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Value investing and the fine art of negativity

Asking what could go wrong – thinking negatively – helps to reduce the impact of bad decisions and improves the overall returns of a portfolio.
A good investment process focuses on how serious the consequences might be if you turn out to be wrong – how badly could things go, and how much would it matter? Photographer: Patrick T Fallon/Bloomberg

‘If there is difficulty or doubt the security should be declined.’ Benjamin Graham, the so-called father of value investing

Risk management is essential to mitigate the consequences of being wrong about an investment

If there is one important lesson that time in the market will teach you – as it has taught us at Denker Capital – it’s that being wrong is part of the process. There is always an element of unpredictability when you invest in anything, so a certain percentage of these decisions will be wrong. A good investment process focuses on how serious the consequences might be if you turn out to be wrong – how wrong could it prove to be, and how much would it matter?

Taking risks is an inevitable ingredient, but the reward must be worth the risk

You shouldn’t take a risk you don’t have to, or that you won’t be adequately rewarded for. Over the past 12 months, we have seen a significant number of companies succumb to the reality that higher risk is not necessarily rewarded with higher returns. The collapse of shares like Aspen Pharmacare, Tongaat Hulett, Blue Label, EOH, Rebosis, Group Five, Ascendis, ELB Engineering Services and Aveng are proof that, while there are many possible outcomes when initially assessing an investment opportunity, only one will eventually transpire.

We avoided many of the shares that recently collapsed because the investment case was just too complex

Potentially, every investment has something wrong with it – a cheap company may have a risky balance sheet, generate poor returns or have a weak management team. A great company with excellent growth prospects may be overpriced. Our job is to ensure that whatever is or could be wrong with a company isn’t a game-changer. Thinking hard about the risks is key to avoid investing in seemingly cheap stocks where the number of potential outcomes is large, and where their impact may be significant.

Tongaat Hulett had a wide range of outcomes and the potential effect of these was just too great

For many years the company generated very low returns on its South African sugar business. It relied on its profitable starch business and ongoing property sales to fund ever-diminishing returns from the local sugar business. The company also depended on dividends from its Zimbabwean operations to fund its ever-increasing debt position. A change in any of these factors would significantly affect the potential value of the assets, and a scenario of several bad outcomes occurring concurrently would be disastrous. This is exactly what happened. The South African sugar operations made losses, property sales dried up, and the company could no longer access its cash in Zimbabwe. In this example, when we assessed the company as a potential investment, the number of potential outcomes was simply too numerous, and the potential impact too significant.

Aspen Pharmacare’s change in business strategy was too risky for us

We followed Aspen Pharmacare for many years and continue to have high regard for its management. However, the industry changed rapidly. This forced the company to make a dramatic shift in strategy away from commoditised generics to specialist therapeutic classes of drugs like thrombosis and anaesthetic drugs. This involved spending R70 billion over the past few years to reposition the company. Such a dramatic shift in business strategy comes with significant risk and the outcome to date has left Aspen Pharmacare generating a meagre return of 7% on capital, with a mountain of debt (R62 billion versus a market cap of R44 billion). While we had owned the business in the past, the risks were just too high and we sold our shares at R240 (the share price at the time of writing is R98).

We continue to learn and do our best to avoid ‘stupid’ decisions

As Berkshire Hathaway vice chair Charlie Munger said: “It’s remarkable how much long-term advantage people have gotten by trying to be consistently not stupid, instead of trying to be intelligent.”

Asking what could go wrong – thinking negatively – helps to reduce the impact of bad decisions and improves the overall returns of a portfolio.


The three key elements of Denker Capital’s due diligence process for assessing companies:

We focus on understanding the economics of the business. We assess whether the business can generate sustainable returns on capital, its growth opportunities, its ability to generate cash, and its capital structure.

* We place significant emphasis on the management team responsible for capital allocation decisions.

* We make sure that we aren’t overpaying for the value we are receiving.

We enhance our process proactively and continuously with fresh insights and lessons

Although we don’t currently own any of the above-mentioned companies whose shares have collapsed, we have made our fair share of errors, which is why our process is designed to ensure that we learn from these valuable lessons. We bring these insights back into our process so that we can continuously improve.

Ricco Friedrich is director and portfolio manager at Denker Capital


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In my opinion…The truth about the Tongaat demise is that over the last year, there has been systematic manipulation. The connected few (including a wellnown institution) knew that there was bad news coming from the financials presented by the auditors…explained away as “ discovered irregularities”. They knew this way before the market did, and held back until they had disposed of their holdings.
Until there is full disclosure and a proper investigation, we will never know the truth. At least with Steinhoff and EOH we have exposure. With Tongaat?……nothing.
Perhaps the legalization of Cannabis for pharmaceutical use will see a JV between Two KZN companies…Tongaat and Aspen. Wouldn’t that be a coup! And all that land Tongaat still holds and can’t develop can be used for the growth of Hemp ( both kinds)

The perception about Tongaat is all wrong. The sugar business earnings fell apart because Staude STOPPED spending any money on maintenance and the inevitable meltdown happened until the point at which the assets no longer have productive value. He saved cents and lost everything. Staude destroyed the company through bad strategic decisions. Mismanagement and accounting lies are completely to blame.

End of comments.





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