For the five years to the end of 2018, there were three companies that stood out on the JSE. Despite overall weakness in the market, Clicks, Capitec and Naspers showed strong, consistent growth over this period.
While these are three quite different companies operating in different industries, they have shown some significant shared characteristics.
“It’s obvious that they have good management, strong balance sheets, high free cash flow and discipline in how they have invested it,” says Hannes van den Berg, co-portfolio manager of the Investec Equity Fund. “They have identified niches in certain markets and kept on finding those niches.”
It’s also notable that none of them would have been obvious investments over this period if you were only considering their valuations. Clicks trades on a price-to-earnings multiple of nearly 30, Capitec around 27 and Naspers 28. These have often been much higher.
“Some people focus a lot on multiples and say this stock or that is too expensive,” says Van den Berg, adding that none of these three fall into the cheap camp. “The way I look at it is that you have to consider what multiple you are willing to pay for a stock that gives you the kind of consistent earnings growth and cash flow profile that these companies have given you.”
Even a forward price-to-earnings multiple gives you just a 12-month view. For a company like Naspers, however, you might have reason to believe that earnings growth is going to continue to be exceptional. What you are paying today for earnings in three or five years’ time may therefore not be that demanding.
In other words, the quality of these companies has, so far, justified the premiums being paid for them.
So what might we be missing?
It is hard to believe that these are the only three quality companies on the JSE. As Hlelo Giyose, chief investment officer of First Avenue Investment Management, points out, Clicks, Capitec and Naspers form a tiny minority of local counters where share prices have rewarded value creation.
“However, you have many companies where the market was not willing to recognise fundamental value created,” Giyose argues. “This includes FirstRand, Bidvest (and Bidcorp), AVI, Vodacom, Santam, Discovery, PSG, Pick n Pay, Nedbank, Mondi, and, dare I say, Truworths and Mr Price. You might argue that banks have done well in the past three years despite Nenegate and the sovereign credit downgrade, but the Industrial 25 Index has been terrible – rightfully so in some cases, and wrongfully so in most cases.”
This, he believes, is where a significant opportunity now lies.
“Share prices of a lot of domestic high quality companies have betrayed their fundamental performance,” Giyose argues. “In other words, the greatest opportunity on the stock market is for share prices of financial and industrial stocks to catch up to their fundamentals – for price-to-earnings multiples to reflect the consistency of earnings per share growth, or for market values to gravitate to economic value added.”
The big, big opportunity?
For Philip Short, portfolio manager of the Old Mutual Top 20 Fund, it is not just South African companies that fit into this bucket. Global tobacco giant British American Tobacco (BAT) has also found itself out of favour. The company’s share price has more than halved since November 2017.
“There have been reasons for this from a sentiment point of view, but BAT still has one of the highest cash flow return-on-investment ratios in the market,” Short says. “We believe this is a good way to measure a company – not earnings, but the amount of cash that a company generates above its cost of capital. The higher your cash flow return the larger your competitive moat, because it demonstrates that nobody has been able to compete away your superior returns.”
Significantly, the fall in BAT’s share price has not been due to the company showing earnings weakness.
“Usually when you have a fall of such magnitude, you have earnings forecasts coming down,” Short says. “But earnings forecasts have stayed the same over the last two years, apart from adjusting for currencies.”
What has hurt the counter has been the Food and Drug Administration (FDA) in the US saying that it wants to ban menthol cigarettes, which account for around 22% of BAT’s group profits, and the growth in e-cigarettes. However, Short believes there has been an overreaction.
“Tobacco litigation is famous for taking forever and its successes being few and far between,” he argues. “In Canada menthol cigarettes were banned, but only 12% of menthol smokers actually quit. The rest went to traditional cigarettes or menthol-flavoured e-cigarettes, the most of which were retained in BAT’s nicotine portfolio.”
Similarly, even though e-cigarettes are becoming more popular, BAT does have a strong presence in this market too.
“Our hypothesis is it doesn’t really matter which nicotine delivery system works, as long as BAT keeps the same market share,” says Short.
For investors, the important thing is to distinguish between what is noise in this case, and what is an argument that carries merit. There have been concerns about BAT’s resilience before, but the company has continued to pump out cash. If that is the case again, this could be a rare opportunity.
“For the first time BAT’s price-to-earnings multiple of eight times is equal to its dividend yield of 8%,” Short points out. “That is a very interesting phenomenon and should send out quite a strong buy signal.”