Month: September 2020

A call for realism in economic and monetary policy

What permanent shape will the global economy take after the lock downs are fully relieved? How fast can the global economy grow when something like normality resumes? There are those who argue that the major economies have entered an extended period of economic stagnation.   Some even argue that demand will have difficulty in keeping up with minimal extra supplies of goods services and labour. That monetary policy has shot its bolt because interest rates cannot go much below zero.

We should dismiss such underconsumption theories.  Monetary stimulus comes not only from lower interest rates but also occurs directly as excess supplies of money are converted into demands for other goods or services and for other assets. Higher asset prices and greater wealth also have positive effects on spending. There is no technical limit to the amount of money central banks can create to stimulate more spending. The only limit is their own judgment as to how much extra is necessary to the purpose of getting an economy up and running again.

Stagnation will be for a want of willingness to supply goods services and labour. If demand remains weak we should expect ever more injections of central bank cash until demand increases enough to make inflation rather than growth the problem for central banks.  This is unlikely any time soon and global interest rates will remain low until then. Such policies can be reversed when the time is right to do so.

These low interest rates encourage a flow of capital to those parts of the world where real interest rates are much higher. As in South Africa where the market still rules the determination of long-term interest rates given the clear unwillingness of the SA Reserve Bank to monetize government debt on any significant scale. The SA government has to offer nearly 10% for ten-year money.  Adjusted for expected inflation of around 5% this provides a very attractive expected real return of around 5% per annum over the next ten years.

The average private firm contemplating investing in plant and equipment in SA would have to add a risk premium of another five per cent to establish the returns required to justify such an investment. These  expected returns would therefore have to be of the order of an expected 10% p.a. after inflation.  A requirement that is prohibitively high and explains in large measure the lack of capital expenditure in SA. And reinforces the prospect of a permanently stagnant economy. It also explains the depressed value of SA facing companies on the JSE regarded as without good prospects for growth. For faster growth in capex, interest rates have to come down or, less happily, inflation must go up to reduce required returns on capex.

Improving our growth prospects requires a steely economic realism in response to current very difficult circumstances. It necessitates more central bank intervention to lower long-term interest rates and much more reliance on short term borrowing that will be much less expensive for taxpayers. It calls for still lower interest rates at the short end. It calls for money creation and debt management of the kind practiced almost everywhere else as a temporary, post lock-down stimulus to more spending and growth- but alas not here.

The blow out in the borrowing requirement of the government –because revenue has collapsed with incomes – is a best regarded as unavoidable. Realism means no increases in tax rates on expenditure or incomes. Doing so would further slow-down the economy and revenue collections with it. Higher expenditure taxes and charges would also raise headline inflation, depress spending on other goods and services and raise demands from public sector unions for better pay. These now pressing demands for improved employment benefits for comparatively well paid and protected public sector employees must be strongly resisted. This will help demonstrate that the SA government can spend within its capacity to raise revenue over the longer term. The debt trap is avoidable.

It calls for policy responses that would best serve the economy now in crisis and act as a bridge to permanently sound policies of a market friendly nature. So providing a signal of improving prospects that would justify significant inflows of capital to lower interest rates and required returns. That in turn would lead to much higher levels of capital expenditure necessary for permanently faster growth.

PSG and Capitec – Shareholders’ (un)bundle of joy

By unbundling Capitec, PSG has done the right thing for shareholders – but shareholders remain sceptical about its prospects.
PSG shareholders should be pleased. The decision to unbundle PSG’s stake in Capitec has delivered approximately R7.85bn extra to them. This estimated value add for PSG shareholders is calculated by eliminating the discount previously applied to the value of the Capitec shares held indirectly by PSG.Without the unbundling, the discount applied to the assets of PSG would have been maintained to reduce the value of their Capitec shares. The market value of the 28.1% of all Capitec shares unbundled to PSG shareholders, worth R960 a Capitec share, would have been worth R31.4bn on 16 September. These Capitec shares might have been worth 25% less, or nearly R8bn, to PSG shareholders, had it been kept on the books.

The PSG holding in Capitec had accounted for a very important 70% of the net asset value (NAV) or the sum of parts of PSG. Before the unbundling cautionary was issued in April 2020, the difference between the NAV and market value of PSG, the discount to NAV, had risen to well over 30%. The difference in NAV and market value of PSG was then approximately R20bn in absolute terms. The discount to NAV then narrowed to about 18% when the decision to proceed with the unbundling was confirmed.

Now with the unbundling complete, PSG again trades at a much wider discount of 40% or so to its much-reduced NAV.

Capitec and PSG delivered well above market returns after 2010. By the end of 2019, the Capitec share price was up over 18 times compared to its 2010 value. By comparison, the PSG share price was then 10 times its 2010 value, and the JSE 2.1 times.  The Capitec share price strongly outpaced that of PSG only after 2017.

The Capitec and PSG share prices, compared to the JSE All Share Index (2010 = 100)
The Capitec and PSG share prices, compared to the JSE All Share Index chart
Source: Iress and Investec Wealth & Investment

The better the established assets of a holding company perform, as in the case of a Capitec held by PSG or a Tencent held by Naspers, the more valuable will be the holding company. Its NAV and market value will rise together but the gap between them may remain wide. Investors will do more than count the value of the listed and unlisted assets reported by the holding company. They will estimate the future cost of running the head office, including the cost of share options and other benefits provided to managers of the holding company.  They will deduct any negative estimate of the present value of head office from its market value. They may attach a lower value to unlisted assets than that reported by the company and included in its NAV.

Investors will also attempt to value the potential pipeline of investments the holding company is expected to undertake. These investments may well be expected to earn less than their cost of capital, in other words, deliver lower returns than shareholders could expect from the wider market. These investments would therefore be expected to diminish the value of the company rather than add to it. They are thus expected to be worth less than the cash allocated to them.

To illustrate this point, assume a company is expected to invest R100 of its cash in a new venture (it may even borrow the cash to be invested or sell shares in its holdings to do so). But the prospects for the investments or acquisitions are not regarded as promising at all. Assume further that the investment programme is expected to realise a rate of return only half of that expected from the market place for similarly risky companies. In that case, an investment that costs R100 can only be worth half as much to its shareholders. Hence half of the cash allocated to the investment programme or R50 would have to be deducted from its current market value.
 
All that value that is expected to be lost in holding company activity will then be offset by a lower share price and market value for the holding company – low enough to provide competitive returns with the market. This leads to a market value for the company that is less than its NAV. This value loss, the difference between what the holding company is worth to its shareholders and what it would be worth if the company would be unwound, calls for action from the holding company of the sort taken by PSG. It calls for more disciplined allocations of shareholder capital and a much less ambitious investment programme. The company should rather shrink, through share buy backs and dividends, and unbundling its listed assets, rather than attempt to grow. It calls for unbundling and a lean head office and incentives for managers linked directly to adding value for shareholders by narrowing the absolute difference between NAV and market value. Management incentives, for that matter, should not be related to the performance of the shares in successful companies owned by the holding company, to which little or no management contribution is made.

On that score, a final point directed towards Naspers and its management: the gap between your NAV and market value runs into not billions, but trillions of rands. This gap represents an extremely negative judgment by investors. It reflects the likelihood of value-destroying capital allocations that are expected to continue on a gargantuan scale. It also reflects the cost of what is expected to remain an indulgent and expensive head office.

The case for funding with equity, not debt

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

The Foschini Group - market value to 19 August 2020 chart

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

Sasol - market value and total debt, 2012 to July 2020 chart

Foresight not only hindsight may well justify equity over debt

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)

f1
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)

f2
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.