CAPE TOWN – As famously contrarian investors, the one stock Allan Gray might be thought least likely to hold is Naspers. Besides being the flavour of the market, the counter is trading on multiples that most value investors wouldn’t want to be anywhere near – an historic price-to-earnings ratio of 110 times, and price-to-book of over 10.
Yet Allan Gray owns about 1% of the company for its clients. That is a total investment of in the region of R7.7 billion.
Although Allan Gray has not bought any Naspers stock for a while – portfolio manager Duncan Artus says that they last bought closer to R1 000 a share rather than the nearly R2 000 a share it is trading at these days – it nevertheless looks incongruous. Why would the asset management company esteemed for being contrarian hold the JSE’s most loved stock?
“It is true that you are more likely to find value in shares that have gone down a lot, and that shares that have gone up a lot will be more expensive,” Artus explains. “But it’s not always that simple, otherwise you wouldn’t need analysts.”
Which is one way of saying that there’s a complicated answer coming.
For a start, Naspers carries a weighting of less than 2% in the Allan Gray Equity Fund and less than 1% in the Balanced Fund. As such, it is actually one of their biggest underweight positions.
In that sense, one could argue that being underweight on Naspers is in itself contrarian. Allan Gray is far less exposed to the counter than the majority of equity and high equity multi asset funds in South Africa, many of which have the stock as their largest holding.
The second part of the answer is that valuing Naspers might not be as simple as looking at its metrics. There is an argument to be made that Naspers defies traditional valuation methods, primarily because most of its value is derived from its investment in Tencent, a distinctly non-traditional business.
The way we are used to seeing businesses progress is that they go through a growth phase while they are small enough to expand rapidly, but the bigger they get the more difficult it becomes to sustain both growth and margins as they face increased competition. However, with platform businesses like Tencent, it may actually be the case that the bigger you get, the easier it is to make more money.
“This may be an interesting time in history, but if you look at Netflix or Facebook, the bigger you become the better your competitive position becomes and so you earn higher returns,” Artus says. “Normally competition eats into your margins, but with these platform businesses once you win, you win.
“If you’ve got the most users people will keep launching their apps and games and other products on your platform,” he explains. “Why would they go to a platform with 10 000 users, when your platform has 10 million? ”
Businesses like Tencent also have very little in the way of capital expenditure requirements.
“If a retailer has to expand, for instance, they have to invest in new stores,” says Artus. “ But Tencent probably needs to hire a few more software people, and that’s about it.”
This means that the company has huge free cash flows, which gives it the capability to buy just about anything it likes the look of. That feeds growth and subsequently more cash flows and so the cycle continues.
What we perhaps don’t know, however, is how the growth path of a company like this plays out. Tencent is itself currently trading on a price-to-earnings multiple of close to 50.
Should we assume that this is a natural level for a company of this type? No company has ever before sustained that kind of growth in perpetuity. So is there a limit, and how do we know where it is?
One thing to consider is that there must be a finite amount of time that users can spend online on any single platform. There must be a saturation point. However does anyone know how near or far away we are from that?
This question might not point to clear and present danger, but there are other obvious risks to owning Naspers at these levels.
“I don’t think we’d be telling people that Naspers is an incredibly cheap share,” Artus says. “You have to treat it with caution because you can see it going up, but equally you can see that argument that it is overpriced. You can probably make the case for three different valuations.”
What happens, for instance, if Tencent comes out with a profit warning? At current levels, there would be an awfully long way it could fall.
All of this makes Naspers probably the most interesting share on the JSE. Deciding where it still represents fair value is probably a question debated by analysts at every asset management firm in the country. And it is a question that will become more and more taxing as long as the share keeps appreciating.
“We’ve spent a lot of time trying to understand Naspers,” Artus says. “You need to have a lot of confidence in why you own it.”