Weekly Update December 10 2017
Over the past year, I have been busy with various projects and a move back to the US from India. Starting in the new year, I will have more time to produce weekly updates on a consistent basis. Hopefully, the weekly updates add a bit of value. Feel free to let me know your thoughts.
Johannesburg Stock Exchange Pass
The Johannesburg Stock Exchange (JSE) was reviewed as a potential recommendation but it was a pass. I was attracted to JSE due to potential network effects combined with a business with all fixed costs leading to potential economies of scale and significant operating leverage. The company is currently trading on a FCF yield of 8.0%. A company with a very strong moat in the form of network effects and economies of scale along with top line growth at GDP and profit growth at a higher rate due to operating leverage should be trading at a higher valuation. If the concerns were solely macroeconomic, I would have recommended the company.
In 2017, ZAR X and A2X were awarded licenses to operate equity exchanges. In 2016, equity markets accounted for at least 60% of the company’s revenue. Operating financial exchanges are a technology business. The biggest risk is new entrants can replicate JSE’s technology at a much lower cost, as JSE technology platform has been slowly built over years and therefore is a patchwork legacy system. The ability to operate a technology platform at a much lower cost allows new entrants to undercut JSE’s pricing. In other markets new entrants have been able to gain share in what was once thought to be an almost rock solid competitive position. The BATS platform has achieved a 19% market share in US equities since entering the market in 2005 and 20% market share in European equities since entering the market in 2008. New entrants in South Africa should at the very least force JSE to cut prices and/or to upgrade its technology platform. Given the fixed nature of the company’s expenses, any loss of revenue will flow directly to a decrease in the company’s operating profit.
Looking at valuation, assuming market share gains by competitors and/or price cuts in the equity division, revenues related to equity markets would decrease by 20% leading to a free cash flow yield and expected return close to 5.0%. Assuming competition has some effect and cancels out any growth, the company’s free cash flow yield and expected return is roughly 8.0%. Assuming competition is unable to enter to gain a foothold in the market and the company is able to continue to grow at 5.0%, the expected return is 13.0% per annum (free cash flow yield + growth). The potential ranges for expected return are only estimates as it is difficult to forecast with any accuracy. Assuming, the highest return scenario has a 60% probability and the other two scenarios each have a 20% probability then the expected return per year is 10.4%. KfW is a German government owned development has a rand denominated bond expiring in October 2022 with a AAA rating, which offers a 8.272% yield. Given the potential risk a 2.0% additional annual return over a AAA rated bond is probably not sufficient to warrant an investment in JSE.
Given my focus on high quality companies, I often read Morningstar’s research and insights. Morningstar put out an article discussing company profitability and changing nature of moats (link)
Alpha Vulture, another value investing blog posted an investment thesis on Stalexport Autostrady, a company I wrote about earlier this year. My post on Stalexport Autostrady can be read here while Alpha Vulture’s post can be read here.
Giverny Capital process is summarized below.
- ROE > 15%
- EPS growth > 10%
- Debt/profit > 4x
- Market leader
- Competitive advantages
- Low cyclicality
- High level of ownership
- Constructive acquisitions
- Good capital allocation
- 5 year valuation model
- Try to purchase at half of the estimated valuation in 5 years = IRR of 15%
The Council of Institutional Investors discusses variable interest entities (VIE) used by Chinese companies when listing in the US. (link) Chinese companies also use VIEs when listing in Hong Kong. Below is one of the most interest aspects of VIEs.
“The VIE structure could be deemed to contravene Chinese laws that restrict foreign investment in strategically sensitive industries. VIEs operate using contractual arrangements rather than direct ownership, leaving foreign investors without the rights to residual profits or control over the company’s management that they would otherwise enjoy through equity ownership. While VIEs have established themselves as common practice among U.S.-listed Chinese companies and have won some validation from market actors, the structure puts public shareholders in a perilous position. VIEs depend heavily on executives who are Chinese nationals and own the underlying business licenses to operate in China, introducing unusually significant “key person” succession risk. Aside from dual-class structures with limited shareholder rights in the Cayman Islands and other jurisdictions in which these companies are often incorporated, the VIE structures themselves create significant management conflicts of interest, complicating, if not foreclosing, the ability of outside shareholders to challenge executives for poor decision making, weak management, or equity-eroding actions. VIEs lead foreign investors to believe that they can meaningfully participate in China’s emerging companies, but such participation is precarious and may ultimately prove illusory.”
Due to the high frequency of financial statements being completely wrong, I no longer look at Chinese companies. Through the end of Sept 2017, our average recommendation is up 7.9% in relative terms on a USD basis. Taking China out of the picture, our average recommendation is up 30.8% in relative terms on a USD basis. The reliance on financial statements within my research process means it is best just to stay away when financial statements cannot be trusted. When the outcome is poor the result is clear but when the investment goes right, there can never be conviction so the benefit of a good outcome cannot be realized. The combination means time is better spent elsewhere. If you are looking at China and concerned with fraud, GMT Research (www.gmtresearch.com) does a good job discussing Chinese companies and potential concerns. There is a wealth of free information on their site. One particular video Faking Cash Flows and How to Spot It is a must watch. A key point from the video is outside of China only 1% of companies above USD500 million meet GMT’s four indicators for cash flow fraud while in China and Hong Kong that rises above 6%. Another blog discusses the risks of investing in Chinese companies (link).
Peters MacGregor discusses its investment in Fairfax India (link). Peters MacGregor is an Australian investment firm that invests in undervalued portfolio of world-class businesses with dominant market shares and good growth prospects. It looks very interesting at first glance.
Kellogg Insights interviews Lou Simpson (link)
An interesting tweet by @ValueStockGeek illustrating the number of position in a value portfolio and standard deviation of monthly returns (link). As the number of position in a value portfolio passes 10 the benefits of diversification decreases. Joel Greenblatt did a similar study in his book You Can be a Stock Market Genius. Validea discussed his finding here.
Fundsmith Equity Fund published an Owner’s Manual, which is well worth a read (link). HT @ToddWenning
This following link is to Amazon’s Shareholder Letters from 1997 to 2016. Amazon Shareholder Letters Jeff Bezos 1997-2016
Clear Eye Investing put together a list of 15 questions to ask management (link). HT @HurriCap