September 2024 – ZA Economist

Retail Therapy – Shopping with purpose

I like to visit the local supermarkets. And not only for the usual reasons. It helps confirm my faith in the power of market forces. Fully evident in the impressively wide range of goods and services on offer.

The SA retailers very adequately fulfil the all-important task that we have delegated to them. That is to deliver a wide range of goods, including food and medicine essential to life and happiness. The retailers are left mostly alone to manage a highly complex supply chain that involves, farms, ports, roads, trucks and ships, factories and warehouses, banks, landlords and regulators. And they manage the always complicated relations with workers and their supervisors to pack the shelves and fill the checkout counters and increasingly to deliver directly to homes.

They are serving us well for highly robust reasons. That is to make a living. Mostly modest but some very impressive. Generating incomes for the owners and staff that will bear a close relationship to the difference between the costs of providing the essential service and the revenues generated. To generate profits they will have to prevent the corruption of the supply chain.

Such profits will also depend on how well the retailer manages the promotion or demotion of managers and workers- including the succession plans for senior executives. The retailer as must any business manage successfully the relationship between the efforts of and rewards for the work force. Providing the right incentives to work harder or smarter remains highly relevant for containing costs, enhancing revenues, and the margins between them. Without which the firm would not survive the competition for the household budget.

The apparent “chasm” between the pay of the CEO and the average worker should be regarded as an important part of the market in action. To be admired rather than resented as representing the natural outcome of the supply and demand for very different capabilities and talents at work. As explaining the wide difference between what Taylor Swift and her hair stylist takes home after a show, given their very different contribution to the bottom line. Such inequalities of rewards are part of the necessary incentives for the best and brightest to ascend the highly competitive and greasy corporate poles to make a better fist of it. We can’t all hope to be as good as a Taylor Swift, or an exceptional CEO. Yet whose contribution to the bottom line will never be as obvious as that of a Prima Donna.

Moreover, the resulting flow of profits realised will largely be retained by the owners and invested in the firm to improve the offers to households. Profits are good for customers. But the profits they realise are not fully under the control of the retailer. They depend heavily on the purchasing power of their customers, their incomes, that in turn depend on how well the economy at large is being managed. The SA economy has acted as a serious headwind for the retailers and even more so for their local suppliers. A headwind revealed in the form of declining returns on capital employed, and in goods that move more slowly off the shelves for want of demand. And call for more working capital to back up delays in the ports and distribution centres and by load shedding. The result of which are poorer returns on all the extra capital employed and less invested in new plant and equipment and in the work force.

The failures of the SA economy have much to do with the unwillingness of the economic power brokers to follow the example of the retail sector. As in the persistent but unrealistic, given past performance, faith in a reformed SOE’s and government departments to raise their games. Rather than contracting out much more of production to the private sector- honestly selected and helpfully incentivised to deliver as are our retailers.

They refuse to do so for their selfish reasons, as well as misguided notions of how an economy works best. Yet they must know that the slow growth outcome is a consistent threat to their influence. “As hulle net geweet het wat ek geweet het…” (if only they knew what I know) learnt shopping with eyes and minds open to the evidence, SA would be, could still be, in a much happier state for retailers and their customers.

Doing penance with purpose

JSE listed companies have been beating down on themselves very heavily. Kabelu Khumalo reports some R250 billion of recent write offs and write downs of assets. (BD August 12^th) It will mean that the book values recorded on the balance sheets perhaps will accord more closely with the market value of the company. Yet the cash flows of the business would be unaffected by the action and there are unlikely to be any taxes saved on the losses because they will not be recognised as a business expense. And the bottom line will be even less meaningful.

The prior damage done to cash flows and market value by poor investments or acquisitions will long have been recognised and deducted from the value of the company by investment analysts and the investors they advise. They will have made their own diminished sum of parts calculations of the present value of the divisions of any company. And they may still have a very different view of what the underlying assets might bring shareholders in the future.

Notice something important about these adjustments to the books designed to align book and market value. There is very unlikely to be an equivalent urgency to upvalue the assets on the balance sheets that have proved to be market value adding. The great new mine that has proven to be so valuable to shareholders is likely to remain on the books at something close to its historic costs. Not written up in the books to enhance earnings and equity capital employed and the strength of the balance sheet. And when an excellent acquisition was made paying above the book value of the company acquired, this goodwill is very likely to be amortised against earnings, so reducing book value and the capital employed by the business. Rather than logically seen as adding to the amount of valuable capital employed by the business.

The benefits of writing off capital employed in a business, rather than writing it up, will show up in an important measure, and that is as Return on Equity Capital employed (ROE) The less capital recognised the better the return on equity all other operating details remaining the same. And the managers of the business are very likely to be rewarded directly on the basis of ROE. Shareholders will benefit when the company they entrust their savings can deliver a return on the capital they employ that exceeds the opportunity cost of capital employed. That is the returns shareholders might expect investing in an alternative company with similar operating risks.

Making poor investment decisions reduces ROE. Recognising past failures will not change past performance. It might however indicate that milk has been spilled, that costs have been sunk, that bygones are bygones and most important that more good money is less likely to be thrown away on lost causes. And if the managers are surprisingly contrite might help add market value by improving expected performance.

But what could be more helpful to an incoming CEO, also to be measured on future ROE’s than to begin a reign with less capital? True kitchen sinking, recognising the mistakes made by predecessors, could be managers wealth enhancing, if future rewards are to be based on higher ROE’s, as indeed they should be.

If the actual capital entrusted to the incoming CEO and the team of operating managers is accurately measured, it is only then that improvements in ROE can be properly recognised and encouraged. And rewarded appropriately in all the operating divisions whose managers can be held responsible for the capital they are given to manage, again accurately estimated.

South African directors of companies now burdened with justifying not only what they pay their senior managers, but with also justifying the absolute difference between the rewards at the top and bottom of the pay scales, may point to the example of Starbucks. Changing their CEO yesterday immediately added over 20 billion dollars to the market value of Starbucks. Paying the right CEO enough, not too much, nor too little, rewards based predominantly on improvements in ROE, properly calibrated and communicated, should be the primary task of any Board of Directors. And when put into good practice with successful and well and competitively paid CEO’s, will deserve the approval of shareholders.

Perceptions are reality

The financial markets have welcomed the Government of National Unity (GNU) The reactions in the bond market have been particularly favourable. The JSE All Bond Index on August 26^th was up by 11.4% since the election of May 2029. The share market was up by 7.1% while the ZAR has gained 4% vs the US dollar and vs other EM currencies. Given the importance of equities and bonds held by SA households in unit trusts and pension plans (some 15.2 trillion rands worth at year end 2023) representing 85% of all the assets held by SA households) such market moves have already had a very significant impact on the wealth of South Africans.

The promise of faster growth has added close to 10% or over 5 trillion rands mutual funds to the SA household balance sheet. Extra real money indeed and helpful for stimulating additional household spending, of which SA has had too little of for many years now. [i]It is not only the supply side constraints that have held back the economy. Demands from households and the firms that serve them have been insufficient to drive growth above an immiserating 1% a year.

The importance of the judgments of the global capital market of SA economic policy for the average South African, their hopes for employment and a comfortable retirement, for which they sacrifice heavily, cannot be underestimated.

Post election movement in the Financial Markets. Daily Data – May 29^th – August 26^th 2024. May 29^th=100

Source; Bloomberg, Investec Wealth & Investment.

The strength of the ZAR is particularly welcome. It brings with it lower inflation and lower short-term interest rates essential for a recovery in the economy. The positive link between the outlook for growth and the behaviour of the ZAR has again been emphasised, (more growth stronger rand and vice versa) as has the link between a stronger rand and inflation.

There is no room for complacency. The status of RSA debt has improved, but interest rates and the cost of capital remain elevated. Our credit rating remains significantly weaker than it was between 2002 and 2008 when our economy did grow at close to 5% p.a. (see below)

The RSA Credit Rating. The CDS spread between the yield on RSA 5 year USD Denominated Bonds and a 5 year US Treasury Bond

Source; Bloomberg, Investec Wealth & Investment.

There is much room to further impress investors. By taking economic policy decisions now, that by promising faster growth over the longer term, could immediately further strengthen the bond and currency market.

The National Health Initiative, now being actively promoted, does the opposite. It promises more of the same fundamental weaknesses that have infected all the State directed enterprises to date. The direction of health care reforms should also be one of seeking partnerships with the private sector- with private hospitals and practitioners. It calls for experimenting with the private control and management of hospital services. Hospitals currently funded by the State that perform so poorly on all metrics, including the costs of supplying inferior service.

A helpful positive note was offered by the Transnet CEO. Michelle Phillips who said yesterday that “…the entity’s move to maintain run and invest at Ngqura and the 670km container corridor would be reworked after potential bidders complained that the conditions attached to the tender were too stringent and costly for the private sector to fully participate..” (BD August 28 Thando Maeko)

The public sector in SA, in all its guises, needs to come to realistic terms with the potential providers of private capital and skills that are essential to our economic purpose. Their managers need to fully understand how to deal with potential private sector partners who operate globally. Such knowledge applies to plans for ports and railways and refineries, for the supply of water and the transmission of electricity. And for bringing minerals, oil and gas to the surface. And to recognise the terms and conditions, no more or less than internationally competitive terms, that would bring potentially abundant and truly economic game changing offshore gas, onshore. Offering credible deals of this kind would be enough to move the markets. And so immediately, with lower interest rates and a stronger rand and less inflation, would help realise the growth in incomes and employment necessary to re-elect a GNU in 2029.

[i] I am drawing on a recent comprehensive analysis of the SA balance sheets by J.Makoena and K Setshedi published in the SA Reserve Bank Quarterly Bulletin, June 2024. The study shows how very well developed are pension and retirement savings in SA (120% of GDP) are compared to other emerging economies. And so the importance of investor sentiment for SA wealth owners.