Month: July 2023

Buying back shares for good and sometimes regrettable reasons

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.

No room at the till. Towards a note less economy.  

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.

The Fed has rescued the Rand

The rand has recovered strongly this month – by about 7% against the US dollar, and has performed similarly Vs the Aussie dollar and an index of EM currencies. The rand had weakened through much of 2023. It weakened by a further 3% when the SARB increased rates unexpectedly sharply by 50 b.p. on May 25th. Since June 1st the ZAR has recovered – as interest rates in SA have fallen away. arply.

The ZAR Vs The USD, the AUD and the EM Currency Index. (Daily Data January 2023=100)

Source; Bloomberg and Investec Wealth and Investment
Long term RSA bond yields have declined significantly and helpfully by between 50 and 70 basis points this month. The Yankee Bond, a five year dollar denominated claim on the RSA, now yields a lower 6.4% p.a. compared to the 7% p.a. offered on June 1st. Moreover, the spread between the RSA dollar bond and a US Treasury of the same duration has narrowed significantly from 3.6% p.a to 2.8% p.a. This interest rate spread provides a very good indicator of the risks of default attached to SA bonds. More important perhaps for the direction of the rand and the economy has been the recent inflection in short-term interest rates. When the SARB raised rates on the 25th May, the money market, as represented by the forward rate agreements of the banks, immediately predicted a further one per cent hike in short rates over the next six months. The SARB is now expected to be much less aggressive. The market is now expecting short rates to rise by a quarter per cent.

RSA Dollar Denominated (5 year Yankee Yield) and the SA Sovereign Risk Premium (Daily Data 2023)

Source; Bloomberg and Investec Wealth and Investment

Why have surprisingly lower short term interest rates helped the rand as surprisingly higher rates clearly weakened the rand last month? There is much more than coincidence at work here. Higher short-term rates – higher overdraft and mortgage rates- combined with the higher prices that follow a weaker rand – are expected to further depress spending in SA and the growth outlook for the economy. The weaker the outlook for the economy, the weaker the growth in incomes before and after taxes, the more government debt is likely to be issued. And the graver becomes the eventual danger a of a debt default. For which still higher interest rate rewards have to be offered to investors to compensate them for the additional risks implied by a deteriorating fiscal condition. These higher interest rates then raise the cost of capital for SA business – making them still less likely to undertake growth encouraging capex.
The Reserve Bank is ill advised to react to exchange rate shocks in ways that further threaten the growth outlook – and can prove counterproductive by weakening the rand that then lead to still higher prices. Interest rate increases make sense when excess spending – excess demand – is putting pressure on prices. Which is not the case for the SA economy today. The right response to exchange rate shocks is to ignore them as their temporary impact on the price level falls away. Absent any additional consistent pressure on prices from the demand side of the economy, over which the SARB will always have strong influence. The notion of self-perpetuating inflationary expectations, as promoted by the Reserve Bank when explaining its interest rate reactions to a weaker rand, is supported neither by evidence nor is it consistent with self-interested economic behaviour. It is poor theory and even poorer practice.
But this leaves open the question- why then have interest rates come down in SA? The answer can be found offshore. The Fed has found good reason not to push its own rates higher. The pause on rate increases in the US became widely expected and was confirmed yesterday gives the SARB even less reason to raise its own interest rates. The Fed by dealing effectively with a surge in inflation (which has not been self-perpetuating) has improved the outlook for interest rates, the SA economy and the rand.

Update on US Inflation – to May 14th 2023.

Both CPI (4.0%) and PPI headline inflation fell more than expected in May. Monthly moves were low – 0.2% for CPI and negative for PPI. The only proviso was the elevated rate 0.4% m-m for core CPI- CPI excluding energy and food. But core has a very large rental weight- over 40% which was up 8% y/y – but rentals are clearly heading lower and core may not be the most useful leading indicator for CPI – PPI- now strongly lower may do much better in predicting CPI.
The Fed paused but member dot plots indicated further increases to come. But the Chairman says the Fed will remain data dependent and my view is that the Fed panic about inflation is over. Because demand pressures on inflation are largely absent- thanks to higher interest rates and negative growth in money supply and bank credit. The global pressure on interest rates in SA is therefore abating. As discussed in my commentary above

US Headline Inflation Y/Y growth in Index

US Inflation over the past three months – % per 3 months annualized. CPI now running at a quarterly rate of 2%. PPI inflation – headline and quarterly- is now negative

Monthly % move in CPI Seasonally Adjusted. Latest April-May 2023=0.12%.

Welcome the overnight sensation. Artificial Intelligence.

Chat GPT has been an overnight sensation in the world of internet dependents – that is most of us. Though as any overnight sensation would attest – it takes a lifetime of sacrifice and investment to become that overnight sensation. As has surely been the case with the application of Generative Artificial Intelligence. Huge investments have been made – are being made – in developing and applying AI. And the great IT firms are leading the way with their impressive operating margins and returns on capital and abundance of cash flow invested in clouds of computers . They profitably supply the indispensable picks and shovels at the frontiers of knowledge.

And much of their heavy R&D is in the form of employment benefits for their army of researchers – increasingly applying AI – to answer the questions their customers and colleagues ask of them- and answer them far more effectively and rapidly. Among the important applications of AI is in the writing of the code that animates software and its development. With AI the applications and adaptations – the answers to the coders – comes much more rapidly. And the R&D is mostly expensed through the income statement and may not appear on the balance sheet. But will attract great value from the investors who determine the share price of the IT giants who dominate the market value of the S&P 500. Understandably so given the promise of AI. Perhaps the most important question shareholders should now be asking their managers is how are you adapting to AI?

It is estimated that a fifth of the time of office workers is spent answering enquiries of one kind an another. Imagine AI as that true expert on the customer or the internal functions and operations of your company always sitting beside you and your laptop, and comfortably speaking and understanding your language. You will have clearer answers and immediate answers to the questions. Better still the expert may help you ask better more imaginative and important questions- the answers to which will follow. It is asking the right questions that lead advances in science. Humans will be needed for that.

McKinsey has attempted to measure the potential of AI from the bottom up so to speak. By examining in detail how AI is now and could be adopted in the workplace. They have come up with very imposing estimates of extra GDP and of faster rates of change of output and productivity. Which is output volumes divided by numbers of work hours producing them. To quote Bloomberg on the McKinsey study “ Whole swathes of business activity, from sales and marketing to customer operations, are set to become more embedded in software — with potential economic benefits of as much as $4.4-trillion, about 4.4% of the world economy’s output — according to the study by McKinsey’s research arm…….Depending on how the technology is adopted and implemented, productivity could increase 0.1%-0.6% over the next 20 years, it found….”

A follow up question is worth asking. How well will the growth in productivity show up in the numbers we use to measure output and productivity and its growth? One of the puzzles economists have been wrestling with for many years is the apparently persistently slow growth in productivity recorded over many years despite conspicuous automation and labour saving. Are we entering a new phase of productivity improvements – almost certainly – but to recognize them we will need superior techniques to measure them.

We measure the value rather than the volume of production. Revenues recorded are prices charged in money of the day, multiplied by the quantity of goods and service supplied- easier to measure in mines, farms and factories than in the increasingly predominant service sector of a modern economy that sells a service the volume of which may not be obvious. For example how does one judge the quality of a report produced by an analyst today- enhanced by abundant data and powerful software and increasingly by AI? Not surely by the number of words written. Furthermore an enhanced customer service, better advice more rapidly provided, as for example, provided by a call centre, now armed with AI, will not be usually be directly charged for. The improved benefits it provides will come with a single charge for the good or service supported by a call centre- a laptop or cell phone for example. Or the fee charged by a customer relationship manager- a financial advisor perhaps, based upon assets being managed. A higher price or fee perhaps charged for the good or service bundled with the call centre or advisor would not necessarily mean more inflation. But rather represent a higher payment for an improved good or service.

To calculate output (GDP) and incomes or the values added we compare firm revenues today with revenues one or ten years ago, when prices observed were generally lower- given inflation. To make comparisons of real output and income and their growth over time, the value of all the goods or services supplied, must be adjusted for inflation to estimate the volume of goods or services produced. To estimate the real volume of goods or services produced or incomes generated over time. Most important prices have also to be adjusted for the changes in the quality of the of the goods and services supplied. We will not just be comparing the price of an aspirins with an aspirin which may well have increased over time. But rather comparing the prices charged for ever more accurately targeted capsules, developed with the aid of AI, and worth more in a real sense. AI is very likely to improve the quality as well as the quantity of goods or services provided.

Improved and lower costs of production could bring a mixture of absolutely lower prices and improved quality. It might mean deflation rather than inflation. How much prices fall in response to increased supplies will depend upon the growth in demand generally. That is on monetary and fiscal policy that could cause prices to rise on average even as economic growth – that is the volume of goods and services provided is growing. But if you underestimate quality gains incorporated into the price of goods and services and overestimate inflation by a per cent or two a year, you will then be underestimating productivity gains and economic growth at the same rate. And then be telling a very different story about economic progress. Perhaps AI will help economists and statisticians adjust more accurately for the changing and improved nature of the goods and services we consume.