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Don’t go big, go home

The importance of good capital allocation.

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.

Investment lessons

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.

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“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!”

The above sounds to me to something very similar to:”all eggs in one basket”

“Allocating capital” – – ZAR31bn would have been better in shareholders’ pockets – but Wiese probably wanted all of it abroad and not in ZAR.

Bad decision, fuelled by him wanting all his money outside of SA.

He has never cared about shareholders – they are a necessary irritant

Wiese is one of the largest Brait shareholders. Your comment makes zero sense.

Andrade – last time I looked, Brait was listed on JSE and therefor R31bn dividends would be paid in ZAR

Hope that clears the issue for you.

Brait burnt me badly. I licked my wounds and I moved on. These days I have zero appetite for stock picking. ETFs is all I do.

Lucky me, I resisted the temptation to buy into Ascendis Health and Steinhof.

I bought Steinhoff after the fall (twice). First round I made about 20% and the second time 100%, bought at R1.16 and sold at R2.32 (barring fees). Doubt I’ll risk it again, but it was money that I was comfortable losing, i.e. earmarked as ‘speculative’.

There is more to this story than meets the eye. The bottom line is that the behavior of the government of SA was so hostile and corrupt at the time, it forced South African businesses to act irrationally and impulsively to move assets offshore as protection, taking gambles with shareholders money and making bad decisions…. look at them all – Steinhoff, Woolworths, MTN, Mediclinic, Okd Mutual, to name but a few…. These disasters can all be laid at the door of Jacob Zuma and his band of merry men and women – in my opinion!

But let’s not forget the one thing, these companies did.

They forgot the South African households … They were the customer that made them a success and the employees that were dedicated to their success

The companies decided to not abandon the very formula to their success and rubbed it in everyone s face … How they leaving … I am not sure we should feel sorry. .. I do hope they learn their lesson though …

Analysts and bankers based in London would advice any other day to protect that to protect your wealth … You have to cut ties with your risky heritage … But you didn’t get here without your heritage in the 1st place

There was great political pressure and incentive to keep external money external, to keep it away from corrupt politicians.

Not quite Mac, it is convenient to blame Zuma (seemingly forgetting the ANC) for just about everything including drought etc. But I note that these companies, like many in SA, are infected with professional executives who pay themselves huge salaries and even “huger” bonuses, regardless of actual company performance; very much like Zuma et al. It is harder and harder to pick exclusions to this cabal.

And shareholders had for write off billions in loans that management gave themselves to buy shares. Gnodde clearly confused the strong Pepkor brand and management with his deal making skills.

Sometimes you throw mud at a wall and it sticks – refer Tencent – and often it slides down to the ground into a dirty puddle – refer Brait.

Brait did nothing wrong with taking their money offshore.

They did everything wrong with their asset allocation offshore.

If they just parked in foreign cash/bonds in 2015, they would have made out with a tidy appreciation (around 20-30% return).

Lesson – don’t go big, don’t buy what you don’t know, and don’t keep all your assets in rands either.

and then there’s Virgin… a business with shrinking EBITDA that they value at 11.5x EBITDA. then they claim that 11.5x is below Virgin’s peer group…but their idea of a peer group includes Clicks??!! Hell, why not throw Dischem in Virgin’s peer group too!?

These guys at Brait were all big players. They ran a successful PONZI. To date no one has been held accountable.

Poor article. Braits downfall has nothing to do with not paying a special dividend or investing outside of South Africa.

It has everything top do with taking on way too much debt and buying businesses in terminal decline.

So ironic that “value” investors once again saw the writing on the wall, yet Brait were contrarian in buying an old economy high street retailer? Is that not supposed to be what value investors do?

To get Terrence Craig to speak about good capital allocation is also a bit rich. Over the past 10 years its equity fund has returned 4% pa! The market did 10%. Of course like all value zealots he will claim that 10 years is too short a period and the tell the bit about the Chinese president that said it is still too early to judge the impact of the French Revolution.

Deep value zealots like all religious fundamentalists are huge hypocrites. Why all of them need to constantly proselytize in the financial press while their LT performance gives you half of inflation is beyond me. Performance numbers below

https://elementim.co.za/element-earth-equity-sci-fund-2/

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