the smartphone market has driven sentiment down. |
"was slow to react to internet search, mobile computing, cloud computing" |
Valued at 9 times earnings. |
"Microsoft's operations can now be bought for about 8x free cash flow. We find it surprising that one can acquire a high quality, growing business for this price." |
The case for an investment into Greece's Hellenic Exchange:
Greece's Hellenic exchange looks cheap on a 5.2 EV/EBIT basis, and normalised EV/EBIT of 3.3 (assuming 1.5 Price/Book of listed companies, compared to 2.1 10 year average).
Stock exchanges generate about half their revenue through equity trading "with the balance earned from settlement, listing fees, data fees, derivatives and other services". " Almost all of these stock exchanges charge fees as a % of the transaction value, so the greater the market capitalisation of the stock exchange the greater the revenue from equity trading. If the P/BV of the market is in line with the long-term average you could assume that revenue is at approximately normal levels. But if the P/BV is substantially below the long-term average, revenue generated through trading would be below normal."
Greece's P/BV is 0.5 vs a 2.1 long-term average. Current depressed earnings are therefore below the normal earnings power of the Greek exchange. The Hellenic Exchange's revenue has dropped from €150m to €50m, but still has managed to generate a 17% ROE, pay a dividend of 6% and has net cash reserves equal to 50% of market capitalisation. "The cost base of an exchange is predominantly employee costs." The Hellenic Exchange reduced its employees from 650 to 260, and costs as a percentage of revenue has reduced from 58% to 40%. "The business has also become less reliant on equities trading and has grown other parts of the business such as derivatives, listing fees and other data services that generate annuity income."
With the derulation and listing of stock exchanges came competition from start-ups backed by banks who especially wanted to reduce transaction charges in large liquid markets, leading to a reduction of market share and revenue. RECM estimate it would cost €100m to start an exchange in Greece, and if they were lucky enough to get 50% market share they would get a net return on invested capital of 2.5%. "We think that competitors may enter at some stage but there are far larger and more lucrative markets to enter first
that don't have the stink, low returns and currency uncertainty of greece."
"A key risk to owning greek assets is the probability of EU expulsion and the return of the Drachma which would result in default, currency debasement and higher inflation". This might lead to a further stock market decline (although it has already declined 85% so much is priced in), which may be partially offset by strong stock-market performance post default.
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