One of the defining characteristics of the poor recent performance on the JSE is how broad it has been. According to analysis by Northstar Asset Management, 52% of stocks in the FTSE/JSE All Share Index have delivered negative returns over the last three years.
This has created an incredibly difficult environment for most local asset managers, since the opportunity to find stocks delivering positive returns has been extremely limited. The consequences for getting it wrong in many cases have also been severe.
The chart below shows a number of well-known counters that have lost significant value over the past 18 months. This shows the period from January 1, 2018 to June 28, 2019, but some of them were in decline even before that.
Sixteen counters have fallen more than 35% over this period. That includes some substantial names like Aspen, Steinhoff, Massmart and Intu.
Many local funds have been hurt by these large declines. Steinhoff was held by more than 300 unit trusts and exchange-traded funds (ETFs) in the months before its share price collapsed.
A different perspective
However, this has also created a fertile set of opportunities for another set of managers – those running hedge funds with the opportunity to short stocks and therefore benefit when their prices go down. In fact, some hedge funds have enjoyed particularly strong performance over the past 18 months as they have been able to take advantage of this volatility.
This requires viewing the market from a different perspective.
“Where we think you have to look at things differently in South Africa is that most traditional managers make investment decisions based on financial forecasts,” says Cy Jacobs, CEO of 36One Asset Management. “They corroborate those with information from the past and draw a line from there to what they will deliver in the future.”
However, the South African economic environment has changed so fundamentally that those forecasts are increasingly difficult to make with confidence.
“You need to take a proper hard look at the economy we are in now, in the industry you are planning on investing in and ask if that industry can survive in these times,” says Jacobs. “Can it actually grow, does it have a sustainable business model?”
You also have to question the quality of the company’s leadership.
“You have to look at the board and management and ask what are these executives really about,” Jacobs notes. “Do they have proper independence, and are they incentivised as you are as a shareholder?”
Where to look
He says there are specifically four areas in which they are identifying companies that he calls “questionable” and therefore potential shorts. The first relates to corporate governance.
“We’ve seen a lot of this of late in South Africa,” says Jacobs. “We’ve had to deal with management teams that have a lack of integrity, that don’t tell you the truth, where their message is not consistent every six months when you meet with them. Those are quite easy to see.”
More difficult to spot are companies in the second bucket – those reporting good looking earnings, but with no cash flows.
“There are large amount of these companies, including the likes of Aspen, which was a great company in the early days when it was really growing earnings,” Jacobs says. “But everybody ignored the cash flows. They saw the gearing climbing but thought that they would just grow their way out of it. But when the growth stops, the truth is that the cash flow can go massively negative.”
A number of property companies have also shown this tendency.
“If you look at their operational cash earnings, which is the rental they earn less expenses, this is what you would expect them to pay out as a dividend,” Jacobs explains. “The truth is that some property companies are doing this and more. In some cases there have been some fake schemes; in others it’s been one-off profits; or they were leveraging themselves and paying a dividend; or they were raising equity and giving it back to you as a dividend. But when you actually looked at the cash flow of the underlying business you realised that the dividend was never going to be sustained at those levels.”
Hide and seek
A third type of company that hedge fund managers have identified for shorting are those with overcomplicated structures.
“Nobody needs multiple trust accounts in Switzerland, holding companies across the globe, or multiple management companies in spider diagrams like Steinhoff had,” says Jacobs.
“If you tried to follow the audit trail of where the money went it was absolutely impossible. Whenever you see that, we say be wary.”
Finally, companies that are reliant on a single or very large customer are extremely vulnerable.
“Obviously having government as your main client comes to mind,” says Jacobs. “The ENSAfrica report on EOH was an exact prime example of that.”
“This whole subset of opportunities does create an extra subset of profit for our hedge funds,” Jacobs says. “In volatile times, why just concentrate on a subset of opportunities in the hope that they are going to go up? You need to be able to make money on both sides of the equation.”