Over the past few years the South African stock market has experienced a number of high profile shocks. The first was the failure of African Bank, followed more recently by the collapse in the Steinhoff share price and the sharp correction in the value of Resilient and its related companies.
At the root of all three was some highly questionable accounting. Shareholders were being shown a version of the company that didn’t match reality.
There have also been some significant share price drops that do not necessarily stem from accounting irregularities, but from valuations running away from company fundamentals. Aspen Pharmacare has been the most notable of these, with its share price having almost halved in just the last few months.
These ‘bombs’ have been a real test for local investors, since the companies have all been large enough to potentially have a material impact on portfolios. This has been exacerbated by the fact that the market as a whole has been so weak.
Over the last three years, the JSE has essentially moved sideways. This means that big losses have been felt hard, because it has been almost impossible to find any way to make that money back.
“There is nothing else going up 90% when you have just lost 90%,” argues Adrian Clayton, chief investment officer at Northstar Asset Management. “There are no offsetting shock absorbers like there were in previous years.”
Three-year JSE returns
This has highlighted one of the truisms of investing – that not losing money is as important as making money. It is simple maths that if a portfolio falls by 50%, you have to generate a 100% return just to get back to where you started.
Avoiding big losses is therefore critical. And Clayton argues that in all of the recent cases on the JSE, there were clear signals of the growing risks to investors.
The key is to look beyond reported company earnings to cash flows and return on invested capital (ROIC). These are critical economic indicators that give a much truer picture of the health of a business.
Clayton points out that with any business, you want to see cash flows following earnings. If profits are going up, but cash flows aren’t, you have to ask why that is.
Similarly, rising profits can actually disguise a falling economic return, particularly where a company is acquisitive. This can be illustrated through a simple analogy:
Two farmers, Farmer A and Farmer B, each own farms worth R10 million. Farmer A makes R1 million a year, which is a 10% return. Farmer B makes R500 000, which is a 5% return.
However, Farmer A wants to expand and so he buys Farmer B’s farm for R10 million. He now makes R1.5 million a year, and so his profits are up 50%. What may be less obvious, however, is that his return on capital has fallen from 10% to 7.5%, since he is now making R1.5 million on a R20 million investment.
This was the pattern that played out at Steinhoff. Over time, the company’s weighted average cost of capital (WACC) actually started to exceed its ROIC.
Steinhoff WACC vs ROIC
“Steinhoff management should not have been going to work,” Clayton argues. “Every day that they did, they destroyed value for shareholders.”
Yet the company was trading on a high valuation based on financial statements that were notoriously difficult to understand.
“We put four analysts on the company and could never follow its financials,” Clayton says. “They changed them annually, and it was just very, very difficult to understand what was happening inside Steinhoff.”
What they could understand, however, was not appealing. While its earnings were climbing – largely based on 34 acquisitions and divestitures the company engaged in between 2000 and 2017 – its ROIC was dropping.
“The lesson is to look at ROIC,” Clayton argues. “Don’t look at the profits they are telling you they are generating.”
Although Aspen does not represent the same risk as Steinhoff, it nevertheless showed a similar pattern when looking at ROIC.
“The cost of running the firm started to exceed the returns generated,” Clayton points out. “On top of that, Aspen’s debt was starting to skyrocket.”
Aspen WACC vs ROIC
For investors, these are the kinds of indicators that should guide a thorough analysis of a company. Rising earnings may look impressive, but unless they are supported by cash flows and returns on capital, one has to ask questions about their sustainability.