At the start of 2016 Brait was an undisputed market darling. The listed investment trust’s share price had shot up from R19.95 to R166.94 in just five years. That is over 800% in half a decade.
The primary reason for this incredible growth was how the investment holding company had managed the acquisition and subsequent sale of a large stake in Pepkor. Brait had acquired a shareholding in Pepkor for R4 billion in early 2011, and just four years later disposed of it at a substantial profit.
“This Pepkor shareholding was sold to Steinhoff in February 2015, at an eye-watering price-to-earnings ratio of more than 30 times,” explains Terence Craig, chief investment officer at Element Investment Managers. “Brait received R15 billion in cash and 200 million Steinhoff shares, which were sold in October 2015 for R16 billion.”
Overall, this meant Brait had realised R31 billion in cash from the Pepkor shares for which it had paid just R4 billion. So it had made almost eight times its money in just under four years. Such a profitable transaction was bound to attract market interest.
“Investors paid up for Brait shares in anticipation of it generating sustainable and superior future net asset value (NAV) growth, as it had demonstrated with its Pepkor purchase and sale,” Craig says.
Paying a premium
There was such an appetite for Brait shares that investors were willing to pay a substantial premium to the company’s NAV.
“Listed investment trusts (such as Brait) usually trade at a discount to their NAV over the long term,” Craig notes. “Yet in 2015, Brait’s share price was trading at more than a 50% premium to its NAV.”
By contrast, shares in Remgro, another listed investment trust, were trading at a 15% discount to NAV. Investors were also willing to pay this premium despite Brait management’s decision not to declare a special dividend from the Pepkor windfall. Instead, they announced that they would “deploy the capital in other high-performing businesses”.
This excited the market, with many investors anticipating that Brait would deliver more transactions like it had with Pepkor. Yet, while many got caught up in this exuberance, others saw it as a warning sign.
“Deals such as Pepkor, with returns so exponential and so quick, are exceptionally rare and seldom repeatable,” Craig argues. “The probability of a Pepkor-type return from any future transaction was extremely low.”
The New Look disaster
To value investors, the Brait share price had run far ahead of itself. It was pricing in extremely high future returns, which were far from certain.
Critically, such investors also began to ask questions about management’s decision not to ‘bank’ some profits for shareholders by paying a special dividend. Instead, they went looking for another deal.
In June 2015, Brait bought 90% of UK fashion retailer New Look for R14.2 billion. A few weeks later, it paid R12.2 billion for 80% of Virgin Active.
“Brait spent R27 billion (87%) of its R31 billion Pepkor proceeds on two material transactions in less than a month – going big when they should have been going home!” says Craig.
Unfortunately for shareholders, the New Look acquisition has been disastrous. Before the end of 2017, a little more than two years after the transaction, Brait wrote off the entire R14.4 billion it had spent on the deal. Then, in January this year, it announced that it had agreed to an arrangement with New Look’s creditors that would see it swapping some outstanding loans for equity. The result is that it could be left with only 18% of the company’s shares, and therefore no meaningful control.
This has, understandably, had a massive impact on Brait’s share price. From a high of R169 per share in February 2016, it now trades at under R28.
Brait’s current market cap is R14.6 billion. That is around the same amount it paid for New Look and subsequently wrote off, and less than half of the R31 billion it received for the sale of the Pepkor holding in 2015.
While these things are always more obvious in hindsight, there are nevertheless two clear lessons for investors from Brait’s incredible rise and fall.
The first is being very conscious of not overpaying for shares in a company. The overwhelmingly positive sentiment towards Brait due to its handling of the Pepkor deal had pushed its share price to a point where there was no margin for the company to disappoint. It had to deliver exceptional returns to justify the valuation, and when the opposite happened the collapse in the share price was inevitable. The risk to investors was therefore substantially to the downside.
The second, and equally as important, is paying attention to how management allocates capital. After selling its Pepkor stake to Steinhoff, Brait had a huge pile of cash, but instead of investors seeing the benefit of it, much of that value has been destroyed.
In a rush to externalise capital from South Africa, the company bought into a highly competitive UK fashion industry in which it had no experience. New Look was hardly destined to fail, but it was always going to be difficult for it to deliver outstanding returns.
Instead of the certainty of returning money to shareholders, Brait instead opted to pay a substantial sum for a business that didn’t have a clear competitive advantage or path to success.
Given Brait’s past success, investors raised little concern at the time. A more objective assessment of the deal may, however, have delivered a rather different assessment of its value.