Category: Corporate Finance

Shoprite is an outstandingly successful South African business as its interim results to December 2023 confirm.   It has grown rand revenues and volumes by taking an increased share of the retail market. The return on the capital invested in the business remains impressively high. Post Covid returns on capital invested has encouragingly picked up again.

R100 invested in SHP shares in 2015, with dividends reinvested in SHP, would have grown to R231 by March 2024. Earnings per share have grown by 55% since January 2015. (see below) The same R100 invested in the JSE All Share Index would have grown to a similar R198 over the same period. (see below) Though SHP bottom earnings per share seemed to have something of a recent plateau – load shedding and the associated costs of keeping the lights on have raised costs.

SHP Total Returns and Earnings (2015=100)

Source; Bloomberg and Investec Wealth and Investment

But earnings and returns for shareholders in rands of the day that consistently lose purchasing power need an adjustment for inflation. The performance of SHP in real deflated rands or in USD dollars has not been nearly as imposing. Recent earnings when deflated by the CPI or when converted into USD are still marginally below levels of January 2015 and well below real or dollar earnings that peaked in 2017. (see below) The average annual returns for a USD investor in SHP since 2015 would have been about 6% p.a. compared to 10.6% p.a. on average for the Rand investor. SHP earnings in US dollars are now 6% below their levels of 2015.

Shoprite Earnings in Rands, Real Rands and US dollars (2015=100)

Source; Bloomberg and Investec Wealth and Investment

Shoprite- performance in USD (2015=100)

Source; Bloomberg and Investec Wealth and Investment

The SHP returns realised for shareholders compare closely with those of the JSE All Share Index but have lagged well behind the rand returns realised on the S&P 500 Index. (see below) Even a great SA business has not rewarded investors very well when compared to returns realised in New York. It would have taken a great business encouraged by a growing economy to have done so.  

The depressingly slow growth rates realised and expected are implicit in very undemanding valuations of SA economy facing enterprises. The investment case for SHP and every SA economy facing business, at current valuations would have to be made on the possibility of SA GDP growth rates surprising on the upside.

It will take structural supply side reforms to surprise on the upside. Of the kind indeed offered by the Treasury in its 2024 Budget and Review. The Treasury makes the case for less government spending and a lesser tax burden to raise SA’s growth potential. It makes the right noises and calls for public – private partnerships and  “crowding in private capital”. The help for the economy would come all the sooner in the form of lower interest rates, less rand weakness expected and less inflation, were these proposals regarded as credible. With more growth expected fiscal sustainability would become much more likely. Long term interest rates would decline as the appetite for RSA debt improved. And lower discount rates attached to SA earnings would command more market value.

Lower long term interest rates (after inflation) would reduce the high real cost of capital that SA businesses have now to hurdle over. Whichever fewer businesses are understandably attempting to do. Without expected growth in the demand for their goods and services, businesses will not invest much in additional plant or people. SHF perhaps excepted. The current lack of business capex severely undermines the growth potential of the SA economy over the long term.

Yet SA suffers not only from a supply side problem. The economy also suffers from a lack of demand for goods and services. Demand leads supply as much as supply constrains incomes and demands for goods and services. The case for significantly lower short term interest rates to immediately stimulate more spending by households – seems incontestable- outside perhaps of the Reserve Bank.

https://podcasts.apple.com/za/podcast/the-monocle-banking-podcast/id1714449953

The case for a company buying back its own shares is clear enough. If the shareholders can expect to earn more from the cash they could receive for their shares than the company can expect to earn re-investing the cash on their behalf, the excess cash is best paid away.

Growing companies have very good use for the free cash flows they generate from profitable operations. That is to invest the cash in additional projects undertaken by the company that can be expected by managers to return more than the true cost of the cash. This cost, the opportunity cost of this cash, is the return to be expected by shareholders when investing in other companies.  Such expected returns, a compound of share price gains and cash returned, are often described as the cost of capital. And firms can hope to add wealth for their shareholders when the internal rate of return realized by the company from its investment decisions exceeds the required returns of shareholders.

All firms, the great and not so good, will be valued to provide an expected market competing rate of return for their shareholders. Those companies expected to become even more profitable become more expensive and the share prices of the also rans decline to provide comparable returns. How then can a buyback programme add to the share market value of a company?  Perhaps all other considerations remaining the same- including the state of the share market, the share price should improve in proportion to the reduced number of shares in issue. But far more important could be the signaling effect of the buy backs. Giving cash back to shareholders, especially when it comes as a surprise, will indicate that the managers of the company are more likely to take their capital allocating responsibilities to shareholders seriously.

The case of Reinet (RNI)  the investment holding company closely controlled by Mr. Johann Rupert is apposite. Mr. Rupert believes the significant value of the shares bought back by Reinet have been “cheap” because they cost less than their book value or net asset value (NAV) Yet the market value of Reinet still stands at a discount to the value of its different parts and may continue to do so. Firstly, shareholders will discount the share price for the considerable fees and costs levied on them by management. Secondly, they may believe the unlisted assets of Reinet may be generously valued in the books of RNI, so further reducing the sum of parts valuation suggested by the company and reducing the value gap between true adjusted NAV and the market value of the holding company. Finally, the market price of RNI has been reduced because the returns realized by the investment programme of RNI may not be expected to beat their cost of capital and will remain a drag on profits and return on capital. Therefore the value of the holding company shares is written down – to provide market competing, cost of capital equaling, expected returns- at lower initial share prices.  And realizing a difference between the NAV reported by the holding company (its sum of parts) and the market value of the company – share price multiplied by the number of shares in issue (net of the shares bought back)

Yet for all that, the shares bought back may prove to be cheap should Reinet further surprise the market with further improvements in its ability to allocate capital. And the gap between NAV and MV could narrow further because the value of its listed assets decline. Indeed, shareholders should be particularly grateful for the recent performance of RNI when compared to the value of its holding in British American Tobacco (BTI) its largest listed investment. RNI has outperformed BTI by 50% this year. Unbundling its BTI shares – an act normally very helpful in adding value for shareholders because it eliminates a holding company discount attached to such assets- would have done shareholders in RNI no favours at all this year.

Fig.1; Reinet (RNI) Vs British American Tobacco (BTI) Daily Data (January 2020=100)

Source; Iress and Investec Wealth and Investment

The  recent trends in flows of capital out of and into businesses operating in SA are shown below. It may be seen that almost all the gross savings of South Africans consist of cash retained by the corporate sector, including the publicly owned corporations. (see figure 2) Though their operating surpluses and retained cash have been in sharp recent decline for want of operational capabilities and revenues rising more slowly than rapidly increasing operational costs. Their capital expenditure programmes have suffered accordingly as may be seen in figure 3.  The savings of the household sector consist mostly of contributions to pension and retirement funds and the repayment of mortgages out of after-tax incomes. But these savings are mostly offset by the additional borrowings of households to fund homes, cars, and other durable consumer goods. The general government sector has become a significant dissaver with government consumption expenditure exceeding revenues plus government spending on the infrastructure.  It may be noticed that the non-financial corporations in South Africa have not only undertaken less capital expenditure with the cash at their disposal- they have also become large net lenders- rather than marginal borrowers- in recent years. (see figure 5)

Fig.2; South Africa; Gross Savings Annual Data (R millions)

Source; South African Reserve Bank and Investec Wealth and Investment

Fig.3; South Africa; Gross Savings and the Composition of Capital Expenditure by Private and Publicly Owned Corporations

Source; South African Reserve Bank and Investec Wealth and Investment

In recent years, during and post the Covid lock downs, total gross saving has come to exceed capital; formation providing for a net outflow of capital from South Africa. Rather a lender than a borrower might be the Shakespearean recipe, but the problem is that both gross savings and capex in South Africa commands a comparably small share of GDP as shown below. South Africans save too little it may be said for want of income to do so. But they invest too little in plant and equipment and the infrastructure that would promote the growth in incomes, consumption and savings. The source of capital exported is that the gross savings rate held up while the ratio of capex to GDP fell away significantly.

Fig.4; South Africa, Gross Savings and Capital Formation – Ratio to GDP – Annual Data, Current Prices

Source; South African Reserve Bank and Investec Wealth and Investment

Fig. 5; South African Non-Financial Corporations; Cash from Operations Retained and Net Lending (+) or Borrowing(-) Annual Data

Source; South African Reserve Bank and Investec Wealth and Investment

The reason many SA companies are buying back shares on an increasing scale is the general lack of opportunities they have had to invest locally with the cash at their disposal. And the cash received has been invested offshore rather than onshore on an increasing scale. For want of growth in the demand for their goods and services for all the obvious reasons. As a result the aggregate of the value of South African assets held abroad at march 2023 exceeded those of the foreign liabilities of South Africans, at current market valuations, by R1,699 billion. Total foreign assets were valued at approximately 9.5 trillion rand.

Fig 6; South Africa;  Inflows and Outflows of Capital; Direct and Portfolio Investment. Quarterly Flows 2022.1 – 2023.1[i]

Source; South African Reserve Bank and Investec Wealth and Investment

Fig.7; All Capital Flows to and from South Africa;  Quarterly Data (2022.1 2023.1)

Source; South African Reserve Bank and Investec Wealth and Investment

The reluctance to invest in SA makes realizing faster growth ever more difficult. That the cash released to pension funds and their like is increasingly being invested in the growth companies of the world, rather than in SA business, is the burden of a poorly performing economy that South Africans have to bear. Rather a borrower than a lender be- if the funds raised can be invested in a long runway of cost of capital beating projects. Faster growth in the economy would lead the inflows of capital and restrain the outflows of capital required to fund a significant increase in the ratio of capital expenditure to GDP and a highly desirable excess of capex over gross savings.

[i] The investments are defined as direct when the flows are undertaken by shareholders with more than 10% of the company undertaking the transactions. And as portfolio flows when the shareholder has less than 10%. Much of the economic activities of directly owned foreign companies in South Africa, including their cash retained and dividends paid to head office will be regarded as direct investment. For example, describing the activities of a foreign owned Nestle or Daimler Benz in SA.

Starbucks has a prominent notice. Responsibly Cashless. It might have read better or more honestly as profitably cashless. Avoiding the costs and dangers of handling and transporting cash and the associated bank charges – including the likelihood of cash not making it to the till in the first instance – will surely be in the owner’s interest and justifiably so.  On the proviso that the sales lost would not be at all significant as affluent and tech savvy customers tender their telephones. It is not a conclusion the owner manager of a small stand-alone enterprise in control of what goes in or out of the cash register will come to.  For them cash is still king.

Starbucks and other cash refusers are probably within its rights refusing legal tender. Only the notes and coins issued by the Reserve Bank qualify as legal tender in SA – money that cannot be refused in proposed settlement of a debt. But presumably can be rejected when offered in exchange for a good or service. SARS would probably approve of a cashless society for obvious income monitoring purposes. The Reserve Bank might, were it a private business, have mixed feelings about reducing the demand for a most valuable monopoly. It pays no interest on the notes it issues and earns interest on the assets the note liabilities help fund. In 2004 the note issue funded 40% of the Assets on the Reserve Bank. That share is now down to 15%. It was 20% before Covid.

Clearly notes, have lost ground to the digital equivalent- a transfer made and received via a banking account. A trend that becomes conspicuous after the Covid lockdowns. Since then, the transmission and cheque accounts at SA banks have grown very strongly from R790 billion in early 2020 to nearly 1.1 trillion today- or by about a quarter. By contrast the notes issued by the Reserve Bank since have increased only marginally – by R20b – with most of the extra cash issued being held by the public. The private banks have managed to reduce their holdings of non-interest bearing cash in their vaults and ATM’s. By closing branches and ATM’s and retrenchments. Replacing notes with digits- have been a cost saving response. A central bank replacing paper notes with a digital alternative could be an alternative. But it would be very threatening to the deposit base of the private banks and their survival prospects.

South Africa; Money Supply Trends.

Source; SA Reserve Bank and Investec Wealth and Investment

The Banks in SA have however dramatically increased their demands for an alternative form of cash- deposits with the Reserve Bank. They now earn interest on these deposits. What used to be significant interest charged to the banks when they consistently borrowed cash from the SARB – to satisfy the cash reserve requirements set by the SARB – at the Repo rate- has now become interest to be earned on deposits held with the SARB. These deposits have grown by R100bilion since 2020 while cash borrowed from the SARB has fallen away almost completely from an earlier average of about R50 billion a month.

SA Banks – demand for and supply of cash reserves since Covid

Source; SA Reserve Bank and Investec Wealth and Investment

The SARB, following the Fed, regards the interest it pays on these deposits as fit for the purpose of preventing banks from converting excess cash into additional lending. Which would lead to increased supplies of money in the form of additional bank deposits. It takes a willing bank lender and a willing bank borrower to power up the supply of cash supplied to the banking system by a central bank into extra deposits The testing time for central banks in a banking world full of cash will come when increased demands for bank credit accompany the improved ability and willingness of the banks to turn excess cash into extra bank lending. Then interest rate settings may not control the demand by banks for cash reserves to sufficiently restrain the conversion of excess cash into additional bank lending, that in turn will lead to extra and possibly excess supplies of money and so extra spending as money is exchanged for goods, services and other assets, that will force prices higher. Clearly not for now the banking state of SA or of the US where the supply of money is in sharp retreat.

A depressing reflection of the State of South Africa was the complaint of Richard Friedland, CEO of private health provider, Netcare, about a coming nursing crisis. An aging cohort of nurses, many more of whom will be retiring, is not being replaced for want of government action – ‘…..about which it was warned well in advance and chose to ignore it …” Netcare, he reported “…had been accredited to train more than 3,000 a year; it now trains barely a 10th of that…”

Clearly there is a demand for more nurses and a very large potential supply of aspirant nurses, given the current employment benefits and prospects. Why the government stands in the way of Netcare helping to close the gap between supply and demand of nurses is perhaps not as obvious as it should be?

Let us attempt to round up the usual suspects. The first suspect must be the arguments against private medicine that are made in principle. The case for equal treatment for all, paid for by the taxpayer, is one that ideologues employed in the Department of Health, hold fervently. Helping the nursing and other services a private hospital provides may provide may threaten this vision.

Though even the ideologues appear to concede the case for top up medical benefits paid for by the more prosperous. Perhaps they realistically understand that the better off in their key economic roles are much more likely to take themselves and their contribution to the revenues of government away from SA, for want of a world class and affordable medical service. A benefit we assuredly receive from the private hospitals and independent physicians that they are willing to pay for through a pay as you go system.

For an economy so obviously lacking in human capital, and not only for the capital embodied in the cohort of nurses, who are especially attractive immigrants, the consequences of an uncompetitive medical offering for highly mobile skilled South Africans are truly disastrous for income growth and taxes collected in SA. Upon which any National Health Service must ultimately

depend. Equal and hopelessly inferior is not an attractive prospect even for those who ignore the current realities of our government provided medical services.

It may still be asked why can’t the government, via its own large suite of public hospitals and large budgets, are failing to train more nurses and doctors for that matter? The answer is in the existing budget constraints. Budgets that provide well for those already in government service, provide employment benefits that keep up with and often exceed inflation of living costs, but leave very little over to employ new entrants to government service, of whom there are potentially legions. The private sector does not compete at all well with the public sector in the competition for workers of all skills- taking into account the private medical and pension benefits that the public sector employees draw upon.

But more important in the resistance to private medicine may be the force already prominent in explaining the actions and allocations of budget, commonly taken by state operated agencies in SA. Public hospitals and their procurement practice –definitely not excepted. The taxpayer has been held to ransom by the opportunists who intermediate between the State as payer and the service and goods providers. They have been extracting wealth from the taxpayers on a mind-numbing scale as Zondo our media and the US government has revealed.

The envisaged National Health Service will be a single payer for all the health services provided by the state. The intended budget will be an enormous one and the opportunities to navigate the gaps between the government as payer and the service and goods providers will be many and valuable. That that you can’t do (big) business with the SA government without a bribe or kickback must be regarded as alas, unproven. The evidence, the reality of SA, vitiates the case for a universal health system. But the private interest in such arrangements is a powerful one. That providers of private medicine in SA will have to resist to survive. They must make their case to the voting public- as Netcare has done.

Mpact a South African paper and packaging company has recently reported highly satisfactory results. It has a rare attribute for a SA based industrial company. It appears to have very good growth prospects linked to good export prospects for SA agriculture as highlighted in BD on May 2nd.

And Mpact seems very willing to invest in the growth opportunity and to raise capital from internal and external sources to fund the growth opportunities. It speaks of a 20% internal rate of return on these projects which would be well above the 15% p.a. that could be regarded as the opportunity cost of the capital it raises.

But the Mpact story is complicated by its shareholding. Caxton an apparently less than friendly shareholder unwilling to raise its 34.9% stake to the point where it has to make an offer to all other shareholders. It prefers to merge its operations with Mpact, a prospect the Mpact board is actively discouraging.

Caxton however argues that Mpact has raised too much debt for its comfort. It may have in mind using its own cash pile to fund the capex after a merger. It may nevertheless have a generally valid point. Mpact might be better advised to fund its growth raising more additional equity capital and less extra debt. This might not suit Caxton but would be a less risky strategy. And there is not good reason that SA pension funds with their typical 60% equity – 40% debt would not welcome the opportunity to contribute additional equity capital that promises good returns.

It is a strategy to be recommended to any growing company. Any equity capital raised that beats its cost of capital will very likely add value for its shareholders old and new. The value of the firm will increase by more than extra capital raised- adding wealth for shareholders with a smaller (diluted) share of what will have become a larger cake. Dilution can take place for good growth reasons- and not only to save off the bankruptcy – that always comes with too much debt.

The temptation always offered by interest rates below what prospective internal rates of return on capex is to raise debt to improve the return on shareholder’s equity. When the internal rates of return have in fact exceeded the costs of finance, hindsight tells us more debt, would and should have been the obviously preferred source of capital. But in an uncertain world such favourable outcomes cannot be known in advance.

The savings in taxes paid, because interest payments are deducted from taxable income, that is equal in value to the tax rate multiplied by the interest paid, may be presumed to reduce the “weighted average cost of capital’ – and so perhaps reduce the target internal rate of return required to justify an investment decision. I would counsel against such an approach. Expected return on all the capital put to work, however funded, should be the initial critical consideration independent of tax to be paid. If the expected returns are attractive, the appropriate financial structure can then be considered.  Debt is not necessarily cheaper than equity – because it is more risky – and the firm may well have to pay up for the financial risk it has taken on, usually when it is least convenient to do so.

When the source of any reported growth in earnings appears to be financial engineering, and is largely debt financed, it should be treated with suspicion by actual or potential investors in the shares of such a company. Returns on all capital invested needs to be greater than the interest rate on debt raised and in addition need to at least meet the returns required by shareholders who have alternative investment opportunities. How best to fund the growth should be a secondary consideration after the favourable return on all capital invested can be assumed with confidence.

MPact should be strongly encouraged by its shareholders and South Africans more generally to realise all the projects that can confidently earn 20% p.a. And raising extra equity rather than only debt capital will help ease their way down their apparently long runway -should the 20% materialise.

SA Breweries with 90% or more of the beer sold in South Africa has intervened before the Competition Tribunal on the terms of the Heineken acquisition of Distell. SAB has argued that the Tribunal should force Heineken to dispose of its powerful Hunters and Savanah brands rather than, as Heineken has proposed, to dispose of its own weaker by sales, Strongbow cider brand, to a local consortium.  That is in order to meet the likely Competition Policy objections to the deal of what would become a cider monopoly. Heineken’s intended local buyer is a consortium of the craft brewer Devil’s Peak and a BEE partner. SAB has argued that it would lack the “relevant expertise, financial muscle or distribution network”, to effectively compete with the other two ciders: Hunters and Savanna”

What is at work here is but another example of rivals or potential rivals hoping to influence competition policy to improve their own ability to compete in the market. In other words, to manipulate policies, intended presumably to enhance competition, to limit competition, in the interest of their owners, their shareholders.  And why, it may be asked, should they not attempt to do so? They are simply playing by the rules made by their governments for them.

To expect corporations and their managers to do otherwise – other than to attempt to maximise the value of the assets including their brands – competing in all the ways they are permitted to do – including in the courts of law- is not only naïve but also unwise. Self-interest is the powerful driving force of the market led system that delivers the beer and the cider and everything else that consumers choose – subject to regulation.

It is competition that keeps the prices companies charge in close relationship to the costs they incur. Cost that they have every incentive in containing in the interest of holding down prices, improving service and realizing the profit maximizing, optimum scale of operations. Which may, when economies of scale present themselves, as it does in beer and cider production, lead to a degree of dominance in the markets served. When the competition policy or any policy outcomes are perverse, we should look to reforming the policy, not the business modus operandi that naturally competes in all the ways legitimately open to them.

That Advocate Jerome Wilson acting for Heinekens to quote BD “… accused SAB of being “opportunistic” and using the guise of competition concerns for its own business interests…”  is a non-sequitur of the kind more easily made by lawyers than economists. It reinforces my concern that competition policy in SA has become such a fertile field for lawyers with precedent, not necessarily good economics, as the guide.

But there is a certain irony in SAB, now a wholly owned subsidiary of ABN-INBEV, choosing to compete in this way. The pioneers who built SAB to the great global company it became, as well as the dominant brewer in SA, effectively expanded the demand for and supply of beer in SA at what were surely attractive prices and terms for their customers. They could not have succeeded otherwise.  Then in a final glorious act, agreed to sell their business at what has proved to be highly favourable terms for their highly appreciative shareholders. Pensioners living off the SAB shares they owned can well say cheers. They might not have thought it in their interest, or even perhaps, appropriate to invoke competition policy. The goose can easily become the gander.

SAB were fond of arguing evocatively that they were competing for a “share of throat” That is with every other beverage, alcoholic or non-alcoholic that competed with their beer for a share of household’s budgets. And that this gave them every motivation to expand, not restrict the supply of beer, with truly competitive pricing and related services. And they were right. And their successful practice proved it so. Market dominance was the outcome of serving the customer. They earned it and did not abuse the power it gave them. If we widen the definition of any market, as we should to be realistic, we reduce the share of any participant in it.

The competition will always be intense for the choices that households make, regulations permitting. The pursuit of self-interest will ensure a constant striving to beat the market and become very wealthy doing so. How consumers will come to choose from the unpredictable and changing menu placed before them is impossible to predict. Their larger interest is in changing the menu, in innovation and technology that can significantly alter how they spend over time. Best therefore to leave the mysterious forces of competition to evolve.  To trust the pursuit of self-interest and competition – not its regulators- with possibly very different interests to those of consumers.

Competition policy would best ask the simple question, will some acquisition or arrangement be in the consumers’ interest? Will it mean lower prices, better service – enhanced supply and or quality – more R&D -more innovation or not?  Chat-GPT might provide the answer.

The problem with competition policy in SA is that it pursues a broad public interest. And the public interests, very diverse public interests, may conflict with that of consumers. Maintaining employment (in the interest of workers) after an acquisition is likely to mean higher costs and higher prices and or less capable service delivery. And will in advance, given the likely constraints on efficiency, reduce the case for a potentially cost-saving merger that will not be in the interest of consumers.  Cost saving is very much in the customer’s or potential customer’s interest.

Forcing the owners of any business, local or foreign owned to meet empowerment or any other criteria demanded of their potential investors, is likely to reduce the ability of an acquirer to raise capital on favourable terms. Capital with which to compete with established interests in the SA throat – as SAB is surely well-aware

The value of your home only partly depends on is location, size and the quality of all its fittings and fixtures. It also depends crucially on the quality of the services provided by your local municipality. By how much they charge for services they deliver or fail to  deliver and how much of a wealth tax they impose for your right to own. The better the services provided the more valuable will be your home. And the more you are charged the less the home will be worth to others for any services provided. Negative feedback effects on home values are painfully apparent to home-owners in most parts of the country. The real value of homes of all kinds and types are falling because of the growing in-balance between what is being extracted by municipal governments compared to what they deliver.

But not in Cape Town. Where service delivery is holding up well, as are home values. The difference between what you get for a home or apartment owned or rented in Cape Town and in the other major urban centres is strikingly wide. Despite the charges levied by the City that have been rising well ahead of inflation. In 2010 Rates collected by the city were R3.84b. By 2020 these had grown to R10.08b, that is at an average compound rate of growth of 8.8% p.a. Well ahead of inflation that averaged about 5% over the period. Evidence surely of more valuable real estate. Revenue from electricity water etc compounded from R8.7b to R19.8 at an average rate of 7.5%  p.a. over this period. They took a knock from Covid, declining by R329m in 2020. Which begs a question – what is the present value of a predictable income stream of R10b growing at a real 3% p.a? Perhaps twenty times current revenues or possibly R200b. It is this potential value that secures any borrowing the City or any city might want to do to support its growth with well-designed and honestly executed capex.

The City of Cape Town does however have a spending problem. It has spent far too little on its infrastructure over many years now. Capex (PP&E) was R4.7b in 2010 and only R6b in 2020. Capex in Cape Town has been declining in real terms by about 2.5% per annum on average. Surely not nearly good enough to support and encourage a growing metropole and its property values.

The result is a very strong City balance sheet. The financial assets on the 2019 CTC balance sheet, cash, other financial assets less debts meant net financial reserves of a positive R10.1b. The equivalent amount on the 2015 balance sheet was a mere R2.3b. Debts have remained constant at about R6b since 2015 while cash reserves grew from R3.2 to R8.4b.  It is a build-up in financial strength that should be hard to justify to property owners and residents. Perhaps it is the self-evident hopelessness of the potential competition to run the City that explains such parsimony. The reserves did come in useful in 2020. The City had budgeted to raise an extra 2.5b in debt in 2020. It did not have to do so. It drew down its cash reserves by R2.6b still leaving it a large cash pile of R5.8b.

The City is now realistically budgeting for a significant increase in its capex. It plans to increase its capex to over R11b in three years. To be funded in part by an extra R7b of debt that will cost the City a very manageable net financial charge of 573m in 2023-4. Cash reserves nevertheless are planned to increase to R9b by the end of the three-year planning horizon. I would suggest that the City urgently needs help with its capital expenditure problem. It should partner closely and usefully with the businesses that could help plan and undertake the spending programmes.

Voters at the next municipal elections should choose their mayors and councillors on local not national issues. Essentially by what they can be expected to do to protect, perhaps even enhance, the value of their highly vulnerable homes.

Written after being fully frustrated listening to an Interview on how we can and should collect more taxes from SA companies that Michael Avery conducted with Keith Engers, Edward Kieswetter and Dennis Davis on Business Day TV Tuesday 20 th April 2021.

Janet Yellen the US Secretary of the Treasury wants to collect more tax from US corporations She is lobbying for the same minimum rate of corporate tax to be applied everywhere to prevent competition between different tax regimes. Edward Kieswetter, SARS Commissioner, as unsurprisingly, also wishes to collect more tax from companies who do international business from SA. But he knows better than to believe that standardising tax rates would mean more tax collected. He points out that the amount of taxable income these companies report is much more important than the rate at which they are taxed. He intends to employ more skilled tax collectors, armed with more powerful algos to closely examine the company spread sheets, to ensure more income is reported. To make sure that local costs are not inflated by off-share head office levies or by overstated imports – or indeed overstated exports that are not included in value added and so on and so forth ad infinitum, given the ingenuity of the CFO’s.

What would be required to eliminate the competition is an internationally code of generally agreed standard to measure taxable income. But more important, for any economy, is how well will taxable income as defined for tax purposes, accord with the after-tax income that drives the income and wealth producing actions of the economic decision makers? How consistently does it treat investment allowances that can exceed or fall well short of the decline in the market value of any asset employed be treated that can make a large difference to true economic income? Or how will incentives of one kind or another, tax concessions made to employ more workers, and employ more of them in special zones, or differences in the tax treatment of R&D expenditure be managed? It all calls for a standardisation of fiscal policy that seems very unlikely.

Furthermore, will the calculation of business income under a new standard include an allowance for the opportunity cost of employing equity capital in a business, as it does for interest paid on debt? An unlikely but essential treatment of business costs that are not only measured in cash paid out. Such irrationality about the treatment of economic, as opposed to cash costs, is meat and bread and taxable income to the legion of analysts and investors who know better. Only by providing true economic returns that cover all costs including opportunity costs of own capital employed, is a business likely to gain market value. And provide capital gains- including unrealised gains, which is as useful a form of income as any other even if not paid out in cash. And is only taxed when realised and so best postponed, or used as collateral to fund spending or investments. And helpfully too the interest incurred on the extra borrowings may be regarded as a business expense. And then the gains in cash are only taxed when realised by the private investor or company, not by the pension funds and other investment collectives who own most of the large, listed companies.

If we are to reform our tax system sensibly, the truth to be recognised is that taxes of all kinds are ill suited for redistributing income. They end up influencing pre-tax incomes and so the prices of goods and services, including wages and salaries. It is the distribution of government expenditure that should be used to help the poor and deserving. To tax the corporation, as well as its beneficiaries, the dividend receivers, some more than others, is unnecessary, inconsistent, and harmful to the economy.

The corporation can be treated as a limited liability partnership and be required to act as an efficient tax collector. By withholding tax from all the dividend, interest and rental payments it makes to all parties, without exception, as it does now from its employees and its suppliers. With the tax collected reconciled in tax returns as is the case with PAYE. The lesson to be learned from the tax havens, and how best to compete with them, is to adopt the same zero rate of corporate tax. It then becomes a simple matter for the tax authority to measure what is paid out, and it will not have to police the tax legitimacy of revenues or costs. No well-paid tax sleuths need be employed. The tough measurements of economic returns and what should be done with them, how much cash should be retained and how much paid out are then well left to the business organisation. They will know very well how well they have really done for their shareholders and will measure their results accurately. Economic rationality will rule. Not after-tax rationality. With very helpful consequences for the economy. More will be invested wisely, more paid out in dividends and wages and salaries and more wealth (capital gained) will be created. And the tax base of the economy would become a much wider one. The tax dog, however pedigreed, having to chase the tail of corporate income will be of the past.

But alas do not hold your breath that SA will adopt policies that are truly radical and useful. Our ability to think creatively for ourselves is not well developed.

An analysis of discount rates shows the extent to which a high risk premium encourages short-term thinking.

In making economic or social choices today, how far ahead do you look? You may blow your Friday wage packet on hedonistic pursuits without any regard to how little food will be on the family table the following week. Or you may run up the mortgage bond to fund the next holiday abroad. We might ascribe such myopic actions as reflecting high personal discount rates. In such cases, future benefits clearly command very little competition with immediate pleasures.

When a business contemplates an investment decision, how far ahead should it calculate its expected benefits? How many years of future cash flow would your business estimate as necessary to justify an acquisition or an addition to plant and equipment? The longer the estimated pay-back period, the greater will tend to be the present value of the investment decision.

Expecting to get back capital risked in 10 or 20 years, rather than in five years, encourages investment by reducing required returns. It means the application of a lower discount rate to future incomes or expected cash flows. It brings higher present values that are more likely to exceed the current costs of the plant, equipment or acquisition. Future-conscious economic and social actors, with longer time horizons, benefit themselves by saving and investing more. They also benefit their broader communities, by helping to contribute to a larger stock of capital and so more productive workers capable of earning higher incomes.

South African investors are exposed to high discount rates. They are as high as they have been in recent times and are high when compared to discount rates in the developed world. The long-term promises of interest and capital repayments by the SA government are discounted at about 9% a year. Adjusted for expected inflation of 5%, this provides savers with a real return of about 4% a year, with which every risky SA business contemplating capex has to compete for capital.

A risk premium of at least 5% for a well-established and listed SA company would have to be added to this 4% and so the discount rate applied to any prospective cash flow. A required return of more than 10% a year after inflation makes for short pay back periods and so limited capex and limited growth opportunities generally. It also means much lower present values attached to established SA business so that they can satisfy such demanding expectations. Higher discount rates destroy wealth.

For example, assume you have an investment that earns income, initially worth 100, that is expected to grow at 5% a year over the next 20 years. Assume a developed world discount rate of 6% – made up of 1%, which is all that is available from government bonds, plus an assumed 5% extra for risky equity. The present value of this expected income or cash flow stream will be 320. Moreover 81% of its current market value can be attributed to the income expected after five years.

The same business, with the same prospects in SA, and with the same risk premium, but competing with government bonds offering 9%, would have future income discounted at 14%. This is more than double the discount rate applied to an averagely risky investment in the developed world. It would have a present market value of 116, about a third lower. Of this, only 54.9% of its present market value will be attributed to income to be expected after five years. This forces such a business to adopt a much shorter focus, with fewer viable investment opportunities.

The direction of economic policy reforms in SA should be evaluated through the prism of the discount rate. The purpose of reform must be to build confidence in the future growth and stability of the economy to lower the damagingly high discount rate. Only this can make businesses more valuable, by encouraging their managers to think more about the long term than the short, and to invest more and thus improve the economic prospects for all South Africans.

Two recent cases of JSE-listed companies reveal the advantages of equity funding over debt funding.
While issuing debt can be more dangerous than issuing equity, it receives more encouragement from shareholders and the regulators. Debt has more upside potential: if a borrower can return more than the costs of funding the debt (return on equity improves) and there is less to be shared with fellow shareholders.

But this upside comes with the extra risk that shareholders will bear should the transactions funded with debt turn out poorly. Any increase in the risk of default will reduce the value of the equity in the firm – perhaps significantly so.

The accounting model of the firm regards equity finance as incurring no charge against earnings. You might think it would help the argument for raising permanent equity capital rather than temporary debt capital. But this is clearly not the case, with the rules and regulations and laws that govern the capital structure of companies. It is also represented in the attitude of shareholders to the issuing of additional equity. They have come to grant ever less discretion to company boards to issue equity. Less so with risky debt.

(Note: I am grateful to Paul Theodosiou for the following explanation of the different treatment of debt and equity capital raising. Paul was until recently non-executive chairman of JSE-listed REIT, Self Storage (SSS), and previously MD of the now de-listed Accucap of which I was the non-executive chairman).

Typically at the AGM, a company will seek two approvals in respect of shares – a general approval to issue shares for cash (which these days is very limited – 5% of shares in issue is the norm) and an approval to place unissued shares under the control of directors (to be utilised for specific transactions that will require shareholder approval). These need 75% approval. So shareholders keep a fairly tight rein on the issue of shares.

Taking on or issuing debt, on the other hand, leaves management with far more discretion. Debt instruments can be listed on the JSE without shareholder approval, and bank debt can be taken on at management’s discretion. The checks and balances are more broad and general when it comes to debt. Firstly, the memorandum of incorporation will normally have a limit of some kind (for REITs, the loan to value ratio limits the amount of debt relative to the value of the assets). If the company is nominally within its self-imposed limits, shareholders have no say. Secondly, the JSE rules provide for transactions to be categorised, and above a certain size relative to market cap, shareholders must be given the right to approve by way of a circular issued and a meeting called. The circular will spell out how much debt and equity will be used to finance the transaction, and here the shareholders will have discretion to vote for or against the deal. If they don’t approve of the company taking on debt, they can vote at this stage. Thirdly, shareholders can reward or punish management for the way they manage the company’s capital structure – but this is a weak control that involves engaging with management in the first instance to try and persuade, and disinvesting if there isn’t a satisfactory response.)
Perhaps the implicit value of the debt shield – taxes saved by expensing interest payments – without regard to the increase in default risk, confuses the issues for investors and regulators. It is better practice however to separate the investment and financing decisions to be made by a firm. The first step is to establish that an investment can be expected to beat its cost of capital, whatever the source of capital, including internally generated cash that could be given back to shareholders for want of profitable opportunities. When this condition is satisfied, the best (risk adjusted) method of funding the investment can be given attention.

The apparent aversion to issuing equity capital to fund potentially profitable investments seems therefore illogical. Or maybe it represents risk-loving rather than risk-averse behaviour. Debt provides potentially more upside for established shareholders and especially managers, who may benefit most from incentives linked to the upside.

Raising additional equity capital from external sources to supplement internal sources of equity capital is what the true growth companies are able to do. And true growth companies do not pay cash dividends, they reinvest them, earning economic value added (EVA) for their shareholders. A smaller share of a larger cake is clearly worth more to all shareholders.

There are two recent JSE cases worthy of notice.  Foschini shareholders approved the subscription of an extra R3.95bn of capital on 16 July to add about 20% to the number of shares in issue. By 19 August, the company was worth R25.8bn, or R10.5bn more than its market value on 16 July, or R6.5bn more than the extra capital raised. The higher share price therefore has already more than compensated for the additional shares in issue.

The Foschini Group – market value to 19 August 2020

Source: Bloomberg, Investec Wealth & Investment

The other example is Sasol, now with a market value of about R87bn, heavily depressed by about R110bn of outstanding debt. The extra debt was mostly incurred funding the Lake Charles refinery that ran far over its planned cost and called for extra debt. Sasol was worth over R400bn in early 2014, with debts then of a mere R28bn. The recent market value, now less than the value of its debts, is clearly being supported by the prospect of asset sales and a potential capital raise.

The company would surely be much stronger had the original investment in Lake Charles been covered more fully by additional equity capital, capital they might have been able to raise with much less dilution. It might also have prevented the new management team from having to sell off what might yet prove to be valuable family silver – assets capable of earning a return above their cost of capital. In this case, a large rights issue could still be justified to bring down the debt to a manageable level and, as with the Foschini increase, the value of its shares by more (proportionately) than the number of extra shares issued.

Sasol – market value and total debt, 2012 to July 2020

While issuing debt is more dangerous than issuing equity it receives more encouragement from shareholders and the regulators [1]. Clearly debt has more upside potential. If a borrower can return more than the costs of funding the debt- return on equity improves- and there is less to be shared with fellow shareholders. But clearly the upside comes with extra risks that shareholders will bear should the transactions funded with debt turn out poorly. Any increase in the risks of default will reduce the value of the equity in the firm – perhaps very significantly so.

The accounting model of the firm regards equity finance as incurring no charge against earnings. Hence you might think would help the argument for raising permanent equity capital rather than temporary debt capital. But this is clearly not the case with the rules and regulations and laws that govern the capital structure of companies. It is also represented in the attitude of shareholders to the issuing of additional equity. They have come to grant ever less discretion to the company boards and their managers to issue equity. Less so with risky debt.

Perhaps the implicit value of the debt shield – taxes saved expensing interest payments – without regard to the increase in default risk- confuses the issues for investors and regulators. It is better practice to separate the investment and financing decisions to be made by a firm. First establish that an investment can be expected to beat its cost of capital,-. Cost of capital being the required risk adjusted return on capital invested whatever itsthe source including investing the cash generated by the company itself. Somethingof capital, including internally generated cash that could be given back to shareholders for want of profitable opportunities. When this condition is satisfied the best (risk adjusted) method of funding the investment can be given attention.

The apparent aversion to issuing equity capital to fund potentially profitable capes or acquisitions seems therefore illogical. Or maybe it represents risk loving rather than risk averse behaviour. Debt provides potentially more upside for established shareholders and especially managers who may benefit most from incentives linked to the upside.

Raising additional equity capital from external sources to supplement internal sources of equity capital is what the true growth companies are able to do. And true growth companies do not pay cash dividends, they reinvest them earning Economic Value Added (EVA) for their shareholders. A smaller share of a larger cake is clearly worth more to all shareholders

There are two recent JSE cases worth notice. TFG shareholders approved the subscription of an extra R3.95b of capital on July 16th to add about 20% to the number of shares in issue. The company on August 19th was worth R25.8b or R10.5b more than its market value of the 16th July. Or worth some R6.5b more than the extra capital raised. The higher share price therefore has already more than compensated for the additional shares in issue. ( see below)

The Foschini Group (TFG) Market Value R millions (Daily Data to August 19th 2020)

Source; Bloomberg, Investec Wealth and Investment

The other example is Sasol (SOL) now with a market value of about R80 billion so heavily depressed by about R110b of outstanding debt. The extra debt was mostly incurred funding the Lake Charles refinery that ran so far over its planned cost and called for extra debt. SOL was worth over R400b in early 2014 with debts then of a mere R28b. The market value of SOL (R86b) now less than the value of its debts, is clearly being supported by the prospect of asset sales and a potential capital raise. The company would surely be much stronger had the original investment in Lake Charles been covered more fully by additional equity capital. Capital they might have been able to raise with much less dilution. It might also have prevented the new management team from having to sell off what might yet prove to be valuable family silver that they intend to do. That is assets capable of earning a return above their cost of capital. If so a very large rights issue could still be justified to bring down the debt to a manageable level and as with TFG increase the value of its shares by more (proportionately) than the number of extra shares issued. (see chart below)

Source; Bloomberg, Investec Wealth and Investment

[1] Paul Theodosiou until recently non-executive chairman of JSE listed Reit Self Storage (SSS) and previously MD of now de-listed Acucap (ACP) of which I was the non-executive chairman repoded to my enquiry about the differential treatment of debt and equity capital raising as follows

Typically at the AGM a company will seek two approvals in respect of shares – a general approval to issue shares for cash (which these days is very limited – 5% of shares in issue is the norm) and an approval to place unissued shares under the control of directors (to be utilized for specific transactions that will require shareholder approval). These need 75% approval. So shareholders keep a fairly tight rein on the issue of shares.

Taking on or issuing debt, on the other hand, leaves management with far more discretion. Debt instruments can be listed in the JSE without shareholder approval, and bank debt can be taken on at managements discretion. The checks and balances are more broad and general when it comes to debt. Firstly, the MOI will normally have a limit of some kind (for Reits, the loan to value ratio limits the amount of debt relative to the value of the assets). If the company is nominally within its self-imposed limits, shareholders have no say. Secondly, the JSE rules provide for transactions to be categorised, and above a certain size relative to market cap, shareholders must be given the right to approve by way of a circular issued and a meeting called. The circular will spell out how much debt and equity will be used to finance the transaction, and here the shareholders will have discretion to vote for or against the deal. If they don’t approve of the company taking on debt, they can vote at this stage. Thirdly, shareholders can reward or punish management for the way they manage the company’s capital structure – but this is a weak control that involves engaging with management in the first instance to try and persuade, and disinvesting if there isn’t a satisfactory response.

The threat to the value of SA retailers as cash has drained away during the lock downs has been as damaging to their landlords. The value of the average market weighted general retailer and property company on the JSE is less than 40 % of what they were worth in January 2018. The damage to the balance sheets of the property company of Covid19 is perhaps far greater than that of the average retailer. Who have shown a greater willingness to raise fresh equity capital to repair their balance sheets

The Value of JSE listed Property Companies and General Retailers January 2018 =100 Month end data to June 2020.

Source; Iress and Investec Wealth and Investment

A number of these  JSE listed Real Estate Investment Trusts (Reits) with seemingly little growth in expected to come from SA assets, sought faster growth offshore. These offshore investments were funded very largely sometimes exclusively with foreign currency denominated debt.

The market value of average JSE Reit assets less debts, their net asset value (NAV) had fallen away before the Covid crisis that then decimated their rental revenues at home and abroad. A number of these JSE listed Reits now lack a sufficient buffer of equity to absorb the losses from COVID 19 related shutdowns. Debt to market value ratios have risen and NAV fallen further.

To qualify as Reits and avoid corporate taxes they are required to pay out at least 75% of their income after interest and all other expenses. They are appealing for an exemption from the Treasury and the JSE to skip dividends to conserve cash and still retain their Reit status.

They might do much better to raise equity capital, if they can, issue more shares for cash and pay off foreign and domestic debts. Even if the saving on foreign interest paid is minimal, provided the rand holds up, the improvements to their survival prospects and so market value could be substantial. Shareholders supported by stronger balance sheets could be well served facing up to a reduction in cash distributions per share.  They would receive less income per share, but with lower risks attached to expectations of future distributions, this could add value to all the shares issued – even when there are more of them.

The purpose in raising capital may be, ideally, to grow a business successfully. Successful businesses mostly fund their growth from the cash they generate from operations. More unusually they may have to raise additional debt or equity capital secure the survival of a still potentially successful business.

The same fundamental question needs to be asked in both circumstances.  Will in other words the increase in the market value of the company, plus the dividends paid, both measured in extra rands come to exceed the amount of extra capital raised. also in rands. Plus something extra to cover the opportunity cost of the capita raised.   That is will the investment of extra capital return as much as could be expected from any alternative, as risky, a SA investment? Equal that is to the return from the bond market plus an equity risk premium- of about 5% p.a. (About 13% p.a.) If so investors will get all their capital back – and more – and perhaps very quickly as share prices could respond immediately to the expectation of good returns to come.

Any potential capital raise needed to save or de-risk a business will be reflected in the ongoing survival value of a company. Any surprising refusal of its owners to refuse to supply extra capital, when needed to secure the business as a going concern, will provide a very negative signal and surely damage the share price. Preventing the downside will be part of the upside of any capital raise.

A successful secondary issue, especially when underwritten by bankers exercising due diligence, is perhaps an even stronger signal of favourable longer- term prospects for any company. More so than a rights issue supported by established shareholders with everything to lose. With a successful secondary issue raising capital for the right value adding reasons, established shareholders can expect to have a smaller share of a larger cake and be better off for it.

The obvious way to maintain the share of established shareholders in a company is to raise extra debt, rather than equity capital. But more debt, makes any company more risky, and may destroy rather than add market value for shareholders. Debt only looks cheaper than equity with hindsight, after the good times have rolled by. And the good times may not last- as we have been so cruelly reminded.

A PS on the fundamentals of capital raising

The past quarter has been record breaking.  Records have been set in extra spending by governments measured as a share of (normal) GDP. For the developed world this additional emergency spending by governments has ranged between an extra 5 to as much as 15 per cent of GDP. Another record has been set in money created by central banks. Of the order of an extra 5 trillion dollars worth. Included in their current bout of QE have been substantial purchases of corporate debt.

The monetization of much debt has meant very low interest rates with which to fund rapidly growing fiscal deficits and rising debt to GDP ratios. Records are therefore also being set in the amount of cash raised by businesses. Since the end of March, U.S.-listed firms have raised a quarterly record beating $148 billion of extra capital. Monetary policy has made capital raising on a vast scale possible on increasingly favourable terms. And without which a strong recovery from the lockdowns would be impossible.

Loan guarantee schemes, provided to commercial banks by central banks backed up by their Treasuries, has been an important component of the financial relief promised. These loan guarantees – should they be fully required to offset defaults – which is not at all expected – are available on a very large scale. In normally fiscally conservative Germany extra government spending on relief is of the order of 15% of GDP while the loan guarantee provision is of the order of 30% of GDP. For the US the stimulus plan is equivalent to 7% of GDP with the guarantee adding another 8% of GDP to the package.

It makes every economic sense that ordinarily sound and profitable businesses in SA as elsewhere not be forced out of the economy for an inability to service or roll over their debts for reasons entirely beyond their control. And are able to start up again by recapitalising their operations – given how much capital has been lost during the lock downs

The South African economy has not benefitted from fiscal and monetary relief on anything like the scale offered elsewhere. The additional borrowing requirement of the SA government has surged to over 14% of GDP more than double the deficit planned in February as we learned from the Minister of Finance yesterday June 24^th. Largely because largely because tax revenues have declined so sharply- by over R300b with further declines expected. Extra government spending on its adjusted Budget is estimated as but R36b.

Despite a relative lack of encouragement of the kind offered in the US and elsewhere to the market for corporate debt, the capital market in SA has been active. We have seen something of a flurry of capital raising by JSE listed companies. The issue of relevance to shareholders (and the banks underwriting the issues) is whether the extra capital intended to be raised can pay for itself. That is will the extra capital raised earn a return that will covers the (opportunity) cost of the capital raised. That is equivalent to the high long-term RSA bond yield of 8% plus a equity risk premium of 4% or more for the least risky of businesses- something ahead of 12% p.a. returns for the least risky of enterprises.

If the answer is a positive one a rights issue or indeed any secondary issue to raise capital or indeed debts – should go ahead. And the hope must be that the market immediately shares this justifiable optimism and re-prices the company’s shares accordingly. That is prices the businesses raising additional capital them now for more likely survival rather than extinction.

The same positive answer is required of any business large or small that needs to raise capital to resume business post-Covid. Will the essential extra capital raised cover its risk-adjusted costs? We must hope that the SA financial markets, especially the banks, can help meet these additional, calls for extra capital. The loan guarantee scheme offered by the Reserve Bank in SA is perhaps the best hope for business and economic rescue.

The government has the task of ensuring that the capital market is up to this vital task of funding both government and business on sensible terms. Without which the prospects for a post-Covid recovery in SA, absent fiscal stimulation, remain especially bleak.  The burden of economic relief has passed to monetary policy.

Postscript on capital raising on the JSE

We have seen something of a flurry of intentions to raise additional capital raising by JSE listed companies.  The latest by retailers the Foschini Group (TFG) and Pepkor in the form of rights issues to their shareholders. Mister Price (MPR) another retailer has also indicated an intention to raise more equity capital.

TFG announced plans on June 18^th 2020 to raise R3.95b from its shareholders, equivalent to 22% of its current market value of approximately R17.5b. A market value that has shrunk by more than half this year on fears of exposure to Covid19 accompanied by  a seemingly debt laden balance sheet. The market has however reacted somewhat favourably to the announcement. The share price has held up since the announcement and regained a little lost ground when compared to the Truworths (TRU) share price, a rival retailer. ( See below the figures that chart the market value of TFG over recent years and where we compare the TFG share price to that of clothing retail rival Truworths (TRU)

TFG Market Value of Company Daily Data; 2016- June 22nd 2020

Source; Iress and  Investec Wealth and Investment

TFG Share price and Ratio of TFG to TRU share prices – Daily Data 2020 to June 24th

Source; Iress and Investec Wealth and Investment

The terms of the TFG rights issue (to be underwritten by a consortium of banks) will only be announced should the proposal gain shareholder approval on the 16^th July. It should be understood that as a rights issue this extra capital cannot reduce the share of the established shareholders in the company, should they follow their rights. They may however prefer to sell such rights to subscribe extra capital. This benefit in selling the rights to subscribe can be regarded as compensation for giving up a share of the company’s profits and dividends and market value in the future.

The value of their rights will depend on the difference between the subscription price and the ruling market price. The larger this discount, the more shares will have to be issued to raise the required 3.95b – but only from its own shareholders. Hence there need be no dilution of shareholders. The market value of TFG must have increased by at least R3.95b for the shareholders to break even on their additional investment. They will be hoping for more upside over time. And some of the upside may even have been registered already in anticipation of the rights issue going through, even before the announcement of the rights issue itself, because of the better times it portends for the company.

The larger the difference between the ruling market price and the price at which the additional shares will be offered (the larger the discount) the more likely the rights will have value and be taken up. This outcome is only of importance to the underwriters. The more enthusiastic the response, the fewer shares the banks will have to take up. Presumably in this case the intention of the underwriters is not to hold shares in TFG.

A rights issue is equivalent to an additional investment by a sole shareholder in a company. The nominal value attached to the additional shares will be of no consequence other than to determine the number of extra shares issued, as identified in the books- all with the same owner. In practice the additional capital invested in a non-listed business  is very likely to be identified as loan rather than share capital, to enable the owner to rank equally with other creditors in the event of a business failure

The issue of relevance to shareholders is will the extra R3.95b. of capital raised will pay for itself over time. That is earn a return over time on the R3.95b of additional capital that more than covers the cost of the capital raised. To add value for shareholders such future returns would need to average around 12-13 per cent per annum.  That is to presume that the required returns from a retailer in SA would have to be at least equal to the returns certainly offered by a long dated government bond (currently about 9% p.a) plus a risk premium of 4% premium. They could hope to realise similar returns from any other JSE company taking similar risks with their capital.   If the answer is a positive one, that is to say expected returns promise economic profits or economic value added (EVA)  the rights issue or indeed any secondary issue (regardless of any dilution that might take place) should be approved.

There is a further consideration that established shareholders will bear in mind when approached for additional capital. The value of their shares will have declined in response to the damage caused to earnings and cash flow by the disruption of their ordinary activities caused by the lock down. Hence the need for additional capital. Companies that entered the lock down with relatively debt laden balance sheets will be recognised as more vulnerable to financial stress. However the prospect of a rights issue that would mitigate this danger would always be reflected, favourably, in the current value of the shares.

Any unexpected failure of shareholders to approve a share issue of this kind would surely raise the likelihood of default and immediately reduce the value of a shareholding. Not throwing good money after bad may be the right decision. But if it comes as a surprise to the market place such a refusal will provides a very negative signal. Vice versa if a surprising rights issue is successfully launched.

A successful secondary issue, underwritten by bankers, that does not demand participation by possibly jaundiced established shareholders, is perhaps an even stronger signal of favourable longer- term prospects for any company. The avoidance of dilution should not be a primary consideration in any capital raise. If the additional capital is expected to realise an economic profit, established shareholders will benefit in line with newly attracted shareholders. They can expect to have a smaller share of a larger cake and be better off for it.

The more obvious way to avoid dilution of established shareholders is to raise extra debt rather than equity capital. But the market for debt issues may not be as open as the equity market. As would appear to be the case in SA, but not in the USA. But more debt as we have seen makes any company r more risky. Andwhen business as usual is disrupted debt becomes particularly burdensome. Debt is not always cheaper than equity. It may appear so in the good times that may not last.

The same positive answer is required of any business large or small post Covid that needs to raise debt or equity capital to resume business post Covid. That is will it earn economic profits in the true opportunity cost sense? Will the investment beat its cost of capital, that is return more than is required to justify the investment?  We must hope that the SA financial markets, including most importantly the banks, can meet these additional, fully justifiable calls for extra capital. The government with its central bank has the task of ensuring that the capital market is up to this vital task.

Investment holding companies have long played a large role on the JSE. Two of the more important of them, Naspers and PSG, have provided spectacular returns for their shareholders in recent years. R100 invested in PSG in January 2010 with dividends reinvested in the stock has grown to R1435 by late June 2019. The same R100 invested in Naspers would have almost as well for its shareholders over the same period having increased its rand value by 14 times.

Not all holding companies are equal. A one-time darling of the JSE, Remgro has barely managed to keep pace with the JSE All Share index- R100 invested in Remgro or the JSE in 2010 would have grown to about the same R250.

Total returns; Naspers, PSG, Remgro and the JSE All Share Index (2010=100)

Source; Bloomberg, Investec Wealth and Investment

The advantage enjoyed by the managers of an investment holding company is that the capital made available to them is permanent capital. It cannot be cashed in, as is the case with a mutual fund or unit trust, that may be obliged to redeem capital and may have to sell down their assets to do so.

It therefore can invest in potentially market return beating companies, companies that will return more than their opportunity costs of capital – if only in time. Its often significant shareholdings may give it a useful, active role in improving the performance of the operating companies it invests in.

While shareholders in a listed investment holding company cannot force any liquidation of assets, they can always sell their shares. At a price that would have to be attractively low enough to promise the buyer a return at least as good as is promised elsewhere in the market place – for a similar degree of risk.

This market-clearing price, multiplied by the number of shares issued will determine the market value of the holding company. And this market value, as in the case of Naspers (since 2014) and Remgro (continuously since 2010 )– has been well blow their Net Asset Value (NAV). That is the holding company is likely to be worth than the sum of its parts – were the parts unbundled to its shareholders. No doubt to the chagrin of its managers when their company is judged to be worth more- sometimes much more – dead than alive. And who may well have delivered market beating returns in the past.

The market and net asset value of the holding company will always have much in common. The market value of its listed assets and its net debt would be included in both- as would the value of its unlisted assets- though the market may judge them to be worth less than the director’s estimates included in NAV.

The market value will however be influenced by two other important forces, not reflected in its marked to market, balance sheet, its NAV. Included in market value, but not NAV, will be two unknowns -the expected implicit costs to shareholders of running the head office-  and the present value of its ongoing investment programme. Past performance may not be a good guide to expected performance as we are often reminded. The economic value expected to be added by the extra capital to be invested by the holding company may be presumed by the market place, to be insufficiently promising to compensate for the costs of running the head office. Hence reducing market value relative to NAV

The way for the managers of a holding company to close the value gap between NAV and Market Value is clear. That is to adopt a highly disciplined approach to acquisitions and investments. And be as disciplined in the rewards offered managers. A plan to list major unlisted assets to prove their value and to unbundle them when their investment case has been proved, will help add market value.  Market value adding – performance related pay – can also be well aligned with the interest of shareholders if made dependent on closing this gap between NAV and market value.

The Naspers value gap (net asset value less market value) has narrowed significantly since the restructuring – which will see a Newco being listed in Amsterdam – was announced to the market. What does this mean for shareholders?

The proposed restructuring of Naspers, first mooted in March and now confirmed in a circular to shareholders on 29 May, has been favourably received by the market. The intention is to restructure Naspers into two linked companies: a Newco (to be named), with a primary listing in Amsterdam and a secondary listing on the JSE, and a new Naspers with its primary listing still in South Africa.

The Newco will hold the international assets of Naspers, including its 31% of Tencent, and will focus on global opportunities. The South African Naspers will have a 73% share of the Newco, will hold the local assets of Naspers and will also pursue investment opportunities – presumably mostly in South Africa.

Naspers shareholders in absolute terms were, at the start of June, about R120bn better off than they were three weeks previously, according to calculations by my colleague Thane Duff of Investec Wealth & Investment. The Naspers share price has outperformed that of Tencent recently.

To explain, the large gap between the net asset value (NAV) of Naspers  (the sum of its parts of which the holding in Tencent dwarfs all the others) and the market value of Naspers (now R1.462 trillion rand) has narrowed by as much as R120bn in recent weeks.

This value gap (NAV less market value – which we can describe as the difference in the value of Naspers were all its assets unbundled to shareholders and its value as an ongoing business) however, remains a considerable R386bn. The value of the Naspers holding in Tencent is currently worth 127% of the market value of Naspers – or as much as R1.85 trillion.

This value gap emerged only in 2015, with the appointment (coincidentally?) of Bob van Dijk as CEO. The value gap has been as much as R800 billion since then and is now close to its post-2015 low. Its further direction will be of crucial importance to shareholders and, one hopes, also the senior managers of Naspers who control its destiny through the high voting shares they own.

Figure 1: Naspers – NAV minus market value (R billion)

The NAV and market value of Naspers have much in common. Common to both is the market value of the listed assets it owns (Tencent and MailRu being the most important). Also common is the value accorded to the unlisted assets of Naspers, though the value ascribed to these unlisted assets by the directors and included in the balance sheet may well be greater than the value accorded them by the market.

This could be one reason why NAV exceeds market value. What will not be recorded in the Naspers balance sheet or in NAV, but will affect the market value, is the expected cost of running the Naspers head office, as assumed by investors and potential investors. The more shareholders are expected to pay management for their services in the future – including the extra shares to be issued to managers that will dilute their share of the company – the less Naspers shares will be worth today.

A further force that can add to or subtract from the value of a company is the expected value to its shareholders of the business that the company is expected to undertake in the future. The more profitable the investment programme of a company is expected to be, the more value a company will offer its shareholders. Profit in the true economic senses means the difference between the internal rate of return on shareholder capital invested by the firm and its opportunity cost, that is, the returns its shareholders could expect from similarly risky investments made with its capital when invested outside the company. It is the economic, not the accounting profit earned after allowing for the cost of utilising equity as well as debt capital, that matters for the market value.

This cost of their capital for SA shareholders – or the required return on the capital they have entrusted to Naspers – is of the order of 14% a year. This 14% is equivalent to the returns currently available to wealth owners in the RSA bond market (about 9% a year for a 10-year bond) plus a premium, to compensate for the risks that these returns may not be met from the averagely risky SA company.

If Naspers were expected to achieve consistent returns of more than 14% on the large capital investments it makes every year, this programme could be expected to add to its market value. If the market expected otherwise, where the returns on the investments would fall short of their costs, then the investment programme would be expected to destroy the wealth of shareholders. And the more Naspers was expected to invest, the more value destruction would be reflected in its share price: that is, the larger the difference between NAV and market value would become.

We draw on the Credit-Suisse-Holt database for estimates of the recent investment activity of Naspers. The sums invested are large in absolute terms as may be seen in figure 2 below: they’re estimated as of the order of R200bn per annum in recent years. Holt also estimates a currently negative return on capital invested by Naspers – that is, a negative cash flow return on investment (CFROI). If the estimate of the scale of the Naspers is correct, then the investment programme is large enough to account for a large reduction in its market value accorded by a sceptical share market.

The recent sale by Naspers of 2% of its Tencent holding realised nearly US$10 billion. A large additional war chest it must be agreed, but not perhaps enough to result in as much value destruction of the order recently observed.

It suggests that shareholders also attach significant costs to them of the rewards expected to be awarded to managers – perhaps particularly in the form of share issues and options – that over time can consistently dilute their share of the company. If the number of shares issued as remuneration amounts every year to as much as 1% of the shares in issue, this becomes an expensive exercise for shareholders.

Figure 2: Naspers – gross investment

Source: Holt and Investec Wealth & Investment

Will the future be much different for Naspers shareholders?

The critical issue for shareholders in the restructured Naspers remains as before. How successful – how economic value adding or destroying – will its investment programme become, and how generous will the company be to its managers?

There seems little likelihood of much change in behaviour of either kind that would cause investors to change their assumptions about Naspers. The managers are unlikely to become less ambitious in their search for game-changing investments of the kind it made in Tencent. But it will soon be doing so out of two highly interlocked companies.

The international investment activities will presumably be conducted out of Amsterdam. The South African company will also have an investment programme of its own, presumably in South African and African opportunities. One imagines, however, that the larger investments bets will be made internationally by the Amsterdam-listed company, given the much larger opportunity set. Dividends (largely from Tencent) that flow out of Amsterdam back to South Africa will presumably be influenced by the scale of this investment programme.

One anticipates that both companies will not easily convince investors that they are capable of undertaking enough value-adding investments to compensate for the cost of management. Therefore, the Naspers shares will be priced lower (to compensate for value destruction and head office costs) for an expected return in line with market averages. Given a lower than otherwise share price for both companies, both are likely to stand at a discount to NAV and should continue to offer a value gap of significance.

Yet the Amsterdam company will also be priced to offer a market-related return for a company listed in Amsterdam and, under the jurisdiction of the Netherlands, a developed economy. The owners of the 27% free float in the new Amsterdam company will accordingly attach a lower real discount rate to the expected benefits of their share of the company. They will be satisfied with lower expected nominal and real returns, because they will attach less risk to doing business with the government of the Netherlands than with the SA government.

The lower returns required of a company in the Netherlands will be equivalent to the yield on a Netherlands government bond (close to zero, even negative) plus the same 5% risk premium. This makes for a required nominal return of 5% rather than the 14% required of a South African-listed company, where inflation is expected to be much higher and the sovereign risk premium is higher.

The important difference in real expected returns (returns adjusted for expected inflation) is an expected average real 5% in the Netherlands (given no expected inflation, only a risk premium) and a real return in South Africa of about 3% higher (8% real return expected from the average South African company). This 8% real is the equivalent of the 14% nominal required return, less the 6% inflation rate expected in South Africa.

This lower real discount rate makes Naspers shares worth more in Amsterdam than they would be worth in South Africa (all else remaining unchanged) and also worth more for shareholders in Naspers South Africa with their Amsterdam investment.

But all else will not remain the same, including the market value of Tencent shares. This will still be the main force driving the value of the Naspers companies. What could change the game for shareholders – and help further lower the gap between NAV and market value – would be for the company to reward its managers on their ability to close this value gap. That surely would align the interest of managers and shareholders and therefore add value.