A Dozen Things Charlie Munger has said about Reading

25iq

 

1. “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.”

 

1. “You’d be amazed at how much Warren reads – at how much I read. My children laugh at me. They think I’m a book with a couple of legs sticking out.” 

 

1. “As long as I have a book in my hand, I don’t feel like I’m wasting time.”

 

1. “I’ve gotten paid a lot over the years for reading through the newspapers.”

 

1. “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading. I don’t think any one book will do it for you.”

 

1. “For years I have read the morning paper and harrumphed. There’s a lot to harrumph about now.”

 

1. “We read a lot.  I don’t…

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Innscor Spinoff – A special situation for making a profit.

Innscor Spinoff – A special situation for making a profit.

Innscor Africa recently advised shareholders that its Board of Directors has approved the unbundling of the Company’s “Quick Service Restaurant” business unit by way of a share dividend. The soon to be unbundled fast food business unit will be listed as a separate entity – a spin off. We consider spin-offs as one of “almost” sure ways for an investor to make a profit.

There is a theory behind the attractiveness of a spin-off. It is summed up in that a spin-off usually goes on sale shortly after being unbundled. Such an unwarranted share price dip provides a buying opportunity. Thereafter the share price is expected to reflect the fundamentals by firming up with time. Padenga, which was coincidentally spun off by Innscor followed this path too. Upon listing in November 2010, Padenga opened at 5cents and within a month it had dropped to 4cents a share. By February 2011, 3 months down the line, there was a course correction which let the share price to peak at 6cents – a 50% price appreciation.

Why Spin-offs often turn into opportunities.

Why do spin-offs fall in price after the unbundling? Often when a conglomerate spins off a smaller and less attractive company through a share dividend, some of the shareholders suddenly find themselves holding shares of a smaller company they do not want to own. For institutional investors, such as pension funds, shares of the spin-off would not fit their investment mandate. Most of such investors have no option but to sell shares in the spin-off which sends the price spiralling down. More often than not, there is nothing fundamentally wrong with the company, but that it doesn’t fit in their investment plans.

The initial fall in share price has also been confirmed by market analysts across the world. They have however explained it as stemming from a lack of familiarity with the spin-off among investors. It follows then that the rebound in price is the result of a recognition of the value of the company. Whatever the reasoning, the price movement phenomenon is a proven reality among spin-offs.

A common arguement why the fundamental business of a spin-off tends to perform well with time has to do with alignment of incentives and focus. In a lot of cases a spin-off is instigated by the business unit’s management executives who think their unit could perform better if it stands alone. By standing alone, all the bureaucracy and politics associated with conglomerates which often slows decision making is done away with in a spin-off structure. Management of the new spin-off often recieves share options which reinforces alignment of their interest to that of the business.

Cautionary notes

Spin-offs do not always end on a happy note. A few precautions are necessary.

Prospects of the business

No matter how cheap a company sells on the stock exchange you want to pay attention to growth and returns prospects of the business. A declining industry; obsolete products and a competitive industry are features associated with spin-offs you want to avoid. It is therefore important to understand why Innscor is seeking to unbundle the ‘quick service restaurant business’.

Pay attention to what the new company looks like

It is important for the investor to pay attention to the fine print of the transaction – what is Innscor actually spinning off? As an example, it is not unusual for a parent company to offload all debt onto the spin-off, thereby retaining a cleaner balance sheet for the conglomerate. Excessive debt can harm the operations of the business and weaken the share price of the spin-off in the long term. On the other hand more debt could help enhance returns for shareholders.

Way forward

Meanwhile, we can keep our ears to the ground with some capital in hand. Innscor’s latest spin-off of the fast food business could play out better than Padenga Holdings.

Ray Chipendo is Head of Research at Emergent Research. He can be reached on:

ray@emergent-research.com

Is the equity market still undervalued?

Is the equity market still

undervalued?

Posted date: May 26, 2015in: Business, Columnists, Equities, Investment, Opinion, ZimbabweNo Comments

By Ray Chipendo, JOHANNESBURG, May 26 (The Source) –  Balance sheet values and current price to book value ratios may suggest that listed companies are under-valued. But where it matters most i.e. earnings, the majority of the companies are, at best, fairly priced.  In many cases disappointing earnings have put a lid on company intrinsic values, making such stocks look dear. That said, the notion of a grossly undervalued market can now be challenged.

Should investors care how company valuations are faring on both asset and earnings levels? We think both buyout investors and stock market traders need to know. On one end, Buyout firms will be keen to acquire undervalued assets which have room for optimising cash-flows. Depressed asset prices have spurred an uptick in delistings in the last five years. On the other hand, investors and traders may care to avoid value traps by observing earnings outlook for companies they invest in.

Flight to quality gone too far!!

An uncertain economic future has kept many investors at bay. The few optimistic investors have parked their money in the large caps – presumably quality stocks for safety’s sake.

Our research has suggested that this flight towards “quality” among institutional investors has pushed prices for big caps beyond what is reasonable.

BAT and Delta are two examples. We think these companies are now trading at premium on account of perceived safety. For example based on reverse DCF, a valuation approach that calculates the growth assumption factored in stock price – BAT’s current price of 1,150 cents is priced based on an implicit annual growth rate of 18 percent for the next 5years. Contrast this growth assumption with the company’s current contraction in bottom line.

There is nothing in the fundamentals that suggests that BAT will grow its free cash-flow at anywhere north of five percent. Fierce competition and lobbying against smoking are all strong headwinds on the company’s path.

Delta’s share price of 107 cents is based on a growth rate of 12 percent. Delta would be described as fairly priced if it could post at least a modest five percent growth rate. But reality is somewhat disappointing. Revenue growth in sorghum beers and alternative drinks is not accelerating fast enough to compensate the fall in lager and sparkling beverage revenues. In the last financial year, our research shows that sorghum and alternative beverages added $30 million at a time lager and sparkling beverages were losing approximately $60 million in revenue. Again we would expect lagers and sparkling drinks to have higher profit margins than sorghum and alternative beverages. We think that under the current economic conditions shrinkage of the bottom line will persist.

Pockets of value

Our strong view of fully and over-priced stocks is not enduring across the entire market -they are some anomalies which interest us. Hippo Valley is one such example. A year ago we published a post titled “Hippo vs. OK: a tale of a cash compounder and value destroyer”. At the time, Hippo’s seemingly bloated CAPEX was diluting returns on capital.

We contrasted Hippo with OK. OK looked nimble then and had jumped up 2.4 times in stock price in three years ending 2013 against a halving in price for Hippo in the equivalent period. But, today we think fundamentals favour Hippo. Enhanced efficiencies from years of huge capital expenditure; tariffs on sugar imports and unexploited pockets of the domestic market make Hippo exciting. It is on this backdrop that we find the current price of 35 cents bewildering.  If anything, the current market price is suggesting that the company’s free cash-flow will shrink by -21 percent, a far cry from the positive growth we are anticipating.

Unless we are missing something huge we think Hippo is undervalued on both income and asset based valuation approaches. We wait to see how the forthcoming annual results will guide us. We venture that even if FY2015 earnings lose ground by anything not more than 10 percent, Hippo will remain an undervalued stock.

Divergence: choices to make!

Stocks described above paint a picture of a valuation divergence. On one hand we have traditionally safe stocks which in our opinion are straddling in the fully valued to over-priced territory. On the other, we have predominantly small and mid-caps which are undervalued but are perceived to be susceptible to economic swings.

Contrary to common belief that it is size that provides stability, we are of the view that nimble companies are better able to adapt to varying economic conditions. Investors will have a challenging choice to make.  One could limit the downside risk by opting for large caps, but pay more with little upside potential. The opposite is true for value stocks.

An investor could go for value with a large up-side potential but expose oneself to price volatility which is prevalent among mid to small caps.  We would urge the investor to pay more attention to the intrinsic value of the company more than its market price volatility.

Ray Chipendo is Head of Research at Emergent Research. He can be reached on: ray@emergent-research.com

How to get a bang for your buck in 2015!

2014 was a troubling year for Zimbabwean investors. The industrial index lost 20 percent and the real estate market underperformed as shown by financial results of property funds.

Despite a US dollar denominated economy, Zimbabwe completely missed one the decade’s greatest giveaway – cheap money created in Europe and the US. Low interest capital could have encouraged risk taking and created liquidity in the market – thanks to our murky indigenisation policy.

The IMF November country report points to an ambitious 3.2 percent GDP growth rate for 2015. We worry that this growth will not be derived from consumption but from other sources such as import cuts and bilateral funding support. So while the economy will grow on paper, the consumer will not feel better off.

Below we have discussed our investment perspective for 2015.

Equities – Industrial
Looking ahead in 2015, most stocks will suffer from a synchronised economic deceleration. We expect earnings to shrink in 2015 leading to depressed if not negative returns. Unlike in recent years when economic GDP was fuelled by private consumption, this year a contraction in consumer spending is highly probable. We expect a fall in consumption to negatively affect the value of consumer stocks such as BAT, Delta and OK.

Equities – Miners
Contrast to industrial index which lost 20%, the mining index rose by 71% in 2014. We expect miners’ plans to reopen shafts, explore new mines and restart smelters to spur their performance in 2015.

However, record low commodity prices make mining companies a tough call. Gold prices have inched up since beginning of 2014 while industrial metals prices have been a mixed story altogether.

Selective picking will be important. As Europe considers quantitative easing too we forecast a built up in inflationary pressure which will drive investors into inflation hedges such as Gold making the metal a good pick now.

Equities – Major exporters
In the past 12 months we have punted the idea of exporters. Our top picks have been Seed Co, Padenga and for a while Bindura Nickel.

The logic was simple- significant exporters are to an extent insulated from the problems of the domestic market. But not only do these companies sell in growing markets, they are producing in a market where costs of production are deflating while selling in inflationary markets.

The recent national budget also gave exporters a shot. The Finance Minister cut corporate tax for firms that export more than 50% of their produce. That automatically boosts 2015 earnings by 14%. Our three selected stocks fit the bill – yet we do not think they are fully re-priced.

Real estate
Property has lost its shine and has begun to look like an overcrowded trade. Post dollarization, residential property was driven by diaspora-house purchases and a resurgent domestic mortgage market. Both engines have since lost steam and we are left with falling property rentals and prices – notwithstanding a known residential property deficit. The same can be said of commercial property.

A shrinking manufacturing sector is leaving excess capacity, consequently driving both prices and rentals down. These assertions can be backed by financial results of listed property funds. Investors parking capital in property this year may do so with a long term investment horizon – hoping for some catalyst that reverses the cycle.

Fixed income securities
As the drying bank loan market, hamstrung by loan-deposit mismatch, continues to restrain long term financing, we expect credit worthy companies seeking capital to flock into bonds.

As long as defaults are kept at bay, we expect more issuances this year accompanied by a fall in coupon rates from the average of 10% for corporate bonds.

For now, the market remains excited though we worry about bonds raised on the premise that real estate is a safe asset class. Declining property prices and rental income make us fret.

Currencies
If you earned your annual income in rand denomination and decided to save it in US dollar currency, by end of 2014 you would have earned a return of 12% – that is just a currency exchange rate gain.

Depressed oil prices, expected to remain until mid-year, will continue to drag down currencies of oil producing economies and of producers for commodities tied to oil prices.

Going forward, we think investors should be wary of rushing into stocks on the basis of low valuations. As the economy takes an uncertain path, quality trounces valuations.

Investors ought to focus on stocks that can withstand tough times. Low valuations will be best left to buyout firms that can delist these companies and panel beat them off the charts.

This phenomenon explains our forecast of several delistings this year.

Ray Chipendo is Head of Research at Emergent Research.  ray@emergent-research.com

A simple account of the credit crunch in Zimbabwe

By Ray Chipendo and Simba Chimanzi. The last op-ed we released a few weeks ago titled “when financial stability and economic growth seem to conflict” drew interesting comments directed on the subject of “bank deleveraging.” Despite finding the op-ed’s language too technical, the ordinary readers’ comments were quite informed.

In response, using simple language, we thought we could share our version of how the credit crunch came about and how it hassled to high non-performing loans(NPLs) that now threaten an economic downturn.   We also thought of taking the same opportunity to express our thoughts on how policy makers can deleverage banks with minimum harm on the productive sector.

Deleveraging is a process of reducing debt holdings from a highly leveraged position where debt has turned toxic. Deleveraging can be at an individual level, company level, bank level and even country level.  In practice, leverage is the proportion of your assets or income to the amount of debt you hold. As Michael Milken, the god father of high yield bonds once explained: risk has nothing do with the absolute size of credit but leverage. So, even if debt levels are to remain unchanged, falling incomes and shrinking asset sizes can plunge an individual, bank, company or government into financial distress. This useful insight is the starting point to understand rising NPLs.

Credit cycle spiral

Excessive borrowing creates credit cycles. The high economic growth of the “post dollarization” years led to heightened optimism which laid a runway for aggressive lending. As individuals trickled back into jobs, and factories reopened, most people began to feel good about the future.  By 2010, banks had reintroduced lending to households to buy cars, houses and other durable goods. Companies followed by setting out ambitious growth plans for which they borrowed heavily to finance. In our recent market outlook report, we revealed this leveraging behaviour. For example the median company’s debt/equity ratio for ZSE listed companies rose from 4% in 2009 to 12% in 2010 while the mean ratio jumped from 18% to 52%.

During this phase, the economy was growing at more than 10%; stock market was double the size it is today and the residential house market was red hot buoyed by a reintroduction of mortgage finance and Diasporas buying domestic property with the prospect of returning home. Overcome by the desire to participate in this great boom, banks might have relaxed lending rules to accommodate a bigger chunk of borrowers.

Just to digress a bit to provide you with a context, Howard Marks does a good job of simplifying stages of a credit cycle bubble. First stage occurs when a few people notice that things may be getting better and therefore raise credit to finance projects and buy assets in anticipation of growth. Second stage is when most people believe and realise things are getting better and start to raise and borrow significant credit. Last stage is when everyone’s uncle and cousin figure out that things will forever be great. At that point, no one wants to miss the party. Greed and fear of missing out lead banks and investors to fund projects and consumption not worth of being financed – albeit at high interest rates.

With easy credit, asset (real estate and stocks) prices rise; people feel more confident about their wealth. With the economy humming at its highest, banks grow more optimistic of the future and feel comfortable of borrowers’ ability to pay back loans. Normal credit checks point to rising incomes and collateral supported by artificial asset prices. As long as optimism remains in the air, borrowers and lenders continue creating credit with the belief that rising incomes will enable them to pay back their debts. These are the events that prevailed in 2010 and 2011. Drunk with euphoria, and without someone checking time, the party goes on and on. No one has the incentive to stop the music.

Bitter spot- high leverage and slower growth

But it takes a small bit of negative news to stop the music.  Except that the music record does not abruptly stop, it screeches to a stop in a domino-effect way.  The negative news jolts borrowers and lenders into reality and cause panic.  In our case we believe the downward spiral was triggered by two bits of negative news: An improperly articulated indigenisation law that scared foreign investors which in turn woke us up to the reality that we were sitting with a debt maturity wall that could not be refinanced.

With the panic button set, foreign investors started to pull back capital nervous that it was no longer safe to keep money in the economy. With more than 50% of the capital on ZSE coming from across the border, withdrawal of capital sent stock prices tumbling. The same fate hit the real estate market. Individuals and businesses that held stocks and properties begin to feel less wealthy and vulnerable. As assets (and accompanying income) upon which loans were created started to deplete, banks grew edgy and got worried about recouping their loans. They demanded higher interest rates and stringent requirements to lend out any further loans. Recently the central Bank Governor expressed concern over banks’ reluctance to issue loans to businesses.

You will appreciate that most companies that hold bank loans do not really settle them in cash when they fall due, instead they simply roll them over.  In other words they either ask the same bank or another bank to provide a new loan preferably at a lower interest rate to pay the overdue one. As shown in the diagram above, our study of balance sheets of listed companies revealed that most of the loans held by companies were falling due between 2013 and 2015 – 2014 has the highest wall of maturity for business loans. If you take the average business loan to have a 5year horizon, we can reason that the large size of loans falling due in2014 consists of debt that was raised in 2009 and 2010 – a time when the economic euphoria was at its peak- not a coincidence!

In order to refinance the large size of loans falling dues in 2013 and 2014, the credit market needed to operate at the same excitement level it was operating in 2009/10. But with banks becoming more stringent in lending, it meant that some of the businesses that qualified for loans 4-5years ago could not get refinanced. As we witnessed in 2013, a sizable number of companies fell into liquidation. We presume most of these liquidations had to do with failure to refinance loans than inability to meet interest payments. This industrial carnage has continued in 2014, with more companies being sunk by creditors.

Unintended consequences – further spiralling down

As companies began to notice liquidations rise and credit tightening, they started to hold onto the little cash they have and shelve plans to expand and invest in new capacity. Our recent market outlook supports this observation. In the report we show that companies have increased cash holdings in both absolute and relative terms using measures. Please see graph below. Restricted capital expenditure plus liquidations mean more and more people lose their jobs hence less spending and further job cuts. This downward spiral self-fuels leading to prolonged decline in income which leads to less and less spending which in turn means government collects less money through taxes and companies sell less products and services.

Most companies, as we have seen, respond by cutting prices to stimulate demand. But as we are witnessing in the latest financial reports of listed companies, price decreases are no longer stimulating spending. As companies cut down prices, revenues are falling too. This has resulted in bad deflation – something that most Zimbabweans battle to grasp given their recent and unpleasant experience with inflation. With economic growth slowing a nasty combination of deflation and a recession is no longer a distant possibility.

What might have begun as a confidence issue has cascaded into a real economic problem. As companies face falling revenues and incomes, many start to miss interest payments.

We believe it is this combination of (a) an inability to refinance maturity wall of loans and (b) increasing inability to meet interest payments that has spiked up the size of non-performing loans.  With each day the state of NPLs is getting worse. The Central bank governor recently announced that the NPLs rate had gone up to 20% as of October 2014.One outcome is sought – banks need to feel more comfortable to lend again. In order to get that they need to deleverage or cure NPLs.

Options for deleveraging

Ray Dalio, founder of Bridgewater Associates provides a simple to understand view on how deleveraging can be achieved. As pointed out above, if credit crunches (credit cycle troughs) are left unsolved they can lead to a depression- a protracted series of recessions.  Dalio explains four ways in which an economy can come out of the situation similar to which Zimbabwe is in:

1. Austerity– austerity mostly comprises government initiated spending cuts, frugality and tax increases to reduce fiscal deficit while enabling government to spend in areas that stimulate economic growth. Recent tax introductions and increases on mobile calls, alcohol and cigarettes have been introduced to help reduce government fiscal deficits. Though an austerity helps a government to reduce its debt, its net effect is a reduction in spending. One man’s spending is another man’s income. Higher taxes squeeze households and businesses which limit spending.
2. Wealth transfer –according to Dalio, to stimulate growth and spending among individuals, sometimes government will take the proactive role of redistributing wealth. The goal is to move money from the wealthy (where it is currently locked up in unproductive assets such as property) to the lower income groups who will readily spend it on consumption which hopefully stimulate further spending and investment. But this approach often leads the wealthy to hide their money or move their wealth out of the country. Without a middle class or a visible wealthy class (where wealth is accessible) it is difficult for government to initiate such programs. A likely target would be Diasporas. If the economic situation gets worse, we may see some sort of tax on remittances.
3. Printing money–printing money helps to make money cheap, reduce interest rates and allow banks to increase loans. But since we do not own a currency this option is out of the way. The Americans may not be too pleased if we try to print their greenbacks. And we also know that printing our own dollar at this moment is not such a great idea. The Finance minister has shelved the idea for what he calls a considerable amount of time.
4. Debt restructuring– deleveraging occurs when banks and borrowers agree to alter terms of loans that are turning bad. Options include lengthening the loan duration to push out repayment dates and give the borrower some space to breath. Alternatively, the size of the loan can be cut, an unpopular move for banks. But eventually that is what ZAMCO will do to the loans. The last option would be to reduce interest rates. Our research has shown that there are companies that have loans with interest rates north of 20%. Presumably such loans were questionable in the first place hence the high rates. That is one self-defeating aspect of finance – if you have a business which is a marginal performer, why push it into bankruptcy by high interest rates?

Breaking the downward spiral

As can be deduced from the above, debt restructuring is the only practical option that can haul the economy out the credit crunch. But where do you start fixing? We start at the same place it all started – confidence. Credit cycles are mostly driven by fear and greed, which all demonstrate varying levels of confidence. When banks feel confident they become comfortable to lend money at fair rates. When companies are confident that they can access capital and successfully sell their products, they begin to hire more workers and build bigger factories that stimulate households’ spending which fuels the economy.

We believe banks, borrowers and the central bank can work out something by restructuring defaulting loans to make them affordable and payable. The following steps will help attain the stability we desire.

• Loan durations– inadequate refinancing for the loan maturity wall was in our view one of the triggers of defaults and liquidations. Banks need to consider extending the maturities of loans that are falling due. If we did not have the same size of loans falling due in this period, it is possible that the credit crunch would not have been as severe as it is today. The current market atmosphere is not ready to refinance loans of this magnitude.
• Interest rates – some of the high interest rates charged to businesses have fast tracked defaults. Restructuring of rates is required. If banks are to preserve the integrity of their loans whose underlying assets are companies currently threatened by liquidation, they should consider cutting rates. To the extent that industry is supported by financial sector, the latter is also dependent on the productive sector.
• Interest rate guarantees – Similar to US government’s “Build America” bonds, central bank/treasury should consider providing certain interest rate guarantees on some of the loans to cushion banks and prop up confidence. The guarantees will act as an insurance to banks and inject confidence in the financial sector. A consistent program will pull some of the loans out of “Non-Performing Loans” bracket.

In implementing these reforms, it is important to remind ourselves that industry and financial sector are interdependent and equally important.

In the long run…

For the long term, after a successful deleveraging, Dalio had this advice for individuals and policy makers:

1. Do not have debt rise faster than income – Debt burdens will need to be paid at some point in the future. If you fail, they will crash you.
2. Do not have income/spending rise faster than productivity otherwise you become uncompetitive.
3. Do all that you can to raise your productivity because in the long run that is what matters most. Policy makers have to obsess with turning Zimbabwe into an efficient, cheaper and faster place to do business and live.

For our Market Outlook Report (2015) please send us a request on research@emergent-research.com

 Ray Chipendo is Head of Research at Emergent Research. Simba is a Research Analyst. They are contactable on ray@emergent-research.com  and simba@emergent-research.com

When financial stability and economic growth seem to conflict

By Ray Chipendo and Taurai Duku,  HARARE, November 10 (The Source) – At a time when we were wondering what monetary policy would look like without the money printing press, it appears the central bank is not doing a bad job after all. Reading the recent monetary policy, our thoughts on what ought to be priority issues were pretty much summed up in the statement. But there is certainly more runaway that the central bank needs to manoeuvre before the financial sector stabilises and the economy is back on track.

One good takeaway is that in the absence of a money printing machine, monetary authorities and government are obliged to pay attention on fundamental drivers of economic growth rather than easy and flirting solutions. Competitiveness of companies; Human capital development; Regulatory policies; and Infrastructure development creep up on their To Do List.  As we witnessed in the last decade, printing money is a quick remedy which regrettably comes with painful economic side-effects. So, if our wish mattered at all, we would vote for a US dollar for life.

ZAMCO – Stabilising the financial sector

ZAMCO, a state controlled asset manager with the mandate to clean up bad loans and bring the sector back to sanity is a good start. Based on the monetary policy statement, ZAMCO will buy Non- performing loans (NPLs) from banks in exchange of Treasury Bills (TBs) and Cash. ZAMCO as an asset manager will raise cash from selling securities(subscriptions) to what it calls a “broad based investor group” comprising pension funds, diaspora funds and foreign and local investor classes.  It will also raise money from TBs that government will sell. What is not very clear for now is who will be tasked to recover loans from borrowers? Elsewhere, central banks who have been on a similar path understand well that buying NPLs is easy but collecting them is a completely different job.

The central bank faces difficult choices. To begin with, the central bank’s foremost interest is to “stabilise the banking sector”-recovery of loans is secondary. With that background, it is easy to see why ZAMCO might turn out to be a quasi- bail out of banks. In the interest of keeping banks within healthy capital ratio thresholds, the central bank will favour an outcome where bank assets are not severely discounted but remain sizeable enough not to deplete capital of banks. If our deduction is correct, it is not unreasonable to expect ZAMCO to pay the NPLs at a premium of their real worth or what the open market would pay. This quandary might stoke fears of moral hazard and a hidden household tax. No easy answers here.

To secure adequate funds from the broad investor group both ZAMCO’s subscriptions and the TBs will need to offer significantly high returns. We worry both instruments will have a crowding effect on bonds issued by companies – securities that finance the productive sector. Unlike US and European central’s policy of flooring treasury bills’ returns in order to drive investors to take more risk in corporate bonds and bank loans, ZAMCO’s program will likely achieve the opposite effect.

Commercial business loans – the role of investment companies

We believe that the key question that ZAMCO should perhaps contemplate is “how do we clean up non-performing loans while preserving, and at best stimulating distressed companies”. If only the first part of the question is addressed, we risk attaining a stable financial sector at the expense of a productive sector. But we know well that a financial sector is only as good as the productive sector. The RBZ is reported to have stated that it will focus on NPLs backed by collateral. This might be a prudent move but it will still leave the financial sector fragile. Presumably the collateral demanded is in form of assets which the same companies are dependent on for their operations. By the time ZAMCO is done recovering the loans, the underlying assets (companies) would have folded.

To tie in the twin goals of financial stability and economic growth, NPLs will require patient capital backed by investors that have the expertise to nurse struggling companies back to life.

On the solution presented by RBZ, what may be missing is, for a lack of a better name, a robust and regulated shadow banking system.  This system would comprise investment houses and fund managers who have the flexibility to work at different levels of a capital structure. Such institutions can manage distressed debt and are open to turn some of the debt into equity and can also wait long enough to recover their money. Right now commercial banks by their mandate do not have that flexibility to manage distressed debt and restructure capital structures of heavily leveraged companies. The pressure to meet certain capital ratio thresholds robs banks off the patience to work with struggling companies.

Our view is that in more cases than not, it is more prudent and profitable to finance distressed companies than it is to sink capital into new and unproven ventures. So as Western Europe warms up to Zimbabwe and release funds for entrepreneurial and commercial development, distressed funding needs to be prioritised with our view in mind.

From the lessons learnt in Europe and America, it is too much of a burden to solely rely on banks to play the role of financing companies.  Instead of owning all bank loans, American banks currently own about 20% of outstanding bank loans. It follows that banks should rather focus more on originating loans and conducting due diligences than holding assets. When banks are made the sole intermediary of capital, while their mandate remains narrow, we end up with a bloated banking sector holding loans turning bad. NPLs is an age-old problem, which is not so much the result of imprudent lending as it is the consequence of a poor design of incentives and structure of banks.

Where is the liquidity?

The reader may question where the money to promote a secondary market will come from? Banks are visibly cash squeezed but we do not think corporate organisations are in the same boat.  Our recent Market Outlook paper indicates that (request a full copy from research@emergent-research.com), on aggregate companies have been accumulating cash balances in the last 12months. We believe there are cash rich companies which if presented with reasonable risk adjusted returns, will be ready to fund their cash starved peers through an intermediary. This view will only succeed if the secondary market is well supported by creditor protection rights; rule of law and skilled market players.

Another source of liquidity is insurance and pension funds who hold what can be viewed as permanent capital. The regulators should strongly consider widening the pool of alternative investments that insurance companies can invest in. For example, NSSA keeps at least 65% of its assets in real assets. Pension funds and insurance companies need to employ specialist market players who can track high returns with a sober dosage of risk.

The last source of liquidity we have highlighted in earlier posts is the Diaspora. Besides some of the political concerns that Diaspora cite as reasons for holding back, an underdevelopment of the capital markets and lack of middle market investment players who see value beyond stocks, real estate and bonds is obvious. The regulatory authorities, who have been supportive thus far, will need to continually adapt and hand hold some of the players until they can stand as fully fledged money managers. The horrors of 2002-2006 should not stop us from liberating the markets.

According to central bank’s policy update in September, Bank loans were about $3.8billion. Cash balances of listed companies were at their highest in five years totalling $405million.During the same time NSSA’s pension fund had assets slightly above $600m.  In 2013 remittances were an estimated $2billion including informal funds. Unless we have intermediaries who can effectively connect capital with human capital/enterprise, illiquidity will remain. It is helpful to remind ourselves that capital follow ideas everywhere – even in tough environments.

Ray Chipendo is Head of Research in the Johannesburg office. Taurai Duku is an Associate in the Harare office. They can be contacted onray@emergent-research.comand taurai@emergent-research.com

Gospel from 20th Century Investment King

Investing Caffeine

Exceptional returns are not achieved by following the herd, and Sir John Templeton, the man Money magazine called the greatest global stock investor of the 20th century, followed this philosophy to an extreme. This contrarian, value legend put his money where his mouth was early on in his career. After graduating from Yale and becoming a Rhodes Scholar at Oxford, Templeton moved onto Wall Street. At the ripe young age of 26, and in the midst of World War II tensions, Templeton borrowed $10,000 (a lot of dough back in 1939) to purchase 100 shares in more than 100 stocks trading at less than $1 per share (34 of the companies were in bankruptcy). When all was said and done, only four of the investments became worthless and Templeton made a boatload of money. This wouldn’t be the end of Templeton’s success, but rather the beginning to a very long…

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Where will returns come from?

By Ray Chipendo, JOHANNESBURG, October 31 (The Source) – A few days ago we released our Market Outlook report on Zimbabwe with a view for 2015.  The 14 paged paper provides Emergent Research’s perspective on the future of Zimbabwean equity market.  It also shares how the last five years, post dollarization, have shaped the market and outlines what we perceive to be key drivers of returns going forward.

Great investors we have followed will let you know that forecasting the direction of Markets and economies is a futile exercise, let alone for extremely uncertain environments such as Zimbabwe. So while we itched to put a growth number out there, reason prevailed and we eventually adopted Howard Marks’ approach of “simplifying the unknowable future”. The approach applies probability ranges or distributions for specific scenarios.

We constructed three scenarios for the economy and equity market namely: Holding on the ledge (35% chance of occurring) – pessimistic view of the future with economy sliding back into recession; Reasonable expectations (55%) – a prolonging of the status quo with economy growing in the region of 0-2% rate; and Growth Reloaded (15%) – happy days where the economy is pumping north of 4% growth rate.

But before I share with you the main themes in our report, something happened this week that weighed more on our optimistic scenario for the Zimbabwean economy. It is a five member UK business delegation that has been in the country for the first time in 20 years. What made the news more meaningful to me is that Turner & Townsend, my former employer, a global construction and management consulting firm, UK headquartered was part of the delegation. When I joined Turner & Townsend in 2008, the company’s Africa MD told us that in 1995 the company was making more money in Zimbabwe than any other African market including South Africa.  A replay of those days excites those that still have hope for ‘beautiful Zimbabwe’.

Major market themes for 2015!!

Back to the market outlook report – below are some of the major themes identified in report:

Polarised Market

Our report explains that if the status-quo persists or conditions worsen, we see performance of equity market becoming polarised between companies confined to the domestic market and those with export markets.

IMF’s growth forecasts for the sub-Saharan African economy stand at 5% for 2014 and 5.5% for 2015. These growth prospects are presenting strong market fundamentals for companies exporting in the region. Overall, we believe companies with firm export markets will continue on a strong growth trajectory. On the other hand companies restrained to domestic markets will be subjected to top line growth pressure reinforced by decelerating economic growth and deflation.

Valuations Reset likely for commodities and miners

In the last three years commodity and financial stocks have generally under-performed the market with the exception of a few cases such as BNC’s recent rally. Commodity price volatility and more important questions around the impact of indigenisation law have kept investors at bay. As Government tones down on the law and investors feel more comfortable we expect to see more steel and concrete going into the ground.

The RBZ’s rescue asset manager (ZAMCO) is, in our opinion, a quasi-bailout vehicle for banks.  We believe banks that will survive this phase will be in better shape and carry more confidence. With more investor confidence we expect a valuations reset moment. Most domestic banks have been trading at near bottom valuations.

Companies holding more cash now

Our research suggests that companies may be building up cash balances. Three factors might explain.  Problems in the banking sectors are tightening credit markets and making refinancing difficult. Therefore, it is better to hold on to cash than retire loans which may prove impossible to raise when needed. Secondly, companies may be forecasting tough times ahead – no better way to prepare than build cash.  Last, slowing aggregate demand combined with low production utilisation rates (37%) may be dissuading any investment into capacity.

What will drive Growth?

Three major elements drive market returns, namely earnings growth; dividends and multiples expansion (increase in P/E ratio as a result of investors willing to pay more for future earnings). Going forward what will drive market returns? We ignore dividends which are not a major element in Zimbabwe.

Earnings Growth?

The post dollarisation phase was followed by large increases in revenue among the majority of companies. Of the forty five companies that were part of our survey in 2010, 89% recorded positive revenue growth and in 2011 the ratio jumped to 91%. Corporate growth lost steam in 2013 as the number of companies boosting revenue by more than 50% plunged to zero.    In 2010 the median company registered revenue growth of 69%. The following year the figure declined to 28%; 16% in 2012; 5% in 2013 and so far this year it is 0%.  The trend is quite obvious, top line growth is now facing immense pressure. A slowing economy and deflation are to blame.

The staggering revenue growths of 2010 and 2011 were not translated into bottom line growth.   Earnings performance have been polarised since 2010. Companies with earnings growing or shrinking in the single digit range were on average 14% of the total companies between 2010 and 2013. More than a third of the companies were growing earnings at double digit and the rest, approximately half, were shrinking at double digits. As highlighted in the major themes we believe the majority of companies will continue to face earnings pressure if not contraction. A few exporters might continue on an earnings growth trajectory.

Will multiple expansion come to the rescue?

Excluding BAT, an anomaly valuation-wise, the entire market’s P/E value is approximately 11. Going forward three factors will influence the market’s valuation namely: Perceived risk; liquidity and economic prospects. Our data has shown that the dizzy performance heights reached by the stock market post dollarisation were primarily driven by a multiples’ expansion – investors being euphoric about the future of the economy and subsequently paying more for future earnings. Dollarisation and a unity government were all driving this optimism.

However since 2013, a slur of harmful political talk and less clarity on critical policies, such as indigenisation policy which have implications on property rights and business certainty triggered a multiples compression.  Going back to the UK business delegation, it takes these bits and pieces of optimism to drive interest in our local market and trigger a multiples expansion which will jolt up prices. This why government’s welcoming a UK business delegation should be lauded and encouraged. We have maintained that Zimbabwe’s economic problems are more policy and relationship based than structural. We have nations posting better growth figures than us despite battling with a myriad of challenges (militants killing innocent people; low literacy rates; really dilapidated infrastructure; and terrible environmental conditions).

Winning Strategies

In our opinion a winning strategy will need to satisfy our “stock grading” approach which focuses on GROWTH; VALUATION; and QUALITY.

Unless if you are aiming to have outright control of a company, buying stocks based on their valuations alone will be dangerous. Most undervalued stocks are likely to remain undervalued for extended periods of time. And the majority are under-valued on many metrics expect the most important one – free cash flow.

Quality

We place premium on quality stocks. Stocks that have little need for capital investment to maintain their earnings. Such an attribute will be desirable since raising capital is likely to become difficult in light of a banking sector burdened with high bad loans.  Quality will also come in the form of stocks that easily translate earnings into cash. Liquidity will distinguish survivors and victims.

High Returns on invested capital (ROIC) will be important as well. Post dollarisation most of the companies loaded up debt which was at interests rates in the mid-teens yet their returns on capital were in the in single digit region. Such companies were destroying value with the debt they used to recapitalise. High ROIC is a precondition.

 Growth

Throughout we have emphasised the need to tap into growth in export markets.  In an environment where production utilisation is below 40%, growth is necessary to improve utilisation of plant and equipment and hence improve efficiencies. Apart from supporting earnings growth, efficient operations are important in securing markets in a competitive global economy.

For a full copy of our Market outlook report- 2015, please email your request to                               research@emergent-research.com

Ray Chipendo is Head of Research in the Johannesburg office. He can be contacted on                     ray@emergent-research.com

Zimplow- Any value left for investors

 A stock that has rapidly deteriorating fundamentals can experience a significant decline in its market value in a very short period of time as investors abandon the ‘sinking ship’ in droves.

Throw a seemingly failed corporate acquisition and an increasingly tough business environment into the mix and most certainly there will be extreme casualties as investors’ net worth plunges.

The Zimplow share price has been in a downward spiral since 2012, from a high of 30 cents to the current seven cents a share.

Why? Read on.

Background

Zimplow Holdings, formerly, Zimplow Limited was once a corporate shining star in the unexciting business of animal-drawn implements manufacturing. Limiting its activities to this niche market, it prospered to the point of almost conquering the wider African markets. With this prosperity came a sizeable amount of cash which got management charged up and dreaming of extending its tentacles to a much more glamorous market space. Between 2009–2011, Zimplow generated $4.6 million in free cash, enough to buy back half its issued shares at current prices.

From the mega profits of their flagship operation, Mealie-Brand, Zimplow acquired 49 percent of Afritrac in 2011. This is an animal-drawn implements distributor in South Africa. It seemed reasonable as it was purported to be an entry point into the southern African markets. Following this noble acquisition came the Tractive Power Holdings (TPH) purchase from RBZ’s Finance Trust in 2012.

Zimplow was no longer a mundane business that produces ‘old technology’. In fact through TPH, it had become the largest distributor of high tech farming and mining equipment, locally. Barzem, Farmec, Northmec, Valtra and Massey Ferguson are popular brands which they now housed under one Zimplow roof with equipment such as bulldozers, combine harvesters and tractors.

Management was so upbeat and confident of their purchase that they declared Zimplow would have $100 milllion dollars in revenues by the year 2015. Revenues then were $33 million. What worried us about this assertion was that there was no mention of the word ‘profitability’. But nonetheless, this was going to be the greatest success story of Zimbabwe after Econet. Or was it?

Zimplow overstretched its means to acquire TPH. After an initial purchase of a 16 percent stake, internal resources failed to buy control of TPH. Management called on investors to provide funds through a rights issue and $11 million was raised for the acquisition of a further 57 percent. Zimplow wanted all of TPH and they were going to stop at nothing. Another $3 million was borrowed to buy out minorities and finally consummate the take-over of 100 percent control.

Happily never after

Two years later, today’s Zimplow pales in comparison to the shining star it once was as a smaller company. What management did not foresee was a slowdown in revenue growth as a result of the underperforming agricultural and construction industries along with softening mineral prices internationally. The result was a sharp decline in demand for heavy machinery, aggravated by the absence of asset purchase finance. High restructuring and finance costs diminished the profits and Zimplow had now been successfully turned from a cash compounder into a cash burner.

In the six months to June 2014, revenues of the mining and construction equipment division plunged 58 percent to $4.7 million against the prior comparable period. The farming equipment division was largely flat in terms of revenue growth. Zimplow posted its biggest loss since dollarization of $2.2million. Substantial.

The market’s reaction

Judging from the share price decline, the market did not share management’s optimism and rightfully so. The fundamentals did not support those ambitious assertions. Market capitalization for Zimplow before the acquisition was a lofty $25 million while that of TPH was $15million. Current market cap for Zimplow Holdings (combined Zimplow limited and TPH) stands at $11 million. It is this sort of excessive market behavior that drew us to look closer at the situation.

Is it true that TPH was such a bad addition to Zimplow that it wiped out half its value? Indeed at the current share price of 7 cents, the entire Zimplow company is selling at about 60 percent of its estimated liquidation value. In other words, if the company was unbundled and assets sold, investors would get 9.7 cents a share, netting a 40 percent profit. This is our margin of safety.

The investment case

Zimplow is a market leader in the animal traction business, claiming 65 percent local market share. Its diverse product offering in the heavy equipment segments is unmatched within the Zimbabwean borders. It is difficult to imagine that its fortunes are worse than other smaller players in the market.

Protracted economic stagnancy will have a telling effect on Zimplow’s fortunes. But should this be reason enough to discount the company’s assets below their net saleable value? We believe that mistaking extreme negativity as realism can create absurdities in asset valuation in much the same way as irrational exuberance can create unsustainably high valuations. This pessimism has created the unduly low price.

For one, the Zimplow balance sheet is largely made up of inventory, receivables and cash which account for about 60 percent of assets. These are current assets which management, in view of the prevailing difficulties, can control to avoid over-stocking and ensure reasonable cash flows. It is vastly dissimilar to a mining company whose greater chunk of capital is locked up in immovable assets which are illiquid for the most part. The flexibility attached to Zimplow’s balance sheet will provide room for management to take decisive action – to prevent the creditors’ book or debt from growing if the economy fails to recover timeously. As a matter of fact, efforts to this end have already been initiated at Zimplow. A $3.5 million building owned by Zimplow is reported to have found a buyer and the sale is almost complete. We expect this piecemeal liquidation of assets to be a cash buffer against losses in the short to medium term.

Secondly, a firm the size of Zimplow is unlikely to remain priced at this extremely low level without attracting a take-over bid from a bargain hunter or some sort of private equity operator. The major shareholders themselves may decide to take the company private by making an offer to minorities. This offer will not be lower than the liquidation value. In essence this is an indication that the minority stands to make a return at least equal to the margin of safety. We have seen this happen twice in 2014 with TA Holdings and Astra Industries.

Furthermore, on October 6, Tetrad which was Zimplow’s largest shareholder, sold part of its 39 percent stake in Zimplow in a special bargain sale for 9.5cents ($2.2 million) to unnamed foreign investors. Such negotiated purchases give a good indication as to the value of a company. But in this case Tetrad may have been forced to sell at the depressed price because of the pressure exerted on it to recapitalize its investment bank. It is noteworthy that even in its dire straits, Tetrad could not accept the market price of 7 cents.

Thirdly, the recently signed Russian and Chinese infrastructure deals will be a boon to Zimplow operations as and when the projects kick off. It seems overly simplistic and rather too pessimistic that the status quo in the economy will continue much further into the long term.

Is it all worth it?

Successful investing in these sorts of special situations requires strength of character and great patience. The fundamentals for Zimplow could deteriorate further in the short term before they eventually recover along with the general health of its markets and economy. It can be tough to remain resolute in the face of such circumstances.

However, the wait can prove very rewarding. We will leave you with an example: TA Holdings’ share price hovered substantially below its intrinsic value at around 5-11 cents a share for nearly 2 years between August 2012 and July 2014. In July, the largest shareholder then made an offer of 20.6 cents a share to minorities, a price that was a 275 percent premium to the ruling share price on the date of the announcement. The rest is history!

Oswell Kapotsa is a Research Analyst in Emergent Research’s Harare office and Ray Chipendo is Head of Research in the Johannesburg office.   oswell@emergent-research.com and  ray@emergent-research.com

– See more at: http://source.co.zw/2014/10/zimplow-any-value-left-for-investors/#sthash.XS9pPs2W.dpuf

Bindura Nickel – End of runway?

Missing a stock that grows at double digits in three months can be annoying. But snoozing while a company doubles in price can leave you distraught. Nothing, though, compares to Bindura Nickel Corporation’s 400 percent jump. Not in a year, but in only three months.

Before you cringe at this slip-up, we think the stock price run was just a nervous start; a long runaway still stretches ahead. BNC, we reckon, will soon be contending for a spot in the top five stocks by capitalisation.  It is already the largest mining counter by market capitalisation.

BNC has had a tough going in the last three years. Going by its numbers, the miner must have been worth $3 million on the stock market in 2012. Today, BNC’s capitalisation is $87 million and its stock price is at 7 cents.

Reading the news, it is not a difficult task telling why BNC has had the big jump, but understanding if this upward trend is sustainable is what most investors will be interested in.

Background

BNC is the only fully integrated Nickel mining operation in Africa.  The miner owns the Shangani and Trojan nickel mines, as well as the Bindura smelter and refinery complex. BNC also owns the Hunters Road nickel deposit, which is currently in the predevelopment stage.

Following four years of stalled operations while the mine was under care and maintenance, BNC started shipping concentrates to Glencore in 2013. In the last financial year BNC delivered a total of 7,1 tonnes of Nickel concentrate to Glencore at a price of $65 million. This year the company hopes to pump up that tonnage to something north of 9,000 tonnes.

So how does BNC fare against our three ponged stock assessment approach?

Growth Prospects

Revenue growth for commodity driven businesses is largely driven by prices. Higher international prices precede production ramp ups. Until this year, Nickel has traded very weak with prices averaging $16,000 a tonne in three years. Last year was worse, with prices averaging $14,300 a tonne. A slowly reviving global economy and, to a greater extent, moves by the Indonesian government to ban export of unprocessed Nickel have spiked the price to current levels of $18,500 a tonne.

Large investment banks including Goldman Sachs, Morgan Stanley and Citigroup have all revised their 12-month estimates to an average of $22,000 a metric ton. In any case, the long term London Metal Exchange price for Nickel has averaged $19,500 a tonne in the last five years. A reversion to mean suggests that in the long term, BNC’s revenue prospects will only get brighter.

That said, BNC made a net profit before tax of $16.4 million. All this happened on tepid Nickel prices averaging $14,300 last year. Now with prices up by 30 percent, it is not difficult to figure out why we are painting growth-prospects with bright colours.

In the last annual report, Mwana Africa, BNC’s holding company, committed to ramping up ore production from last year’s quarterly average of 149,000 tonnes to 195,000 tonnes a quarter this financial year. So far, its current first quarter’s output at 151,000 tonnes was 30 percent shy of the target. Management explains that refurbishment of underground mobile equipment was to blame.

From our analysis we estimate that total concentrate produced might not reach the originally envisaged target of 10,000 tonnes (195,000 tonnes of ore a quarter) instead we see annual total tonnage settling at 8,800 tonnes. A 23 percent jump from last year’s production. At the estimated current price of concentrate of $11,000 a tonne, (20 percent increase from last year), revenue growth is estimated to be up by 49 percent this current financial year.

Quality

BNC’s steps to revive the smelter and refinery are turning the integrated miner into a more productive and quality oriented operation.

The operation’s chairman Mr. Mpinga noted that BNC’s most significant cost was currently transport, stating that it cost the company about $1,2 million a month to truck concentrate from the mine as part of an offtake agreement. With the smelter in operation, $14,5 million will be added straight to the bottom line each year.  At a cost of $26 million to refurbish the Smelter and refinery, BNC’s transport savings will pay back the project cost in two years.

BNC’s return to profitability has reinforced its balance sheet.  Return on invested capital is currently at 58 percent and operational margins at 27 percent, signifying a quality operation.

Management has set the current financial year to focus on enhancing efficiency of operations and optimising machinery. But it is unlikely that savings from efficiency gains will reflect on the company’s bottom line this financial year. Not after BNC has paid the consultants for trimming their operations.  At least BNC will eventually emerge leaner and more efficient.

As a result of employee and government stakes in the company, BNC’s chairman asserts that the operation is considered indigenised. Resolution of indigenisation concerns gives BNC a breather. More importantly, management can concentrate on creating value for shareholders.

Valuation

In October 2013, a competent person review restated proven and probable reserves to 32,975 tonnes of contained nickel. Applying the Real options valuation method, we estimate the value of the reserves at $13 million – a very conservative estimate.

Last financial year revenue was $65 million and average concentrate price per tonne was $9,120. If the price of nickel concentrate has increased in tandem with the price of nickel alloy, the former’s price should currently be hovering at around $11,000 a 20 percent jump from last year’s price.

At $11,000 a tonne and producing an estimated 8,880 tonnes, revenue from concentrates is expected to reach $96.8 million this year. Our valuation base estimate suggests a valuation of 17 cents a share, which is a 145 percent upside to the current price. It is important to note that our valuation estimate excludes revenue and savings that will be earned from a resuscitation of the smelter.

Bottom line

Expectation of a revived smelter is perhaps BNC’s biggest attraction to many investors. Yet without factoring the smelter, the miner is still an attractive stock. It seems BNC has a lot of running before it is out of breath.

Ray Chipendo is Head of Research in Emergent Research’s Johannesburg office. Oswell Kapotsa is a Research Analyst in the Harare office.  ray@emergent-research.com and oswell@emergent-research.com