The plan seemed simple at first – to invest R100 000 in a handful of shares that are trading at ridiculously low prices, as measured by their price/earnings ratios.
The next step would be to sit back for two years while the company management sorts out the problems and grows earnings, and then for other investors to rush on board when they realise the good value the shares offer.
A strong recovery in earnings and re-rating by investors would lead to a significant increase in the share prices and see my initial R100 000 balloon.
It is not a novel idea. There are a lot of value investors looking for neglected shares, as well as big funds that specialise in distressed stocks and debt instruments.
During the last few years courageous and patient investors were rewarded with investments in shares that were shunned by the markets at one time or another. A few come to mind, such as Anglo American which increased by 600% from R57 in January to the current R400; and Kumba Iron Ore that recovered from R26 in January 2016 to a high of R529 in July 2019 – a gain of 1900%. Implats ran from below R16 to R104 during the last year or so.
Few investors had these shares at the top of their lists two years ago. Most of us only saw the problems that the companies faced and did not contemplate the possibility of such a strong recovery.
However, it is meaningless to look back and say: “I would have made a lot of money if I bought at the low and sold at the ten-year high”. It is equally meaningless to say that: “I wanted to buy shares, but couldn’t because [insert applicable reason here]”.
Very difficult to look ahead
It is a different matter trying to identify shares with recovery potential before the event.
To choose even a few shares with the potential of strong recovery, among the many that are currently trading on very low price-to-earnings (PE) ratios, turned out to be a daunting task.
It seems that the share market is fairly efficient after all. Most share prices are probably reflecting their true value in line with information that is available.
There are usually good reasons why investors are shunning a particular share. In many cases the prospects seem limited. Other companies that are trading on low PE ratios are just too small and shares are too tightly held by larger shareholders, including management, to reflect their true value.
Obviously, a low PE based on historic earnings only means that the share is low relative to its profitability in the past 12 months. It might show that earnings will decline in the next financial year.
It is also short-sighted to rush into shares only because they declined sharply.
Read: The risk of selling low
Just because a share is 95% lower than last year’s record high does not necessarily mean that it will recover.
Steinhoff is the most obvious example – recovery will probably take years and investors would like to see some recovery before they will even consider it.
My risky plan
The morning paper’s share page yielded a list of nearly 50 shares that look neglected if using a low PE ratio as a guide. A few other companies with known challenges and recovery potential were added to a (rather long) short list of 19 shares.
Eventually, only four made the cut for my risky portfolio: Comair, Sasol, Astral and Sasfin. Another four are included on a reserve list. The plan is to invest more or less R25 000 in each share and wait two years.
The only airline listed on the JSE looks cheap, at a share price of R2.69 and a PE of only 1.4 times.
There are enough reasons for the low rating. In fact, the latest results show that the PE ratio is misleading, given that Comair would have reported much worse earnings if not for the settlement of the old claim against South African Airways (SAA) to the value of nearly R1.3 billion.
The claim related to a charge of uncompetitive behaviour that Comair laid against SAA, due to the latter’s agreement with travel agents that excluded Comair from certain booking services. Comair included the settlement in its earnings for the year to June 2019 and reported an increase in headline EPS from 69.8 cents to 197.2 cents.
In contrast, Comair’s operating profit decreased by nearly 60% from R671 million in 2018 to only R284 million in the past financial year. It attributed the bad performance largely to the grounding of its new Boeing Max aeroplane. All the models in the series were grounded worldwide, after two accidents revealed a fault with what should have been a safety feature.
Comair received the first of its eight new Boeing 737 Max aircraft in February this year, only to have it grounded in March. The annual report states that this increased costs by R195 million, as Comair had to rent replacement aircraft. It also impacted revenue, as flights had to be curtailed.
Availability of aircraft was also affected by bad service at SAA Technical Services, which serviced Comair’s aircraft, as well as another grounding of planes due to uncertainty around whether all spare parts supplied by SAA Technical were correctly certified.
It seems like the decline in Comair’s share price from a high of R6.75 in April 2018 to the current R2.69 is justified, but there are prospects of recovery.
Comair moved the maintenance of its aircraft to Lufthansa Technik and is bound to receive compensation from Boeing for the loss of revenue due to the grounding of its brand new 737. Boeing has already put aside nearly $5 billion to compensate its customers for losses.
Boeing has no choice. It has already delivered more than 300 of the 737 Max aircraft and has nearly 400 ready for delivery. It plans to sell a few thousand more over the next few years.
The provision of $5 billion for damages equates to the profit on around 15 aircraft and is a small price to pay to retain customers.
Boeing has indicated that the Max series will be airborne again by January next year, as had American Airlines which operates several hundred and has placed orders for a few hundred more.
The trigger for a recovery in Comair’s share price lies closer to home.
It seems that somebody cracked the whip – maybe majority shareholders Bidvest or Alan Gray – and Comair announced a restructuring of its board of directors to stir things up.
I believe better operating results and compensation from Boeing, as well as extending domestic operations as SAA is slowly fading away, would make a recovery in the share price likely. A recovery in EPS to around 70 cents and a re-rating to a PE of 10 would push the share price to R7.
A lot has been said and written about Sasol’s problems lately, after it announced an independent review into the construction of its Lake Charles chemical plant in the US and delayed its annual results.
This delay was not well received by the market and neither were the results. The results focused largely on the problems with the construction of the new chemical plant and it seems that people paid scant attention to the figures.
The income statement indicated other problems. In fact, only the mining division performed to a level that investors have come to expect from Sasol over the last few decades.
While the chemicals company can definitely not be described as a forgotten share or trading on a ridiculously low PE (9.7 times), the fall in the share price from above R600 to below R300 attracts attention to the possibilities of recovery.
I hope that the new broom in the person of CEO Fleetwood Grobler will sweep the whole office clean and bring renewal in Sasol’s existing businesses.
Recovery in the ‘old’ Sasol can push earnings up to those of a few years ago, which will help the share to recover.
Prospects are that the Lake Charles plant will contribute $1 billion to earnings before interest, tax and depreciation in the 2021 financial year. This will help the share further along.
The main concern and risk is Sasol’s high debt levels. To date, interest on the loans to develop the new project has been capitalised, but interest becomes current expenditure and will reflect in the income statement as soon as the project is completed.
Nevertheless, the foreign currency earnings and potential to recover earns a place in my risky portfolio, with the hope that the share will recover back to R600 and run even further within the next two to three years. Analysts’ forecasts over the next few months will make for interesting reading, to see if expectations of a recovery in earnings are shared by more capable people.
There were days when niche financial companies traded at healthy premiums to the vanilla commercial banks, but the ratings in the sector are telling a different story now. Sasfin, on a PE of 5.3 times at its current share price of R27.30, attracts attention due to its remarkably strong growth in the past financial year.
Headline earnings increased by 32% to R161 million in the year to June 2019, compared with R122 million in the previous financial year. Headline EPS showed a similar increase to just above R5.
With the announcement of its results some six weeks ago, management pointed out that the return on equity also improved, but that they were pushing for further improvements.
Sasfin also saw a change in management and the new CEO, Michael Sassoon, assured shareholders that the company has done all the necessary preparation to put it in a position to improve profitability.
He said that the weak economic environment and political instability affect medium- and smaller businesses proportionally more than larger enterprises, which affected Sasfin due to its focus on smaller businesses. Sasfin experienced lower growth in loans and advances during the financial years and also noticed a deterioration with regards to bad debt.
Sassoon said that Sasfin invested a lot of capital during the past two years to enhance its capacity – especially its digital offering to improve services to smaller businesses. He also said that it had to contend with a lack of business relative to the scale of Sasfin’s high fixed overhead cost base, which saw a deterioration in the very important cost to income ratio.
Management committed itself to leverage off its improved structure and focus on improving marketing, product offering and costs.
In short, Sassoon implied that the company can achieve strong growth in the 2020 financial year and thereafter.
Shareholders have sold down the share since 2017 and the price lost two-thirds of its value, falling from R75 at the beginning of 2017 when Sasfin started its hefty investment programme. Hopefully these investments start to pay off now.
My portfolio is banking on a few years of good earnings growth and a bit of recognition from investors to kick the share higher. Shareholders only need EPS of R6.25 two years out and a PE of 8 times to double their investment.
Astral has been in the news often during the last few years. Unfortunately, it was mostly for the wrong reasons.
The share price halved from a high of R326 in May 2018 to the current levels of around R165, after management had to issue several warnings to shareholders during the last 12 months. They all repeated the sad message of declining earnings.
In addition to the usual problems of high feed costs, low economic growth, increasing imports and low prices, Astral also suffered from a few unexpected and unique problems over the last year. The latest profit warning came in a trading update last month, which said that headline EPS will decline by between 50% and 60%, compared with the previous year’s very good figures.
The figure at the higher end of the range put Astral on a PE of 7.4 times – which is not really that cheap, but not expensive either.
All I hope for is that management can solve the short-term problems quickly, and for an improvement in consumer confidence.
The effect of cheap imported chicken will decrease in time if the rand stays weak, while a slight recovery in the economy would do the rest to help recovery in profitability and the share price.
Astral’s results are due next week and management would give a better idea of the prospects. All my portfolio needs is an improvement in headline EPS to R25 and a bit more optimism from other investors.
Still far from R1 million
Putting all the pieces together shows that I am still far from growing my portfolio from R100 000 to R1 million in the next 24 months, given ‘guestimates’ of a target share price two years out.
Portfolio and target price
|Comair||R 2.69||8000||R 21 520||R7||R 56 000|
|Sasol||R 286.73||100||R 28 673||R800||R 80 000|
|Sasfin||R 27.30||900||R 24 570||R50||R 45 000|
|Astral||R 166.58||150||R 24 987||R400||R 60 000|
|R 99 750||R 241 000|
Source: Own calculations
If all goes well, I will end with ‘only’ R241 000. The solution is to borrow a BFR rocket engine from Elon Musk to give things a proper boost, and worry about the consequences later. To be continued….