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Facing the cold, hard facts

The good, the bad and the ugly of Intellidex’s monthly company analysis.

This article was first published in the latest issue of the Moneyweb Investor. To read the magazine click here.

2016 was a difficult year for investors. Locally markets were weighed down by fears that Finance Minister Pravin Gordhan would be arrested and removed from his post amid a volatile political situation and concerns over the direction of governance and economic policy in general. Throughout the year, downgrade risks also weighed heavily on equity markets.

The JSE all share index ended down 5% in the 12 months to October 28, while the top 40 index lost 9%. 

While we cannot compare those returns directly because we made our calls at different times, the average return on Intellidex’s buy recommendations was 13% and our speculative buys returned 6% (from the time the calls were made to October 28). Similarly, the average return of our hold calls was 11% and on sells, 7%. 

 

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Global equity indices were also under pressure. The MSCI emerging market index, which consists of indices from 23 emerging markets, gained a measly 6% over the period while the developed markets – MSCI World – ended marginally lower than its level in November last year. Volatility was driven by a slowdown in the Chinese economy, a collapse in the oil price, terror attacks across Europe, the European immigration crisis, Brexit and an attempted coup in Turkey – rounded off neatly by Donald Trump’s being elected president of the US.

Our calls

Intellidex analysed 48 notes on 46 companies, of which 39 were published in The Investor magazine and nine on Moneyweb’s main sites. Our calls on companies are typically done for the medium to long term. We issue three core ratings: buy, hold or sell, but also issue a “speculative buy” call on stocks we think have potential but carry a high degree of risk.

A company is rated as a buy when our target price is 10% above the current price; a sell when it is 10% below; and a hold when it is within 10%.

Despite what was evidently a challenging year Intellidex calls were largely on point. As shown in the graph below, 15 of the 20 buy calls resulted in positive returns. Only five had negative returns. We only had three sell calls, of which two were off the mark.

 

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Our “buys” were largely on point, capturing four of the five top performers from the pool of 46 companies we covered.  Afrimat and Wescoal were the best performers, gaining 39% each. 

 

 

 

 

Top five

 

 

 

 

 

Counter

Share code

Publisher

Issue month

Beg price

End price

Change

Div yield

Total gain/loss

Our call

Got it right?

Afrimat

AFT

The investor

July

1 948

2 700

39%

2%

41%

Buy

C

Wescoal

WSL

The investor

July

175

243

39%

2%

41%

Buy

C

Raubex

RBX

The investor

June

1 810

2 450

35%

3%

39%

Buy

C

Rolfes

RLF

Main site

Feb

296

400

35%

2%

37%

Buy

C

Blue label

BLU

The investor

May

1 600

2 020

26%

2%

28%

Hold

E

 

While we had successes in anticipating the upside in most companies, we were not as good at anticipating the downside. The table below shows we got it wrong on the worst performers.

 

 

 

 

Bottom five

 

 

 

 

 

 

Counter

Share code

Publisher

Issue month

Beg price

End price

Change

Div yield

Total gain/loss

Our call

Got it right?

Truworths

TRU

The investor

Sep

8 402

6 964

-17%

6%

-11%

Hold

D

Calgro M3

CGR

The investor

Jun

2 055

1 679

-18%

0%

-18%

Buy

D

Brait SE

BAT

The investor

Sep

11 800

9 374

-21%

1%

-19%

Buy

D

Taste

TAS

The investor

Aug

234

175

-25%

0%

-25%

Hold

D

Ellies

ELI

The investor

Mar

148

24

-84%

0%

-84%

Hold

D

 

Top five performers

Afrimat

Afrimat is one of the most consistent small-cap counters on the bourse. It has grown its earnings at an average of 22% a year over the past five years and declared dividends every six months since listing ten years ago.

Factors we like about this company is that it enjoys strong revenue growth (up 15% in its half-year results to end-August) with an expanding operating margin (from 12% in 2012 to 18%), while some smart acquisitions have brought product diversity and increased profitability. 

While we expect the group to continue posting good growth numbers and pay a good dividend, our valuations show that after a 28% rally since our buy call in May, its shares are now trading closer to our estimations of their fair value.

(Intellidex’s full note on Afrimat is published in this edition under the companies section.)

Wescoal

Things are finally looking up for Wescoal and investor sentiment on this stock is improving. Despite the rally in its shares since the beginning of this year, we still have a buy rating on Wescoal shares. The most significant development during the year was the securing of long-term contracts with Eskom and stability in production. Elandspruit, Wescoal’s flagship colliery which supplies the bulk of its coal to Eskom, has been working on short-term contracts since commissioning, which has been a drag on the company’s performance.

With supply contracts in place, Elandspruit can run at or near its capacity of about 2-million tonnes of coal a year. If that happens the group will be able to double its current sales to around 4-million tonnes in the medium term which will likely see it generating the bulk of its income coming from the higher-margin mining activities. At present, lower-margin trading activities contribute more than half of group revenue. The higher contribution from the mining division and the volume-based costs dilution are likely to see overall margins expand which is likely to drive further earnings growth in FY17.

Raubex

Raubex is having a stellar run. Over the past 12 months its shares have gained 44% (35% since our buy call in May this year) on the back of solid earnings and what seems to be improved investors sentiment towards the construction sector.

While we expect its top line to be muted over the next 12 months, we think it can still post good earnings growth and expand margins. We are encouraged by healthy margins on most of the work the group is undertaking. The biggest driver though should be the improvement in the materials division where conditions are expected to remain favourable.

Raubex benefits from a vertically integrated business model. Through strategic acquisitions, it has established a vertically integrated supply chain giving it control of bitumen, aggregates and asphalts used in road construction. It is also the only construction company in the country able to provide the full road construction cycle from earthworks, crushing and asphalt production to the final product. This gives it more control over costs – something that cannot be said for its competitors.  It also means it can capture value along the entire chain. 

Rolfes

We remain bullish on Rolfes. We feel that even after a strong rally that started in June, its market valuation, with a price:earnings ratio (PE) of 7.89, still does not fully capture the growth promise that the stock offers. Our model shows a fair value of around R4.70/share, 24% ahead of its spot price.

Rolfes has transformed itself from just a pigment business into a diversified specialised chemical business. It discontinued its loss-making resins business, disposed of lower-margin businesses in the agricultural and chemicals divisions and is expanding its higher-margin agriculture and water interests through minority buyouts and acquisitions. This has left the company with highly profitable businesses capable of consistently posting good growth numbers. The market, however, does not seem to have credited the company for these value-enhancing developments.

The group also took a bold step last year in moving into the food chemicals market with the acquisition of Bragan Chemicals, an importer and distributor of chemicals used in the food industry. The acquisition comes with higher operating margins than Rolfes’s existing operations. Apart from diversifying Rolfes’s sector exposure, it also provides opportunities to supply its product range to Bragan’s customer base.

These events have bolstered Rolfes’s growth trajectory. We expect the operating margin to expand to around 10.5% (FY15: 7%) and headline earnings per share to be between 60c and 65c in FY17. Average earnings growth of 15% should be achievable over the next three years. Our projections imply a rolling one-year PE of 5.8, which we think undervalues this company substantially.

Blue Label

Blue Label shares have climbed strongly recently with a year-to-date return of 57%, driven initially by its announcement to buy a significant equity exposure in the embattled mobile operator, Cell C. The stake has finally been confirmed at 45%.  Furthermore, during its FY16 results to end-May it reported double-digit growth on both the top and bottom line for the first time in years, underpinned by the expansion of its product distribution channels. This was augmented by efforts to introduce new products to diversify revenue streams.

In April, we had a hold view on the counter but in September we changed it to a sell. However, with it now trading on a relatively high earnings multiple of 19 and against a backdrop of lukewarm mobile sector prospects and Cell C’s idiosyncratic challenges, we are now pessimistic on the counter. We think it is time to take profits. Blue Label’s immediate prerogative is to bed down the highly geared Cell C. We think in the short term this will elevate costs, including borrowing costs, and suppress growth metrics. 

Bottom five

Truworths

Fashion retailers experienced a relatively stable and robust performance for the past few years, but this year has spooked investors with most players recording dismal results.

We were upbeat of Truworths’ prospects following its acquisition of the UK’s Office Group towards the end of 2015.  However, in September the counter was decimated when it announced below par results. We issued a hold recommendation then but sector sentiment deteriorated further after Mr Price, one of the sector darlings, announced a drop in earnings. This pulled the entire sector down and it has not recovered. After that, Woolies also announced that it expects poorer results when it reports its next set of financials.

In its recent trading statement Truworths expects a fall in like-for-like metrics, although overall it will record growth when Office is included. Worsening Truworths’ position is that it acquired Office when the rand was around its historical lows against the pound, but has since recovered significantly since the Brexit vote. So, it means it paid a premium due to a weak rand, but will get discounted translated earnings now as the rand has since strengthened.

The outlook for SA is poor and UK is covered by a cloud of uncertainty following the Brexit vote. However, Truworths has fallen deep into value territory, with an earnings multiple of just 10 times (compared with 14 for its sector) and a dividend yield of more than 6%. We think the share is worthy of our speculative buy call – it carries much risk but holds potential.

Calgro

Despite the poor performance by Calgro we still have a buy call on its shares. We feel it continues to present patient investors with a compelling investment case. Its underlying growth drivers remain strong: government investments in affordable housing as it tries to eradicate the 2.1 million housing backlog, and traction in the gap housing market.

Calgro’s most comforting aspect is that it is not reliant on tendering for projects as is the case with its bigger peers. It does not build anything that is not sold in advance. It develops properties in partnership with the government and private players, sparing itself from the competitive pricing vagaries of securing projects with tight margins in these strained times. That allows it to maintain its operating margin, which is almost three times the industry average. 

Also at the centre of Calgro’s success is its turnkey approach. The group prefers to own the land on which it develops. From there it does everything in-house, from land development, planning and infrastructure (roads, water, sewerage and electricity) to the construction and marketing of homes. This enables it to capture value along the entire chain, which we think will continue to be instrumental in enhancing its earnings and its ability to control revenue and cash flows. 

Calgro’s management has also done a bit of work in de-risking the business, which has been a weak area in its investment case. After introducing memorial parks a few years ago, it is now partnering with SA Corporate Real Estate to form a real estate investment trust (Reit) to service the rental market.

Brait

Brait’s shares have been in freefall since our review – the first for this company – in September. Prior to the Brexit vote, Brait benefitted extensively from the weakening of the rand against the pound. But since the Brexit vote, the pound has been losing ground.

Though we had given the group a buy we highlighted in our note that our projections were prone to high forecast error due to Brait’s exposure to Brexit and the influence of the pound/rand exchange rate on its earnings. Its share price is therefore going to continue swinging up and down, tracking the developments in the UK.

Taste

Notwithstanding top-line growth, Taste will most likely continue underperforming as it beds down its new master franchises. We had a hold view on the counter after it released its annual results end-February but the share has continued to lose ground.

High establishment costs for the Domino’s and Starbucks franchises, as well as high interest charges related to additional debt as well as increased scrip continue to suppress profitability and per share metrics. However, the group’s product range now has wide appeal, catering for the entire market continuum, which should help to stabilise earnings. 

While the company still faces many short-term headwinds as the new operations bed down we expect to see margins recover, making Taste potentially attractive in the medium term. Expansion into the rest of Africa, where fast-food penetration is low, also brightens long-term prospects. We maintain our hold opinion on the counter.

Ellies

Ellies shelved plans to separately list its consumer and infrastructure divisions due to a disastrous performance from the latter. We put a sell call on this stock after management released annual results to end-April on July 26 then filed for voluntary business rescue for the embattled infrastructure division about a week later.

Its small balance sheet has been unable to meet the working capital requirements of its troubled infrastructure division. High impairments charges inflicted the most damage to the group income statement, which has since recorded negative accumulated retained earnings for the first time.

The company desperately needs more external resources to fund its working capital gap as its gearing position worsens. The thin margins in its remaining viable unit, the consumer division, need to be tripled to justify the current share price. It is now difficult to believe anything management says at it misguided investors in the mid-term results: giving the impression that the infrastructure division was on a recovery path, only to be liquidated just after the financial year end. We are avoiding this counter.

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