Some of the JSE’s most successful companies are not those selling goods and services. They are holding companies that generate a return by investing in other businesses that they expect to deliver growth.
Perhaps the most well-known example is Remgro, which has created real long-term value for shareholders by investing in a range of assets from banking to infrastructure. PSG Group is another that has grown a successful portfolios of assets, including in private education and financial services. Naspers is also largely seen as a holding company, since its value is derived from its underlying investments, primarily in Tencent.
Recently, however, many of these companies seem to have lost some of their attraction. This can be seen in how they are trading at large discounts to the value of their underlying assets.
Investment holding company discounts are getting wild. ARCInvest at 60%
— Piet Viljoen (@pietviljoen) January 31, 2020
As the table below shows, some of the smaller holding companies on the JSE are being valued at less than half of what you would get if you added up the reported value of all of their investments. Even larger stocks like Reinet and PSG are trading at significant discounts to their net asset values (NAVs).
|Investment holding companies’ discounts to latest reported NAV|
|Company||NAV per share||Share price||Discount|
|African Rainbow Capital Investments||R9.34||R4.00||57.13%|
|Trematon Capital Investments||R5.21||R2.46||52.78%|
Source: Company financial statements and ProfileData
Getting more for less
Seeing a discount on a holding company is not unusual. In fact, for a number of reasons, it should be expected.
Firstly, the discount is there to take into account the cost of managing the business.
“A holding company can always tell you exactly what its assets are, but there are some contractual liabilities on which no value is ever put,” explains Piet Viljoen, chief investment officer at RECM.
“If there is a contractual management fee, that is a liability that you need to include in your estimation of fair value.”
How significant this liability is also takes into consideration the quality of the management team. If the market sees management as exceptional, the discount may disappear completely and investors may even be willing to pay a premium in expectation of future value being delivered.
This was the case with Brait towards the end of 2015. After the acquisition and subsequent sale of a large stake in Pepkor that realised enormous value for shareholders, Brait shares were trading at a 15% premium to its net asset value. This is because investors were expecting management to produce more of the same.
Read: Don’t go big, go home
Another important consideration is that even though a holding company’s assets may be given a market value, shareholders would never actually receive all of that if they were sold. This is because any sale would both attract capital gains tax and incur other transaction costs.
It’s also worth considering that, for most holding companies, the underlying investments are not all equally attractive. This has an impact on how the market values the holding company as a whole.
“Investors like to diversify for themselves, but they are now relying on a management team to diversify for them,” explains Kokkie Kooyman, portfolio manager at Denker Capital. “And that management team might have diversified into assets investors don’t like.”
Hannes van den Berg, a portfolio manager at Investec Asset Management, expresses a similar sentiment.
“As a fund manager investing in listed equities, I often feel you could do better to pick one or two of the underlying businesses and invest in them, rather than buying the holding company,” he says. “With RMI Holdings, for example, you can decide whether to buy Discovery or Momentum Metropolitan. Of course Outsurance is unlisted, so if you invest in RMI you have to believe that it will outperform the other two.”
It may also be the case that there is one asset within a holding company that overshadows the rest. Investors may be prepared to pay more just to get access to that.
“The discount will generally depend on the quality of the assets and the scarcity of the assets,” Kooyman points out.
“For a long time PSG traded at a premium to its underlying assets, simply because Capitec was such a hot commodity. Investors liked the business, but the liquidity in Capitec was so low that investors rather bought PSG.”
For these reasons, one can expect investment holdings companies to ordinarily trade on around a 15% to 25% discount to the net asset value of their assets. However, as the table above showed, the discounts on many JSE-listed stocks have grown much bigger than that.
“What has happened is that we’ve generally seen these discounts go to significantly wider levels than they have traded at historically,” notes Nadir Thokan, co-chief investment officer at 27four Investment Managers. “And it’s fairly similar across the board, irrespective of the quality of the underlying assets.”
Reinet, for instance, gives investors exposure to British American Tobacco. Remgro holds FirstRand, Mediclinic and Distell. PSG’s major investment is in Capitec. These are high quality assets.
Yet the discounts on these companies are all unusually large. As the graph below shows, for example, PSG’s discount to its sum-of-the-parts value is about as great as it has ever been.
What’s at play?
One reason for this, Thokan believes, is the scale of foreign selling on the JSE. There has been particularly little appetite for these kinds of companies from foreign investors.
At the same time, large South African investors have rather been looking for opportunities in other parts of the market.
“Local fund managers have [increasingly] been trying to get big calls right, such as their positioning around Naspers or the resources sector,” Thokan argues. “There has also generally been more interest from local fund managers in rand hedges.”
In the current economic environment in South Africa, it is also quite difficult for the management teams of these holding companies to express a longer term strategy that can give investors a good sense of the growth they can look forward to.
“There are a lot of uncertainties that need to play out,” Van den Berg explains. “As we get more clarity, they can make more medium and longer term decisions, but it’s difficult to do that at the moment.”
The final issue, as Viljoen puts it, is “the rationality of the market”.
“When markets are very optimistic there are no discounts on these companies,” he says. “There may even be premiums. But when the market is pessimistic, those discounts widen up a lot. Sentiment is a big driver.”
In other words, the discounts to net asset value being offered to shareholders are not for reasons that can be identified in balance sheets and income statements. Investors are reacting to the negative perceptions about the South African economy, and the performance of the JSE.
“I would say about half of what you see today is purely emotion,” Viljoen argues.
And he therefore sees this as an opportunity to pick up some of these companies at attractive levels.
“We are buying where we can,” he says. “That doesn’t mean the discounts get unlocked tomorrow. If we survive as an economy, then our clients will do well out of it. But if the economy goes to rack and ruin, there is no protection in an undervalued asset.”
For Thokan, the important thing is to identify those companies that have the highest quality assets. That is where buying them at a discount is most appealing.
“A lot of businesses locally are facing difficult trading outlooks, but there are some very high quality assets in these companies,” he says. “And irrespective of the economic environment, we are seeing high quality companies still compounding their earnings growth above 10% and generating good free cash flow.”
Outsurance, of which RMI Holdings owns 89.1%, is an example. There are also some interesting growth opportunities within the portfolios of some of these companies, such as with Remgro’s investment in Dark Fibre Africa.
“That is a world class business, and it’s growing quickly in a segment where there isn’t a lot of competition,” says Thokan. “So we see instances where these companies have high quality assets and they are trading at a discount because the market has become apathetic.”
The question for investors is whether they take the opportunity to invest now, or wait to see sustained earnings growth coming through before they do.
“Our investment philosophy is more focused on fundamentals and growth profile,” says Van den Berg. “We prefer to invest where revisions to growth are positive.”
For a value investor like Viljoen, however, the current discounts are too attractive to ignore, even in the current environment.
“Investing is always about the odds you are being offered and how those stack up to reality,” says Viljoen
“Right now the market is saying there is quite a high likelihood of the South African economy going to the wall,” he says. “I would say there’s a chance we won’t go to the wall, and so I will invest some money in some of these assets.”
Patrick Cairns owns shares in PSG Group.