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    Seed Weekly - EXXARO – interim results

    South Africa’s second largest coal producer Exxaro (EXX) released its interim results on Thursday 21 August. It was a good opportunity for the Exxaro executives to reflect on the recent acquisition of Total Coal South Africa as well as review their outlook for the year ahead.

    History & Operations

    Exxaro is the result of an empowerment transaction which involved the unbundling of Kumba Iron Ore in 2006, making it the largest BEE mining company in South Africa. As can be seen by the group structure below, they are a well-diversified company with interests in coal, titanium dioxide, ferrous (iron ore & steel) and energy with current operations in SA, Botswana, Congo, Inner Mongolia, and Australia.

    TCSA Deal

    Exxaro acquired Total Coal South Africa last month for R 5bn ($ 472m) and together with the interim results announced that the company had secured a bank guarantee from Absa.

    The deal will be financed through cash and debt as well as a combination of dollar and rand funding. Almost all of Exxaro’s coal is currently sold to Eskom on contract but it is keen to increase coal exports, at better margins. One of the constraints has been limited access to the Richards Bay Coal Terminal (RBCT). The TCSA deal will give Exxaro access to an extra 4.09 million tons of coal through the Richards Bay terminal. There are still some concerns by analysts as to whether the high price paid for the asset is justified, given that there may still be some capital expenditure needed.


    Exxaro has committed R 10.2bn to the Grootegeluk Medupi Expansion Project to supply Medupi, Eskom’s newest power station, which is at least three years behind schedule. The first unit is due to come on line only by the end of this year.

    Though Medupi has started to take delivery of coal from Grootegeluk, it is taking far less than originally agreed (3.1 million tons compared to 6.2 million contracted).

    Exxaro will be paid its fixed costs (but not its variable costs) resulting from this, with some analysts saying that not producing Eskom coal may even free Grootgeluk’s capacity to produce more coal for export resulting in a bigger profit margin.

    Interim Results – for six months ended 30 June

    Highlights include:
    • Headline Earnings per Share: Up 11% to 793 cents – better than expected.
    • Interim dividend of 260 cents declared. Up 11% compared to last year.
    • Revenue increased by 19% to R 7.4bn on the back of an increase in exports.
    • Capex decreased to R 1.6bn.
    • Operating profit climbed 48% - again the coal business contributed the most.
    • Earnings per share (EPS) were negatively affected by the R 5.8bn impairment of the Mayoko iron ore project. EPS fell 209% to a loss of R6.88.
    • Market Cap R 50 825 million
    • Share Price at 25 Aug R 147.99 (-6.03% 1 year return)

    With the current economic outlook for SA being on the negative side with prolonged strikes, electricity supply constraints, and higher consumer debt levels, there are not a lot of opportunities on the JSE. The biggest risks for miners in general, and Exxaro in particular, are commodity price and currency risks and we will be looking forward to the next 6 months to see how the company positions itself during this challenging time.

    Exxaro currently constitutes 2.9% of the Seed Equity Fund and is held as a result of its attractive valuation metrics.

    Kind regards,

    Renier Hugo

    021 914 4966

    Permalink2014-08-26, 08:56:45, by Mike Email , Leave a comment

    Seed Weekly - The African Bank Debacle

    African Bank Investment Limited (Abil) has had immense media coverage as the bank went into decline to the point where the Reserve Bank authorised a bailout and placed the bank under curatorship.

    African Bank is not a bank in the traditional sense, which is largely funded by a retail deposit base. Rather this bank had very little by way of retail deposits and was mostly funded by institutional bondholders.

    Banks are typically risky businesses given the way that they have their balance sheet structured between equity and debt. While each business will vary in the amount of debt that it can take on, a typical (non bank) business may have a debt to equity ratio of around 0.5, i.e. for every rand of equity the business has, it will have half the amount of interest bearing debt. SABMiller, for instance, has a debt to equity ratio of 0.6.

    Banks, almost by definition of the nature of the business, operate at far higher levels of debt to equity. In the last set of account, African Bank recorded that it had equity of R 10.3bn, preference share capital of R 1.1bn and total liabilities of R 55bn.

    Essentially African Bank borrowed large tranches of money in the capital markets by issuing various bonds in order to raise capital. As a bank it had very little by way of retail deposits. It then lent this combined capital out into the retail market by way of unsecured shorter duration loans at higher rates of interest.

    The business model started to unravel when the bank extended loans that it could not fully recover and when it made multiple loans to the same highly indebted client base. It also became clear that the bank did not adequately provide for non-performing loans. This has the effect of overstating their profitability and the recoverability of their loans.

    Despite a recapitalisation exercise earlier in the year, it got to the point where the Reserve Bank had no choice but to place the bank into curatorship. At the same time the Reserve Bank announced a recapitalisation plan of R 10bn sourced from the five major banks plus Capitec and the PIC in capitalising a new “good bank” from a portion of the assets.

    The various investors into African Bank will be treated as follows
    • The price of the equity in African Bank fell from around R10 per share at the beginning of the year to 31 cents before the share was suspended. Existing shareholders will be able to participate in the recapitalisation of the new “good bank” when it relists, but it is now highly unlikely that equity investors will recover their almost 100% losses.
    • Senior debt holders will have their debt transferred to the new bank at 90%. I.e. investors in these debt instruments will take a 10% “haircut” of their capital. There is a degree of uncertainty at this stage as to the recoverability of the balance of the outstanding bonds and accrued interest.
    • Subordinated debt holders will remain invested in the “old” bank. It is not clear at this stage what their write down will be, but it is likely to be substantial.

    Seed Investments exposure

    Given the size of African Bank, especially in the bond market, there were many equity, money market and multi asset unit trust funds that had exposure to the equity and debt of African Bank.

    While it was widely reported that Coronation had the largest exposure to African Bank equity, the size of this equity exposure in its various portfolios was relatively small compared to two other equity funds, namely the Momentum Value fund which suffered a 10% write down and the Stanlib Value fund with a 6.1% exposure to African Bank’s equity.

    • The Seed Equity Fund had no exposure to African Bank Investments equity.
    • The Seed Absolute Return Fund had one direct senior debt instrument, which has subsequently been sold. It also had a very small exposure to the Atlantic Stable Income Fund. The estimated total impact on the Fund to investors was -0.06%.
    • The Seed Flexible Fund had a two mandates with asset manager Atlantic – a bond mandate and a cash mandate. The estimated total impact on the fund to investors was -0.09%.
    • The Prescient Wealth Multi Strategy FoHF had 15% allocated to 36One. This manager has publicly announced that they were short African Bank shares, which generated a net return of approximately 1.6% for the fund itself and hence an approximate 0.24% gain for investors in the Fund of Hedge Funds.

    The African Bank failure is a clear indication that all investments carry risk. In this case even many money market funds, which many investors perceived to carry no risk at all, were impacted. Quite obviously while some managers avoided the risk by not investing, or on a more select basis even shorting the shares, most fixed income managers had a small allocation to African Bank debt.

    We continue to assess each investment that we include into the portfolios not only on the basis of the expected return, but more importantly on the basis of the various risks that they carry. Sizing the investment position for both risk and return is a crucial element in risk management and hence portfolio management. While we would always like to avoid all losses of a permanent nature for our clients, we do believe that in this particular circumstance where billions have been written down, losses for our clients are relatively small and commensurate with the additional risk.

    If you have any questions at any time on this or any other issue, please do not hesitate to contact us.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2014-08-19, 09:16:57, by Mike Email , Leave a comment

    Seed Weekly - Early Withdrawals

    Early Withdrawals

    In recent years there has been a trend of people staying in their jobs for a much shorter time than previously. This change in behaviour has had an impact on how businesses are run and how employees are remunerated. The remuneration includes employee benefits offered by the company. Fewer employees are offered a pension/provident fund at work and more frequent changes in occupation leads to disruptions in the investment contribution schedule over a person’s career. When this is paired with the ever present temptation to cash in a provident fund when changing jobs, investors are faced with a few potential pitfalls.

    The first, and most obvious, pitfall is to not invest anything for a prolonged period when joining an employer that doesn’t offer provident/pension benefits. This is more of a behavioural issue of procrastination that we are all guilty of at some stage in our life. We should take cognisance of this and avoid it by taking ownership of our finances and make the decision to invest on our own without too many delays. Delaying your decision to invest can have an adverse effect on your eventual investment value as you miss out on compounding growth which, over long periods, becomes material in your investment plan.

    A further pitfall is making withdrawals, before retirement, from your pension/provident fund benefits. This is an activity many partake in and is particularly harmful to a person’s long term prosperity. A very simple illustration of this point (it speaks more to the younger generation but remains relevant all age groups) is shown in the below graph. The example should serve as a reminder of how material small investment withdrawals can be over longer periods, keep in mind that many 50 year old investors can still easily have a 30 year + horizon awaiting them.

    The graph below shows that a withdrawal of R 100 000 from a fictional 35 year old could effectively be worth (in today’s currency) an estimated R 400 000 at 65 assuming the capital is invested in a balanced fund and allowing some room for error. This is in real terms, meaning the value of money in the graph doesn’t depreciate with inflation over time. If inflation is added to the calculation the R 400 000 is much higher (approximately R 2.2m).

    Taking into account the above, and the opportunity cost suffered by individuals who delay the decision to invest, it is time to review what your options are pre-retirement.

    The most responsible option available to you would be to either preserve the benefit or to transfer your benefit to your new employer’s scheme. Off the bat there is no way to determine whether it is in your best interest to preserve or transfer without more details pertaining to the fees and investment options available.

    A very viable option is to preserve the benefit through either a preservation fund or a retirement annuity. The benefits of either will differ depending on your circumstances and it is recommended that you speak to your adviser before making a decision. Investors generally prefer this route to transferring the benefit to a new company as the preserver option in most cases allows for more flexibility in terms of the investment choices available.

    Kind regards,

    Stefan Keeve

    021 914 4966

    Permalink2014-08-12, 11:29:26, by Mike Email , Leave a comment

    Seed Weekly - Benefits of Global

    The Benefits of Global

    It still amazes me that there are many investors out there that refuse to invest globally because it hasn’t generated the same level of returns as local markets over the past 20 years or so. As a result they hold their entire portfolio of assets in a geography (South Africa) that represents around 1% - 2% of globally listed assets.

    There is an argument that what has outperformed in the past will typically underperform in the future and vice versa. This is generally as a result of shifting valuations rather than the mere out/under performance and makes investment sense. This argument (which many local asset managers subscribe to) currently proposes that investors should invest more globally because valuations are relatively more attractive than locally.

    My argument today is that even if global markets were more expensive than the local markets (and thus expected to generate sub standard returns) that it would often make sense to invest a portion of your portfolio globally.

    You’ll probably ask, “How can this be so?”

    Simply put – diversification!

    Below is a chart of the risk and return of a simply constructed balanced portfolio that only invests into locally listed assets (50% equity, 15% property, 20% bonds, 15% cash) as well as the risk and return of global equity and global bonds (all data displayed in ZAR) for the period 31 December 1992 – 30 June 2014.

    I can hear the questions, “Why would you add an investment that produces a lower return with a higher level of risk into your portfolio? Surely there can be NO benefit?”

    Because these assets have such a different return profile, their inclusion improves the risk/return payoff profile for investors. By simply allocating 25% to global assets (split equally between Global Equity and Global Bonds) investors would still have generated in excess of 95% of the return of the local only portfolio with downside deviation (a measure of risk) 25% lower than the local only portfolio. The chart below shows how investors would take a marginal reduction in return for a material reduction in risk.

    A key reason that the balanced portfolio with 25% global does better on a risk adjusted basis is that it is much better at protecting assets in times of market stress. This is the case as market stress (i.e. falling markets) generally occurs when there is a flight to safety (global bond yields fall, generating capital appreciation in hard currency) and the rand weakens (foreign currency assets translated into rand appreciate).

    The chart below shows the different drawdown profiles for the two portfolios. It is evident that the global allocation contributed at exactly the time investors require – in times of market stress in the Emerging Market Crisis of 1998 (max drawdown of 17% vs 28% for local only) and the Global Financial Crisis in 2007/8.

    In the investment world there are very few ‘free lunches’ but well thought out diversification is one of the surest ways to make your investment portfolio more robust. Naturally we look to optimise the risk and return payoff within our funds and don’t blindly allocate client investments to any uncorrelated asset class, but this simple illustration shows that even an uninformed investor can improve their portfolio by making the correct strategic asset allocation.

    From this analysis it would therefore make sense that where our mandate allows we’d make an allocation to global assets even when their valuations aren’t looking that attractive. Naturally if this were the case (i.e. local assets showing much more value) then the allocation to global assets would be relatively small, but the benefits to a portfolio of even a small allocation to global assets shouldn’t be underestimated.

    Seed Funds currently have close to maximum allocation to global assets as a result of the relative valuation being shown outside of South Africa’s borders.

    Take care,

    Mike Browne

    021 914 4966

    Permalink2014-08-05, 13:42:18, by Mike Email , Leave a comment