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    Seed Weekly: Company Profits: Retain or Payout?

    We recently looked at the history of payout ratio of all listed JSE companies over the last 50 years and is displayed in the chart below. The payout ratio is the percentage of company earnings that a company declares out as a dividend. This will naturally differ from industry to industry and then down to the specific company.

    All things being equal, at the early phase of a business’s life it will tend to require higher levels of capital for growth and as it generates profit, management will want to accumulate that capital in order to invest back into the business for expansion.

    As a business or the industry it is in matures, it will have a reduced requirement to reinvest retained profits and so be in a position to pay out a higher percentage of profits as a dividend.

    Many investors have as their main focus the divided that they receive on an annual basis. But just as important, if not even more so, for investors are the retained earnings, which is that portion of the profit left after paying the dividend and forms part of the available capital. How a company puts this retained capital to work over the years will be a big factor in determining future profitability.

    The portion of annual profits retained by a company each year and not paid out is essentially added to the capital of the company to be used for business expansion and therefore to generate higher profitability.

    So, while there is always a focus on the earnings and dividends announced by a company each year, what is often of more importance is how adept is management at allocating the available capital at their disposal in order to generate future profit. In general, where a company has profitable opportunities to deploy available capital on which it can earn a superior return, it should be doing this as opposed to distributing too much of its profits to its shareholders.

    Obviously it’s not always easy to compare one business with another. Some are more capital intensive and some far less capital intensive. Heavy industry type businesses, for example Sasol, normally require a much higher portion of yearly profits to be retained and invested into new plant in order to be able to grow future profits.

    Other less capital intensive business such as Coronation, have the ability to pay out almost all of their annual earnings as dividend to shareholders and because they have low capital requirements, can still grow their annual earnings. In 2012 they had earnings per share of 217 cents and paid a dividend of 206 cents per share. This year are set to grow earnings by 100%.

    A key factor that investors should look for, therefore, is how management have allocated capital and the returns that they have made. In many instances management have destroyed shareholder value by investing into sub optimal businesses. Conversely others like the management of Naspers have utilised the cash from their more mature businesses and invested it into other high growth businesses, earning a superior return on capital for the benefit of all shareholders.

    Looking back at the overall payout ratio of all JSE companies then, while this ratio reduced in the 1960’s and 1970’s from above 50%, more recently that percentage has climbed from 35% to around 50%. It could be an indication that companies are finding less opportunities to which to allocate capital, which could in turn result in lower company profitability in the years to come. This is something that needs to be looked at very carefully on a company per company basis.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2013-10-29, 12:11:54, by Mike Email , Leave a comment

    Seed weekly - Pick n Pay – Encouraged but not yet Satisfied

    Pick n Pay Stores Limited has been a household name in South Africa for over 40 years, and the family supermarket chain is synonymous with the Ackerman family and value for money. Although the share price has lagged competitors of late, Pick n Pay remains one of the leading retailers in South Africa and remains positioned for growth under new CEO Richard Brasher of Tesco fame.


    The Pick n Pay empire was born in 1967, when Raymond Ackerman purchased four small stores in Cape Town. The company was listed in 1968, and the share price rocketed from R1.00 to R 6.50 and turnover increased to R 5m in the first year of trading. In 1970 Pick n Pay entered the Financial Mail Top 100 companies, and opened SA’s first hypermarket in 1975. The company’s No Name brand was launched in 1976 and R 1 billion annual turnover was reached in 1983.

    In 2001 the chain entered the digital age with the introduction of online shopping, a division that has grown into one of SA’s top online businesses and the first to offer 1 hour delivery slots for groceries.

    Recent Results

    The results for the 2013 financial year were disappointing, and management described it as one of the toughest operating years yet and admitted that a turnaround strategy was in order. Turnover increased by only 6.3% due to depressed economic growth and high levels of household cost inflation, and the trading margin decreased to a thin 1.4%. Management pointed out that investments made in distribution centres and services improvements have not yet started to pay off.

    The market held its breath when Pick n Pay released its results for 26 weeks ended 1 September yesterday, and was clearly surprised on the upside judging by the share price jumping up 7.8% in yesterday’s trade.

    Group till sales, including owned and franchised stores, was up 8.1% in a very competitive market, and turnover increased by 7.5% to R 30.5bn. This enabled the group to grow headline earnings per share by 35.8%. Internal food inflation was kept to 4.2%, compared to CPI food inflation of 6.4%.

    The gross profit margin improved slightly to 18.1%, and the trading margin of 1.1% was a 0.2% improvement over the comparable period last year. Trading expenses increased by 9.4% due to labour costs, increased occupancy costs and customers paying via debit and credit cards instead of cash.

    Customer growth stood at 3.3%, a welcome sign that P n P is at least not losing any more customers to competitors.

    The graph above illustrates that P n P is stemming market share losses, with the gap in year-on-year growth closing down significantly over the last year.

    The group opened 38 new stores in SA during the reporting period, as well as 6 stores across Zambia, Mozambique, Namibia, and Zimbabwe. More than 1,000 stores, of which 60% are owned outright and 40% franchised, are now operated in 8 countries.

    The operations in Africa showed an increase in revenue of 32.8% to R 1.6bn for the 100 stores operated. A trading margin of 4.1% was achieved, demonstrating the immense growth potential from Pick n Pay’s potential expansion in these regions.

    Current valuation and future prospects

    The company currently trades at a high PE of 38 and a dividend yield of about 2%, similar metrics to competitors in the retail sector – albeit off a depressed earnings base. Management has already made significant progress in a short time in improving efficiencies and management performance and accountability. Management aims to strengthen the core SA business first, before establishing the rest of Africa as a second growth engine, and only time will tell if the likes of Shoprite can be beaten in Africa.

    Pick n Pay forms part of the share selection universe for the Seed Equity Fund, and is also held in the Seed Flexible Fund by one of our equity managers.

    Kind regards,

    Cor van Deventer

    021 914 4966

    Permalink2013-10-23, 09:16:06, by Mike Email , Leave a comment

    Seed Weekly - The Pitfalls and Power of PPP

    Investing offshore is often an emotive subject, particularly in South Africa where many investors got burnt at the turn of the century. In the early 2000’s the rand weakened considerably against most global currencies and investors sent large portions of their hard earned savings into developed market equities at exactly the wrong time. From the end of 2001 until now we have seen both the rand strengthening AND the local market outperforming in local currency terms, i.e. investors who sent money offshore lost out both from a currency AND a stock market perspective. These investors are therefore very sceptical about sending any more money out of the country as they don’t want to get burnt again. On the other side of the coin you have those investors that are worried that South Africa is ‘going down the tubes’ and will take ANY opportunity to get money out of the country.

    The reality is, as always, somewhere in between and at Seed we attempt to take an unemotional look at where the opportunities lie. We realise that we will make mistakes, but if we consistently invest where the probabilities are the greatest then our clients will enjoy superior returns over time.

    In our view, investors taking money offshore need to answer two explicit questions:
    1. Is the rand over or under valued?
    2. Are the offshore assets (equities, property, bonds, etc) over or under valued?

    This report will look solely at the first question.

    Purchasing Power Parity, more commonly known as PPP, is a common method of valuing currencies that is popular among academics and investment practitioners alike. Essentially PPP estimates the fair value of a country’s currency based on inflation differentials and the law of arbitrage. While this relationship often doesn’t hold over the short term, it has a good predictive power over the longer term.

    All models have potential pitfalls where human intervention and logic are important to ensure that sound theoretical reasoning doesn’t result in illogical results. One potential pitfall of PPP is that the output is highly dependent on the starting date. One can get wildly different estimations of fair value by using the same model, but different starting dates. When looking at the fair value of the rand vs the US dollar one can calculate PPP anywhere between R 6.90 (1995 start) and R 17.72 (2002 start). Blindly inputting a starting date can therefore produce an output that is far removed from (what we perceive to be) reality.

    The model’s output is extremely useful, and a powerful predictor of future movements, for investors who apply an element of logic when making their initial assumptions. At Seed we look at PPP from two viewpoints. The first looks at the average PPP for periods between 5 and 20 years (i.e. 180 observations). This method gives a current fair value of R 9.44 / USD. The second method uses the end of 1984 as a starting date, and the result is below. This model’s fair value is R 9.47 / USD compared to the current rate (as at 30 September) of 10.03.

    When the rand is above or below the dotted line (1 standard deviation) we are fairly confident that it’s trading significantly away from fair value and make investment decisions accordingly (send ZAR offshore when it’s too strong and bring USD back to South Africa when it’s oversold).

    We used this model to reduce our foreign currency exposure at the end of 2008, and then again to take it to its maximum at the end of 2010. The rand is currently fairly close to fair value and we therefore aren’t making investment decisions solely based on an expectation of currency movements.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2013-10-15, 11:20:59, by Mike Email , Leave a comment

    Seed Weekly - Value Investing the Buffett Way: 1982 - 1986

    The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do – Warren Buffett, 1982.

    The previous newsletter on Warren Buffett’s tenets focussed on some background regarding the value investing philosophy, Benjamin Graham, Warren Buffett, and some of his core principles. Following from his first five letters (1977 – 1981), I worked through Berkshire Hathaway’s annual shareholders letters from 1982 to 1986. Here is some wisdom I learned.

    During the 1980’s Berkshire had already grown to a large investment holding company and correspondingly Mr Buffett started to warn his shareholders that achieving Berkshire’s historical return of above 20% pa would be difficult to achieve. “The Iron law of business is that growth eventually dampens exceptional economics.”

    Mr Buffett mentions that in order for Berkshire to continue to generate exceptional returns a few big ideas would be required as small ideas just won’t do, “Charlie Munger, my partner in general management, and I do not have any such ideas at present, but our experience has been that they pop up occasionally. (How’s that for a strategic plan?)”

    Mr Buffett admits the fact that they have no idea - and never have had an idea on whether the market will go up, down, or sideways in the near or intermediate future. However, he sees the value of getting the economic cycle right for the long term. His job is to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value. It is essential to buy into companies of exceptional quality. Sometimes this might be a rare occurrence and patience is required.

    Sometimes being an active equity manager means to actively wait (i.e. doing nothing). During 1984 Mr Buffett mentioned “It’s been over ten years since it has been as difficult as now to find equity investments that meet both our qualitative standards and our quantitative standards of value versus price. We try to avoid compromise of these standards, although we find doing nothing the most difficult task of all.”

    One can pay a premium for a valuable company – but the price is essential! Paying too much for a share can undo the effects of a subsequent decade of favourable business developments. One must think as a business owner and invest for the long term. When this is done, one needs to keep an eye focused on business results, and not market prices, since these can be volatile.

    A lot was learned reading these five years of letters. Mr Buffett, as always, also mentions some of his delights, like drinking Cherry cokes, as well as some of his dislikes. He has a general distrust of investment bankers (“don’t ask the barber whether you need a haircut”.) He heavily criticises academics for teaching the efficient market hypothesis and he dislikes Wall Street and its stockbrokers.

    “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” Contrary to some Wall Street firms, Berkshire holds on to what is good and thereby doesn’t sell shares just because they are at very high prices. The underlying business means more than its share price. Little fear is visible in Wall Street, instead euphoria prevails and Mr Buffett is of opinion that one should “be fearful when others are greedy and to be greedy only when others are fearful.”

    To conclude, as Benjamin Graham once said: “Investment is most intelligent when it is most business-like.” This is a principle that we at Seed practice whenever making investments on behalf of our clients.

    Keep well,

    Lourens Rabé

    021 914 4966

    Permalink2013-10-08, 10:46:03, by Mike Email , Leave a comment

    Seed Weekly - Behavioural Finance and Investing

    Standard finance theory proposes that all investors are rational in their seeking of returns and reduction of risk, i.e. the rational economic man, but many studies together with observations of actual behaviour reveal that time and time again investors are not as rational as standard finance theory would have us believe. This is because emotions and biases come into play.

    For example psychological studies have demonstrated that the emotional “pain” of losing money from investments is nearly three times greater than the joy of earning money. Small market declines can quickly turn into panic selling, as nervous investors hate to experience short term price volatility even on longer term investments. In such cases, rationality goes out of the window and emotions take over.

    Behavioural finance has therefore developed to study emotional and cognitive biases or errors that many investors bring to bear on their decision making.

    Perhaps one of the most important works on behavioural finance was introduced by two cognitive psychologists, Amos Tversky and Daniel Kahneman, who began research on decision making under uncertainty. Their research paper, “Prospect Theory: An analysis of Decision under Risk.” was published in 1979. In essence prospect theory describes how individuals evaluate gains and losses.

    The various biases can be divided into two main categories cognitive and emotional biases. Within these main categories some of the biases that have been identified include framing, overconfidence, illusion of control, availability, anchoring, mental accounting, optimism, and loss aversion.

    One such cognitive bias is representativeness, which is a tool that the brain uses in order to rapidly classify information. It allows the brain to quickly process large amounts of data, but it remains a shortcut, which can often lead to erroneous thinking.

    Example: You are given the following information:

    Mary is quiet, studious and very concerned with social issues. While an undergraduate at Berkley, she majored in English Literature and Environmental Studies.

    Given this information, indicate which one of the following 3 is most probable

    1. Mary is a Librarian
    2. Mary is a Librarian and a member of the London Literature Society
    3. Mary works in the banking industry

    The best answer is 3, because of the sheer number of the people working in the banking industry versus librarians and therefore it has the highest probability. Selecting 1, individuals are probably making a representativeness mistake, i.e. by assuming that Mary has traits of librarians (English major, quiet and studious), she is one. While many select choice 2, it cannot be because this is a subset of 1.

    Investors often make mistakes with this shortcut.

    o Attempting to determine the success of an investment in company A, by categorizing company A as a value share, and so drawing conclusions about risks and rewards from this simple classification.
    o Assessing the probability of a successful outcome, using a sample of data and incorrectly assuming that the small set of data is representative of the total population of data.
    o Assuming that shares with similar traits are likely to be identical, even though they may be quite different in reality.

    With the vast scale of information that investors need to deal with, it is obvious that we so easily fall back on making representative biases in decision making. What is important is that we recognise this pitfall and try to take appropriate steps to reduce or avoid this bias.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2013-10-01, 10:56:50, by Mike Email , Leave a comment