Category: SA Financial Markets

GDI Barr & BS Kantor

In a previous piece (What can help the Rand and the economy? – ZA Economist) we discussed how ever-changing probabilities make Financial Risk so hard to measure and that investment outcomes are dominated by the return received, with any notion of the past risk faced quickly fading from memory. Thus, if a successful share investment has yielded an excellent return, is the happy result either because the shareholder took on extra risk and got lucky , or because the savvy investor knew the share was undervalued and proved to be so, becomes irrelevant.

Knowing the downside, estimating how much of a loss any portfolio or balance sheet can take and survive a potential loss is an essential task for the risk taking investor. Deciding what is a good bet – improving the odds of success by improving expected returns for any presumed risk -or reducing risks of failure for any expected return -makes every good sense.

Holding gold or perhaps more realistically holding a claim on a stock of gold held in some very safe place, has long proved itself as a sensible way to protect wealth against disasters in the form of war or revolution or more prosaically against inflation and their impact on many other ways to conserve wealth. As the dangers of an economic calamity rise, so typically, as will be expected, the price of gold will move higher.

If so, as will a claim on gold bearing rocks in the ground, that will be gradually turned into gold on the surface by a gold mining company. A share in the expected profits of a gold mining company will then also provide very useful insurance against danger. The gold price and the share price will move in the same direction – but given all the potential gold in the ground, and the risks associate with bringing it to the surface – the share price will be far more variable, hence far riskier than the gold on the surface. The recent sharp upward movement in the gold price provides an appropriate example. The gold price has moved up 10% or so in dollars over the last year. If we take the example of the GoldFields (GFI) share price, this has moved up around 160% (a factor of 1.60times the Gold Price movement) over the same period.

But an investor seeking safety owning gold has still a further alternative. That is to buy an option to buy a share in a well traded gold mining company, at a pre-determined future date, at a price agreed to today. The options can be bought or sold at market determined prices until the expiry date of the option, after which that right or option becomes worthless.

Option prices therefore exhibit a still much greater level of variability (or risk) than the underlying metal or share prices . Because of this character they give investors an excellent opportunity to raise the expected return from an exposure to movements in the gold prices , with a much smaller risk of a loss should the gold price move lower. Give the option price volatility – the factor here

. The availability of gold shares and more so options on gold shares give investors, who want to speculate or to hedge a portfolio of gold bullion against a large contrary or unexpected movement in the gold price make for a very efficient vehicle to hedge the exposure while laying out significantly less capital or incurring expenses to improve the expected return- risk trade-off.

Graham- one needs protection against a fall in the gold price and/or the multiplied fall in the value of a share or an option. One hedges the gold bullion price position by selling (shorting) the shares or selling the option- the puts -to hedge the exposure to the share price. It is cheaper to sell the shares and cheaper still to put the shares. I have tried to spell this out but with difficulty as you will see. A portfolio of gold bullion. Gold price down 10% portfolio down 10%. Bullion price down 10% GFI down 100% – 10 times more. A short of how many GFI shares (1% of the portfolio) would give the bullion portfolio protection against a 10% fall in the gold price. A put option on GFI equivalent to 0.2% of the portfolio in gold would presumably protect against a 10% fall in the gold price.

In recent months a short duration Call Option on GFI, has moved up about 500% (a factor of 50 times greater than the move in the gold price) By agreeing to sell the share and more so an option on the share, one will have exposed (expensed) significantly less actual capital for the same hedging effect. Thatis protection against losses should the gold price move lower rather than higher – as was the expectation. If the gold price had fallen 10%, then one would have lost 10% of the portfolio capital if one had held gold coins (a ten percent fall for ten per cent of the portfolio), 1% of the portfolio for a short on the GFI shares but lost only 0.2% of the portfolio capital, if the outlay was in the form of a put on the GFI shares rather than a short. Therefore, one would have been be unambiguously better off to hold the gold share options (puts) (a 50th of the gold bullion loss). Thus for the portfolio manager who is a gold bull and is already committed to holding a large amount of bullion, he can turbo-boost his investment in gold, with little added risk, by making a relatively small purchase, risking relatively little capital on a highly geared Gold share options. The potential gain (retrun on capital invested in the option) will be very large should the gold price move higher- but the potential loss – compared to the losses incurred by investing the same amount of capital in gold or gold shares – should it all turn out badly – will be much smaller. The return- risk trade-off, calculated looking ahead rather than behind, will have been greatly improved.The fact that at any moment in time judged by observing the random daily nature of the gold price, the gold price has as much chance of rising or falling from its current market determined value, means that the gold bulls are always matched by the gold bears – at the market determined price, or share price, or option price on the shares. The profit seekers in a higher gold price– as in any other actively traded asset – will always be matched by the profit seekers – those who are cashing in on their positions, believing the price will go down. And they will be able to do so at a market clearing price that matches the amounts of bullion or share or options bought and sold. The market makers, including the option providers, will match buyers and sellers. They ideally from their perspective will be rewarded with a fee and not be exposed to the highly unpredictable move in the underlying metal or share prices.

Structuring such risk reducing strategies is complicated for the average private investor. But it may be straightforward for banks or others who provide structured products bought by retail investors. Constructs that trade off less upside gain for less downside risk of losses It should be possible to put together a blended product of say 90% gold bullion and 10% Gold share options of appropriate duration. Such a listed financial security registered for trade on the JSE would exhibit high gearing to the gold price upside but for lower risk of losing capital should the gold price move in the wrong direction, which it may well do. Over to the market place.

We like to think that evidence changes beliefs. The problem with beliefs or rather opinions about economic life is that the economy never stands still to conduct experiments with. The management of Naspers conducted an experiment in September 2019 to reduce the huge gap  between the value of the assets on its books, its Net Asset Value (NAV) or sum of its parts, mostly in the form of its enormously valuable shareholding in Tencent a fabulously successful internet company listed in Hong Kong, and the market value of its shares listed on the JSE.

The board and its management have seemingly learned a great deal from the expensive experiment – unexpectedly so surely – because restructuring its shareholding, establishing a subsidiary company in Amsterdam Prosus (PRX)  to hold its Tencent shares and other offshore investments went so badly. The value gap, the difference between the NAV and Market Value(MV)  of both NPN and PRX rather than narrow had widened significantly after 2019 despite or rather in small part because of the restructuring. By early June 2022 the discount for NPN (NAV- MV)/NAV)*100 was of the order of 62% and 51% for PRX

Such new awareness has been received with great appreciation and delight of its shareholders these past few weeks. As a result of its change of mind, in the form of a mea-culpa about past actions and the much more tangible decision to sell as much as 2% a year of its holding in Tencent shares, worth potentially USD 10 billion a year, and to return the cash realized to shareholders buying back its shares. Since the announcement of June 23^rd, shareholders in NPN have seen their shares appreciate by 34% adding 323 billion rands to its market value by July 5^th while shares in the associate company Prosus (PRX) are up by 26% worth a extra R520 billion rand and the discount has substantially narrowed to the 30% range for PRX and 40% for NPN. A further decision to include success in narrowing the value gap as a key management performance indicator was also helpful. All achieved in days while the JSE has moved sideways. 

Daily share price moves and the JSE All Share Index June 23^rd – July 5^th (June 23^rd=100)

Source; Bloomberg and Investec Wealth and Investment

Market Value;  Naspers and Prosus, Rand millions

Source; Bloomberg and Investec Wealth and Investment

Naspers and the Value Gap 2010 – 2019 Month end data.

Source; Bloomberg and Investec Wealth and Investment

The Naspers board had been of the view that it was the South African and JSE connections, higher SA risk premiums and a limited shareholding opportunity in SA, where NPN featured so largely, stood in the way of their receiving proper recognition for their vigorous efforts in diversifying their balance sheets. Hence the restructuring. My opinion, long shared with whoever might read or listen to them,[1] was that the difference between the market value of the sum of parts of any investment holding company and its share market value including NPN and PRX could be largely attributed to three factors. And that where a company was domiciled or listed would be of minor consequence.

Firstly that the reported value of unlisted subsidiary companies could be over-estimated to exaggerate NAV. Secondly that the estimated future costs of maintain a head office, including the employment benefits (including share options and issues) expected to be realized to senior management would be present valued to reduce the market value of the holding company shares. Managers can prove very expensive stakeholders.

And thirdly and most importantly would be the investors or potential investors estimate of the present value of the investment programme of the holding company. They might well judge and expect that the future value of the investments and acquisitions to be made by the Holding Company will be worth less, perhaps much less, than they will cost shareholders in cash or returns foregone. And the more investments undertaken the more value destruction and the lower the value of the shares in the holding company priced lower to promise a market related return for shareholders. If such were the market view the less cash invested, the more returned to shareholders by way of dividends, share buy backs or via the unbundling of mature investments, the more value created for shareholders. Naspers/Prosus is helping to prove my theory.

[1] Follow for examples these BD links https://www.businesslive.co.za/bd/companies/2020-09-14-watch-is-nasperss-management-destroying-its-value/

19^th January 2022

Fiscal and monetary policy in the US and SA will command close attention in 2022. The US will be expected to adjust to the success it has had  overcoming  the Covid threat to its economy. Success has led to excess in the form of much higher rates of inflation. Larger fiscal deficits, that approached 16% of GDP in late 2020 were incurred to supplement incomes with checks drawn on the Treasury has seen the Federal debt to GDP ratio rise to 128% of GDP. Consequently the ratio of money (bank deposits) to incomes (GDP) is now 25% higher than they were before Covid. This huge stock of money will continue to be exchanged for other assets and for goods – and services -when the time is right. The money will not go away – it will merely lose more of its real value as prices – including asset prices – rise further at the inflation rate.

It is a question of how much and how quickly interest rates go higher to restrain spending. Longer term interest rates may rise should inflation be expected to rise permanently to higher levels – which is not yet the case. The problem with higher interest rates is that they have important fiscal implications. Paying higher market determined interest rates to keep the bond market open to issues of more government debt – takes away from other spending – it may demand higher taxes or less government spending – not well suited to make governments popular.

The US, given the currently low cost of raising debt, remains in a favourable fiscal setting. The average yield on all federal debt is below 2%, while the debt service ratio – the ratio of interest paid to the Fed budget – is below 9%. It was about double that rate in 2000 when the debt to GDP ratio was about 50% Every-one per cent increase in the average cost of funding the US debt, means an extra 250 billion dollars of interest to be paid out – on top of the current 500 billion payments. It will require a resolute, politically independent and inflation fighting central bank to tame inflation. (see figure below)

US Fiscal Trends

The comparisons of SA with the US are not alltogether unfavourable. The national debt to GDP ratio is much lower – only about 60% The debt-service ratio is significantly higher equivalent to 13% of the national budget. it was over 20% of the budget in 2000. The average yield on all RSA Treasury debt has gradually fallen to about 6%. It was 10% in 2008. (see figure below)
SA and the US – some fiscal comparisons

Source; Federal Reserve Bank of St.Louis, South African Reserve Bank, Investec Wealth and Investment

The SA Reserve Bank did not (wrongly in my view) do quantitative easing. The broader money supply has hardly grown at all since early 2020. The money to GDP ratio has fallen back to where it was before Covid. (see below) There is no excess demand.

South Africa and the US – some money and GDP comparisons

Source; Federal Reserve Bank of St.Louis, South African Reserve Bank, Investec Wealth and Investment

Of further relevance is that SA Government Revenues have been growing significantly faster than government expenditure. Thanks to the global inflation reflected in higher metal and mineral prices leading and much improved and taxable mining incomes. Both monetary and fiscal policy settings therefore remain austere. They explain why the economy is growing so slowly.
South Africa Fiscal Trends

Source; South African Reserve Bank, Investec Wealth and Investment

The problem is that our market determined credit ratings have remained unchanged and our cost of raising long term debt very expensive. The RSA pays about 8% more for ten-year money than the US. Even more discouraging is the extra real 4% we offer on long dated inflation protected bonds.

SA Interest rates and risk spreads

Source; Bloomberg, Investec Wealth and Investment

Every-one per cent move in our government borrowing costs- would be worth an extra R37b a year to the Treasury. Lower interest rates would also reduce the returns required by businesses and help revive what is a very depressed rate of capital expenditure. The world of bond investors demands compensation for the danger that SA will sooner or later confront a debt-service trap from which printing money, and the accompanying debt destroying inflation, might be the preferred escape. They are much more generous to the US.
It is fundamentally the failure to grow faster that puts government revenues and Budgets at risk. The best SA can do this year to lower borrowing costs would be to sustain smaller fiscal deficits. And for the Reserve Bank to recognize that growth- not inflation – is the SA problem- and to set short-term interest rates accordingly. To help keep debt service costs down and improve the government revenue line.

The markets for industrial and precious metals are demonstrating some important truths. The price of iron ore, approximately USD 92 dollars per ton this week was more than twice as high, 200 dollars, in early July. Its price is as hard to predict today as it was a year ago when it sold for a mere USD85 ton. The pace of the recovery of the global economy after the lock downs was unusually unpredictable and proved surprisingly strong to increase the demand for steel and iron ore and other industrial metals. It is an expected slow down in global growth rates and so in the demand for steel and other industrial metals in the months to come that has caused prices to fall back as surprisingly.

It should be recognised that there is no predictable cycle of the price of any well traded metal, currency, share or bond to assist timing an entry or exit to the market. Were there any regular cycle of prices or indeed of economic activity, that is a predictable trend towards peak growth rates, followed by a slower growth then a recovery from the trough – it would greatly help traders,  producers or consumers to sell at the top and buy at the bottom. But such cycles are only revealed well after the events. They are the result of smoothing the data, comparing the outcomes to what occurred a year before, when almost all of the numbers overlap. Day to day, the data looks very different and the future of prices will not be at all obvious. They unfold as a random walk, with most prices having an almost 50% chance of rising or falling on any one day.

The annual and daily % movements iron ore spot price. USD per tonne.

Source; Bloomberg and Investec Wealth and Investment

Whether these random moves are drifting higher or lower to establish some persistent trend will only be discovered well after the event- perhaps only a year later. All we can attempt – and there is no lack of such attempts – is to model the forces of supply and demand that will determine prices or quantities in the future – as rationally as possible. And perhaps be bold enough to believe that your model will prove more accurate than the opinions revealed by current prices- that we know will vary with the news.

What happened in-between last year and now to the price of iron ore and similarly to the value of the platinum group of metals has had important consequences for the SA economy. They greatly boosted the SA balance of payments, tax revenues and the GDP. Dependence on capital inflows have become large contributions from South Africans to the global savings pool of over USD100billion p.a. as the foreign trade balance improved. Tax revenues have been growing well ahead of budget projections, approaching an extraordinary extra R250 billion of taxes, if maintained over a year.

And the GDP in current prices has risen almost as high as long term interest rates to help reduce the debt to GDP ratios. Yet long term interest rates remain at very high levels and are still particularly high relative to short rates, implying a doubling of short-term interest rates in three years- which would be very bad news for the economy. It is very difficult to make sense of this view of SA interest rates and monetary policy.

While annual growth rates may well have peaked, there is a lot more global demand still in the wings. Post-Covid stimulus continues to this day. The market judgment may be too pessimistic about demand and so prices and revenues may continue to be helpful for resource companies and the SA Treasury that shares in its profits.

How then should SA and resource companies react to such a further windfall? The answer should be obvious. That is look through any temporary surge or reduction in revenues and for the companies to pay out the unexpected extra cash to share or debt holders. For the Treasury it would be to spend no more and borrow less. The benefits to both parties in the form of lower long-term costs of raising capital would be large and permanent.

South African savers dependent ontheir pension and retirement plans will have become aware that the actions of the Chinese Communist Party are sometimes more important than the actions or non-actions of the ANC. This is because of their likely large stake in a Chinese Internet giant, Tencent, held through their shares they own in JSE listed Naspers, (NPN) and via its controlling stake in Amsterdam and JSE secondarily listed, Prosus. (PRX)

Because of the much greater uncertainty about the policies the Chinese will apply to the Tencents, the Alibabas and Baidus and their like, a share in NPN or PRX has become much more risky to hold and therefore less valuable. Shareholders taking on more risk require compensation in the form of higher expected returns, this almost always means a lower entry price, a lower current share price.

The risk to any asset holder is simply the risk that the price of the asset they hold may rise or fall from its current level, should they have to or be forced to cash in their investment at some perhaps unknown point in time. The chances of a rise or fall from the current market determined price, assuming a well-informed active market in them, will be about the same 50% on any one day. Market prices follow a random walk, rising and falling in an irregular sequence. Hopefully these random movements come with an upward drift to bring actual returns in line with the higher expected returns, that make holding risky assets a rational choice for the long-term investor.

In riskier times the daily or hourly moves in both directions, up and down, become significantly wider, while the average move over any extended period will still stay close to zero. When the sense of the future becomes less certain, volatility of share prices increase, the standard deviation of daily moves about the average of almost zero widens, and the cost of insuring against such changes in market prices in the form of an option to buy or sell an option on the share or Index inevitably increases. As it has done in the case of NPN.

The recent increase in the daily volatility of NPN has been of extraordinary dimensions. Daily share price declines of 7% and then an increases of 10% on August 10^th are truly exceptional and reveal how difficult it has been for well informed investors to make up their minds about what the future will hold for Tencent, NPN and PRX. The standard deviation of daily moves in the NPN share price (30 day moving average) has almost trebled since June 2021.

Daily % Moves in NPN and their Volatility Standard Deviation of Daily price Moves (30 day moving average of the Daily SD) to August 9 2021

Volatility compared;  S&P 500 (VIX) JSE Top 40 SAVI and NPN Standard Deviation of Daily price Moves (30 day moving average of the daily SD) to August 9 2021

The rewards for holding on to your NPN or PRX shares remain to be seen. The China risks may decline to help add value. NPN management also hopes that the value of an NPN or PRX will be enhanced by the shares trading more closely to the market value of their Tencent Holdings. They are rejigging the allocation of its Tencent holding between Johannesburg and Amsterdam to attract stronger investor interest to reduce this discount to the sum of its parts, mostly Tencent.

My theory is that the value lost by shareholders is mostly because of scepticism about the value of the acquisitions and investments made by NPN/PRX. They are expected to return much less that the investors could earn for themselves taking on similar risks and so investors and analysts write down the value of this expensive investment programme when they estimate the value of NPN or PRX. The more invested, the more value destruction expected, the lower the value of an NPN or PRX share and the larger the discount. With the completion of the latest restructuring in sight we will see the alternative theories of the discount put to the market test.

The one possible for shareholders – if my theory holds – though it would be a bitter consolation, is that the lower the Tencent share price and the weaker the NPN and PRX balance sheets, the more disciplined and constrained will be their investment and borrowing programmes. And the lower the discount.

The prospect of an effective vaccine for Covid19 has been particularly good news for investors in SA. The ZAR has recovered all of the ground it had lost to other EM currencies through much of 2020 and is now only about 10% weaker against the dollar this year. In March, when the uncertainty surrounding Covid19 was most pronounced, the ZAR had lost 30% of its USD value of January 2020(see below) The ZAR has gained about 4% on both the EM basket and the USD this month. (see below)

Exchange Rates; The ZAR and the EM basket Vs the US dollar and the ratio ZAR/EM; Higher values indicate dollar strength (Daily Data Jan 1st 2020=100)

Source; Bloomberg and Investec Wealth and Investment
The JSE equity and bond markets consistently also responded very well to the good global news led by the companies that are highly dependent on the SA economy. The JSE All Share Index since October has gained 14% in USD and the JSE All Bond Index has appreciated by a similar 14% in USD. The emerging market index was up by 9.1% over the same period while the US benchmark the S&P 500 gained 5.4% over the same period. The JSE has been a distinct outperformer recently (see below)

The JSE Equity and Bond Indexes Daily Data (October 1st=100)

Source; Bloomberg and Investec Wealth and Investment

The JSE, The S&P 500 and the MSCI EM Indexes USD Values (Daily Data January 1st 2020=100)

Source; Bloomberg and Investec Wealth and Investment

These developments should not have come as a complete surprise. Such favourable reactions in the SA financial markets to a reduction in global uncertainties, usually accompanied by a weaker USD are predictable. What South Africans lose in the currency and financial markets when the world economy appears less certain, we regain when risk tolerance improves. SA unfortunately is amongst the riskiest of destinations for capital and investors who always demand higher returns as compensation for the risks they estimate. As taxpayers we pay out more interest and our companies have to offer higher prospective returns than almost anywhere else where capital flows freely, as it does to and from Johannesburg.
Recent developments in the markets do provide some relief for our beleaguered economy. The yield on long dated RSA bonds has declined by more than a half a per cent this month. With an unchanged outlook for profits such a reduction in the discount rate applied to expected income could add 10% to the present value of a SA business or roughly 10% its price to earnings ratio. (market reactions confirm this) A further reduction in these very high required returns – now equivalent to about 9% p.a after expected inflation – is much needed to encourage SA businesses to invest more. Essential if our economy is to grow faster.
Yet if the economy were expected to grow sustainably faster the discount rate would come down much further and businesses would be very willing to invest more in SA. And foreign investors would willingly supply us with their savings to do so. And the SA government would be much more confidently expected to raise enough revenue to avoid the danger of a debt trap and avoid a much weaker rand- expectations that are fully reflected in our high bond yields.
We can hope for the stars to align but should not expect them to do so. We can help ourselves by making the right policy choices. Opportunity presents itself. The terms at which we engage in foreign trade have improved consistently in recent years, by 20% since 2015. Think metal prices over oil prices. These relative price trends are even more favourable than they were in the seventies when the gold price took off. These developments should spur output and investment by business government policy permitting.
There is a further related large opportunity presented by the discovery of a major energy resource off our southern coast. Bringing the gas ashore can accelerate infrastructure and export led growth, funded by foreign capital not domestic taxpayers and led by business not government. It demands the kind of urgency that has brought us a vaccine.

South Africa. Terms of Foreign Trade. Export Prices/Import Prices (2010=100 Quarterly Data 1970-20200)

14^th July 2020

The SA bond market reacted sharply to the spread of Covid19 and the ever more likely prospect of a damaging economic lock-down. Long term interest rates were pushed higher earlier in 2020 in response to SA’s deteriorating fiscal trends even before the full damage to be caused by lock-downs to the economy and the budget deficits were recognized.  Long rates then reversed as the crisis in financial markets passed by with lots of aid form central banks in the developed world. However the gap between long and short yields in SA had widened sharply and remained very wide, despite the bond market recovery, as the Reserve Bank cut its repo rate.

Fig. 1; RSA long and short rates Daily Data 2015-2020- July 10th

Source; Bloomberg, Iress, Investec Wealth and Investment

The RSA ten-year bond currently (July 10^th) yields 9.67% p.a. while the yield on a three month Treasury Bill is 3.96% p.a. a positive spread of 5.67% p.a. This means that the slope of the yield curve is far steeper than at any time over the past 15 years. close to 10% p.a. Another way of putting this is that the SA taxpayer has to pay an extra 5.67% p.a. to borrow long rather than short.

Fig.2: The slope of the RSA yield curve; 10 year – 3 month yields. Daily Data 2020 to July 10^th  

Source; Bloomberg, Iress, Investec Wealth and Investment

On the face of it this would appear to be a very expensive exercise for the SA government to borrow for a longer-term rather than to roll over short term debt. Given the current strains on tax revenues and the rapidly widening fiscal deficit and the government borrowing requirements is it a choice the Treasury is likely to exercise? Or is it going to finance a much greater proportion of its growing debt at the cheaper short term end of the term structure of interest rates? We think the answer will be and should be yeas to this question. We will attempt to provide more insight as to the borrowing choices the SA Treasury is likely to exercise over the coming months and years.

The answer is perhaps less obvious than it appears at first glance. The expectations theory of interest rates would posit, with very good reason, that the long-term rate is but the average of the expected short term rates over the period of any loan. Hence in principle there would be no good reason to prefer long over short-term lending or borrowing. Borrowing long or short and having to roll over shorter term debts should be expected to turn out about the same for borrowers or lenders with choices.

However, if interest rates at the short end rise faster than expected, borrowing long (and lending short) would turn out to be the better option. And vice versa if interest rates were to rise less than expected borrowing short and then rolling over short term debt would have been the better option. As would lending long.

The chances of unexpected fast or slow increases in short rates over the relevant period must be about the same- if the market behaves consistently with the consensus of expectations. Choosing to borrow short or long or lending long or short, given the freedom to choose either option, then represents speculation, the belief that the borrower or lender can beat the market, a belief that may turn out right or wrong- with the same probabilities- given the rationality of the expectations of interest rates.

This notion of equilibrium in the capital market surely makes sense, lenders and borrowers with the option to lend or borrow for shorter or longer periods would presumably expect to pay out the same or earn the same, one way or the other. If you could lend or borrow for three months at a time or for six months at an agreed rate today the expected interest, to be received or paid out over two consecutive three-month periods must presumably be the same as the interest rate fixed for six months. Thus the average (compounding) interest received or paid if the contract was fixed for three months at a known rate and then re-negotiated after three months at a rate, only to be known in three months time, must be expected to be the same. If the current three- month rate is below the six-month rate then it follows that the three months rate in three-months must be expected to rise to make the expected returns on the interest paid or received equivalent.

If this is not the case there would be every incentive to borrow or lend for longer or shorter periods depending on which was expected to suit better. It is the attempts to minimize or maximise interest paid or received that eliminates any such obvious market beating opportunities.

Thus according to the theory, if the three-month rate is below the six-month rate, then the three- month rate must be expected to rise above the current fixed six month rate in order to average out at the higher rate. Thus a positively sloped yield curve, long rates above short, implies that short rates are expected to rise above the current longer term rate over the duration of the lending and borrowing contract. And vice-versa if the yield curve is sloping downwards, short rates must be expected to fall below the alternative longer fixed-term rate. The same logic applies to longer term contracts. If the ten year RSA bond yield is above the yield on a five year bond, the five year bond yields will be expected to rise over the ten year period enough to provide the same expected, compounding, average return.

The RSA yield curve has had a consistently positive slope since 2005 with the exception of the boom period of 2006-2008 when short rates rose sharply and the rapid growth in the economy was clearly expected to slow down and bring lower short rates with it. As transpired with the aid of the Global Financial Crisis and the recession in SA that followed. As may be seen in the figure below the slope of the RSA yield curve has been at its most positive in 2020. It would therefore for almost all of this period been helpful to have borrowed short rather than long.

Fig.3; Long and Short Term interest rates in SA and the Slope of the Yield curve. Daily Data 2005- July 10^th 2020.

Source; Bloomberg, Iress, Investec Wealth and Investment

The slope of the term structure of interest rates, the differences between longer and shorter yields, allows us to interpolate the shorter-term interest rates expected in-between. Thus for a portfolio manager at a SA insurance company to prefer the 3.44% p.a. received currently for a 12 month RSA Treasury Note Bill rather than the 7.07% on offer for a RSA bond fixed for five years, or the fixed 10.05 % p.a. available from a ten year RSA bond, must mean that the one year yield is expected to rise sharply over the next five or ten years. That is to make lending short rather than long the sensible choice to make.

To provide equivalent returns lending long or short and rolling over each year the one year rate (now 3.4%) would have to more than doubled to 7.31%  in two years. Then increased further to 8.91% after three years and then on to to 11.5%  after five years. After ten years the one-year rate would need to be as much as 14.75% to make preferring one-year loans to five or ten year ones the sensible decision. (See figure below)

Fig.4; RSA one year (forward rates) implicit in the current slope of the yield (for on to ten years)

Source; Thompson-Reuters, Investec Wealth and Investment

It is very difficult to reconcile such expectations with the likely reactions of the Reserve Bank over the next few crucial years. The outlook for GDP growth is very grim and the expectations for inflation over the next few years remain highly subdued. The compensation for taking on inflation risk in the RSA bond market is currently only an extra 3.9% p.a. to be earned over five years. That is 3.9% is the extra yield available from a nominal 5 year bond over its inflation protected alternative.

Fig.5; RSA nominal and real 5 year bond yields and their spread- inflation compensation for five years.

Source; Bloomberg,  Investec Wealth and Investment

Therefore if we subtract this estimate of average inflation expected over the next five years implied in the bond market, from the one year interest rate expected in five-year’s time, we get an after inflation expected return that year 5 of about 6%. This measure of inflation expected is now very close to actual inflation. As are the inflation expectations surveyed and reported by the Reserve Bank and forecast by them. They will all have declined further since the beginning of the year given the global pressures on inflation and the likely reluctance of SA households and firms to spend more over the next few years.

It is very difficult to imagine that the SA economy will be strong enough, or the Reserve Bank aggressive enough, over the next few years, to tolerate real interest rates of the order implied by the yield curve and the spread between nominal and real yields now available in the bond market. Therefore many borrowers, especially the SA government, is surely likely to take the risk that short term interest will not rise nearly as rapidly as implied by the current slope of the yield curve. After all short-term rates are directly controlled by the Reserve Bank itself.

Borrowing long can be avoided and the growing SA government debt can much better be funded short rather than long, and by rolling over short term debt for as long, provided the level of long-term rates remains where they are. Drawing further on the government deposits at the Reserve Bank is a further low interest cost option. The Reserve Bank can also provide the banks with enough extra cash, on favourable enough terms, to have them support the growing market in short-term debt. Any reduced supply of longer-term paper will help take pressure off longer term yields.

For the government to elect to borrow long rather than short in current circumstances would surely now seem the wrong, very expensive option. The current state of the bond market could be argued to be something of an aberration in a world of global bond markets that have been monetized to an extraordinary degree. In the longer run the task for the SA government is to prove to the world that it can manage its debt in a sensible way. This means convincing potential lenders that it can bring government spending closely in line with its ability to raise tax revenues. This will help to bring down the long-term cost of raising RSA debt. In the short term, until the crisis is over, and the economy normalizes, what is called for from the government and its Reserve Bank, is the ability to manage the unavoidably larger national debt and short-term interest rates in a sensible way. If we call it good debt management rather than money creation- that it will be to some degree- then so describe it that way

A shorter version was published in Business Day on 1. november.

It is ten years since the Global Financial Crisis (GFC). R100 invested on October 2009 in the 500 companies that make up the most important equity index, the New York S&P 500 Index, would now be worth as R680, with dividends reinvested in the index. This is the result of extraordinarily good 12 month returns over the ten years that averaged  over 18% p.a. in ZAR and 13.4% p.a in USD.

Most other equity markets have not performed anything like as well. R100 invested in the JSE All Share Index or in the MSCI EM, again with dividends reinvested, would now be worth about R276. This is equivalent to an average annual return of about 12% from the JSE over the ten years.

Ten years ago the SA bond market could have guaranteed the rand investor 9% p.a for ten years. Realized equity returns of 12% p.a therefore did not fully reward investors running equity market risks – assuming a required equity risk premium of 4% per annum.

The strong outperformance of the S&P 500 began in 2013 and has continued strongly since. It reflects very different fundamentals. The S&P 500 delivered growth in index earnings per share in USD of 11.7% p.a. over the ten years.  By contrast the JSE delivered growth in index dollar earnings per share of only 1.46% p.a and 5.5% p.a in rands, over the ten years. Barely ahead of inflation.

Source; Bloomberg Investec Wealth and Investec Wealth and Investment

Back in September 2009, US Treasury Bonds offered a guaranteed 3.4% p.a for ten years. A good yield by the standards of today. This meant, at that especially fraught time, investors would have required an average return of about 7.5% p.a. to justify a full weight in equities, assuming the same required extra equity risk premium of 4% p.a. Actual realized returns on the S&P therefore exceeded required returns by about a very substantial 6% p.a.

Time has proved that the risks of financial failure in the US were greatly exaggerated. The lower entry price for bearing equity risk ten years ago, reflected by Index values of the time, proved unusually attractive.

Dividends per JSE Index share by contrast with earnings have grown from the equivalent of R100 in 2009 to R324 in September 2019 while earnings per share have no more than doubled. The ratio of the JSE index to its dividends was 41 times in 2009- it is now only 27 times. The ratio of the Index to its trailing earnings per share was 16 times in 2009 – and is the same 16 times today. There has been no derating or rerating for the JSE. See figure below

The JSE over the past ten years. Values, earnings and dividends (2009=100) Price to earnings and dividend ratios.

Source; Bloomberg Investec Wealth and Investec Wealth and Investment

The equivalent required risk adjusted return of the highly diversified S&P 500 Index today is a mere 5.8% p.a. on average. With long RSA bond yields now offering close to 9% p.a. the required risk adjusted return from the average company listed on the JSE is now at least 13% p.a.

It has become increasingly difficult given slow growth and low inflation for a SA based company to add value for shareholders by earning returns on its capital expenditure  of over 14% p.a.  . And SA business has responded accordingly by saving and investing less and paying out dividends at a much faster rate. This is not good news for business or the economy. JSE listed companies would be much more valuable if they could justify investing more and paying out less- as US companies have done.

They need encouragement from faster growth in their revenues and earnings and lower interest rates. Lower short-term interest rates are in the power of the Reserve Bank and if reduced could help stimulate extra spending by households. SA business and its share market also need the encouragement of lower required long-term returns. That is from the lower long-term interest rates that would come with less inflation expected. Less inflation expected (and consequently lower interest rates) means a growing belief that SA will not fall into a debt trap and print money to escape it- that could be highly inflationary. So far and after the MTBPS last week not obviously so good. The jury remains very much out on the ability of the SA government to manage its debts successfully and the cost of capital for SA business has become even still more elevated.

The very large weighting of Naspers in leading indices like the JSE Swix and the JSE All Share Index has major implications for active and passive investors alike. Investors need to be aware of what this means for the risk attached to their portfolios.

 The original reason for constructing a stock exchange index was simple: to provide a statistic that summarised the price performance of the average company listed on a widely followed stock exchange. The calculation of such an average or index is supposed to represent the general direction of the equity market.

The most famous and oldest of the indices that tracks share prices on the New York Stock Exchange, the Dow Jones Industrial Average (DJIA), simply aggregates the US dollar share prices of the 30 largest US companies. The higher the prices of the individual shares included, the higher the DJIA and vice versa. The S&P 500 was introduced later and has become the most important of the global indices. In contrast with the DJIA, the S&P 500 tracks the market value of the 500 largest companies listed on the New York stock exchanges. The share price moves of the largest companies carry the most weight in the index and move the index proportionately.

Indices that attempt to summarise equity market performance, however, have much more than simply an informative role. They are also widely used to measure the ability of fund managers who actively manage their share portfolios and compete with other managers for assets to manage. Relative, as well as absolute price performance and returns, matter to both fund managers and their clients.

The performance (total returns in the form of price changes plus dividend income) of the funds they manage are not only compared to those of their rivals, but also to some relevant equity index. The ability to generate returns ahead of the benchmarks – the returns (theoretically) generated by the index (positive or negative) – becomes their measure of success or failure. Conventional wisdom now dictates that index-beating returns, beating the market (after fees), is the only reason for active management. We will show why this is incorrect.

A passive approach

Because of the difficulty that the average equity fund manager faces in trying to perform better than the index, there has been a large move to so-called passive equity investment strategies. Investors simply track some index by dividing their equity portfolios in exactly the same proportions (weights) as the shares included in the index.

Index tracking funds (under the banner of the so-called exchange traded funds or ETFs) have been created in large numbers by different fund management houses to facilitate such an investment strategy. This process generates no more or less than index-equivalent returns for the investor. The advantage for the investor is that since no knowledge or experience of the market place is needed – only a suitably programmed computer – the fees charged for the service (usually measured as a percentage of the assets under management) can be far lower than the fees typically paid for actively managed portfolios. These latter fees are charged to cover the higher costs of active managers, for example the salaries of the stock pickers and their analysts, as well as the trading and marketing costs incurred by the firms.

The ETFs and their originators and managers are therefore taking full advantage of highly efficient and competitive equity markets, without contributing to the process of price discovery. It is this efficiency in processing information about companies and the economic and political forces that will influence their future profitability (and their current value) that makes the share market so difficult to beat. Such information comes without expense for the passive investor.

Another expensive responsibility incurred by active shareholders is the surveillance of the managers of the companies in which they invest client wealth. This responsibility and the accompanying costs are largely avoided by passive investors.  Good corporate governance demands that shareholders cast their votes on corporate actions by exercising proper diligence, which has a cost. Engaging actively with company managers is essential for active investors but not for index trackers.

The index trackers are free riders on the investment bus, paid for by others. The proportion of funds that would have to be actively managed to make for a well-informed, efficient marketplace and to keep the investment bus rolling cannot be known with any degree of certainty. If all investors simply followed rather than led, the market would be full of valuation anomalies, from which only a few active investors could become fabulously wealthy by exploiting the valuation gaps.

The relevance of risk

Prospects like these are what encourage active investors to take risks. Think of hedge fund managers who take large risks in exchange for prospectively (not always realised) large returns. They also add helpful liquidity to the market that facilitates trading activity by risk averse investors. It is the expected distribution of returns, the small chances of a big win on the markets and the potential to achieve long run returns sustained well above average market returns that explains some of the preference for active managers. A select few of these (though we never know which few) will always beat the market by a large and sustainable margin.

This raises an all-important issue. Investment decisions and the make-up of investment portfolios are not determined only by prospective returns. The risk attached to such prospective returns is at least as relevant for the average wealth owner saving for retirement or a rainy day. This is the risk that the portfolio can lose as well as gain value. Stock market indices and the ETFs that track them can be more or less risky, depending on their character and composition. An essential requirement of a low-risk equity portfolio, actively or passively managed, is that it should be well diversified against risks that individual companies are exposed to.

This is achieved by spreading the portfolio among a large number of shares, none of which should account for a large proportion of the portfolio. The threats to the value of a share of a company that comes from adverse circumstances beyond the control of all company managers – i.e war, revolution, taxation, expropriation, regulation, inflation and financial crises – can only be mitigated by diversifying the wealth owners’ total portfolio across different asset classes, such as bonds, cash or real assets – or different jurisdictions. Index-tracking ETFs can simulate a particular equity market or well traded sector of it. But designing an optimal, risk-aware total portfolio – how much equity or other risks a wealth owner should assume – calls for more complicated considerations.

An important consideration for any investor tracking some equity market index is the issue of how well diversified the index being tracked is. A further consideration is which equity markets should be tracked given their very different risk profiles and how they are constructed.

The S&P 500 is very clearly well diversified against US company specific risks. The JSE All Share Index, by contrast, is not well diversified, nor is the JSE Top 40 Index nor the JSE Shareholder Weighted Index (Swix), which has largely superseded the other JSE indices as the benchmark for measuring the performance of SA equity managers. The Swix is weighted by the shares of the company registered by the JSE itself, as opposed to shares registered for transfer on other exchanges where the company may also have a primary or secondary listing. The larger the value of the shares registered by the JSE (Strate), the larger the weight that company will be allocated in the Swix. It should be understood as a measure of the proportion of the shares registered for transfer in SA, not necessarily of the share of the company owned by South Africans.

How diversified is your index?

The largest company currently included in the S&P 500 Index is Apple, with an S&P 500 Index weighting of only about 3%. The largest 100 of the S&P 500 account for about 60% of the index. In strong contrast, the largest company included in the market capitalisation-weighted JSE All Share Index in November 2016 was Naspers, with a weight of 17.14% in the Index. The next largest company included was British American Tobacco, with a much smaller weight of 4.31% followed by Sasol with 4.08%. The largest 10 companies included in the All Share Index now account for as much as 42.6% of its weighting – it’s clearly a much less diversified index than the S&P 500. Until its recent takeover, SABMiller was accorded a large weight in the All Share Index and the other leading indices. It is no longer represented and its new owner, AB Inbev, while already listed on the JSE, at the time of writing had still to make an appearance in the indices. The weights in the Swix have become similarly lopsided as we show below in figure 1. The weight of Naspers in the Swix is now even larger than that accorded to it in the All Share Index.

The weight of Naspers in the JSE indices has risen automatically with the extraordinary and persistent increases in its share price. Naspers shares are also all registered on the JSE, though foreign investors hold a large proportion of the company. As important for increasing the weight of Naspers in the indices has been the near stagnant value of resource companies that once had a very large weight on the JSE, but whose valuations have increased very little over the same period.

From mining to media

In figure 2 we compare the Naspers share price with that of the JSE Resources Index. The Naspers share price has increased 26.4 times since June 2002 while the JSE Resources Index has not even doubled over the same period. In figure 3 we show consequently how the weight of resources in the JSE All Share Index has declined from over 40% in 2008 to about 15% today, a lower weighting than Naspers on its own. The Swix reveals a very similar pattern, according a very high weight and importance to the Naspers share price moves and much less importance to resource companies in the direction the index takes (and so any ETF that tracks the JSE All Share Index or Swix).

It is the rising Naspers share price and its growing and larger weight in the Swix that has made the latter the best performing of the local indices over the past 14 years. The differences in performance are significant. R100 invested in the Swix in 2002 with dividends reinvested (before fees and taxes) would have grown to R864 by November 2016. The same investment in the JSE Top 40 would only have realised R645, with the All Share Index and an equally weighted index of the 40 top companies performing somewhat better. Not only did the Swix deliver higher returns, but it did so with less volatility than the other indices, thanks to Naspers (see figures 4 and 5 below).

Clearly, choosing the right index to represent and track the JSE and measure the performance of active managers is an important decision for investors or their advisers to make. All indices are not alike and some can be expected to deliver returns with much greater risk or volatility than others.

The major JSE indices that might be used to deliver market equivalent returns by some tracker fund or others are not suitable for diversifying the specific company or sector risks that investors tracking the index will be exposed to. Naspers carries far too much weight and therefore exposes index-tracking investors to much more danger than would be appropriate for any risk averse portfolio. The same criticism could have been made of the composition of the JSE indices in 2008: they were too exposed to the specific risks that faced resource companies. Investing over 40% of an equity portfolio in resource stocks – with their well known dependence on highly unpredictable metal prices – is not something a risk averse investor would want. The same argument could be made of a current exposure to Naspers: investing up to 20% of a portfolio in one company would be regarded as highly unwise.

Wise and risk averse active managers presumably would not have allocated 40% of their portfolios to resource companies in 2008. And, they would have been much more likely to have outperformed the indices over the subsequent eight to nine years as resource valuations fell away. They would also have done even better with a larger-than-index weight in Naspers. But the risk conscious fund manager would have had to become ever more cautious about exposure to Naspers after 2013, when its weight in the index began to exceed 10%. Prudence would suggest that no more than 10% of any equity portfolio should be invested in any one company.

Given this, along with the current 18% plus weight of Naspers in the leading SA indices, active managers are therefore much more likely to underperform the index when Naspers is outpacing other stocks, as has been the case until recently. Conversely, they would outperform should Naspers lag behind the other stocks included in the index. The case for or against active management in SA should not have to depend on the fortunes of one company.

Judging the performance of a fund manager in South Africa by reference to a very poorly diversified Index like the JSE All Share Index or Swix would not be an appropriate exercise. Realised returns should always be compared to the risks that were taken to achieve those returns. The task of the active manager is not simply to aim at the highest returns for their clients, they should also be managing risk.

Recognising the risk tolerance of their clients and allocating assets and planning savings accordingly is a large part of a fund manager’s duties. This is even more important when the market (index) carries identifiable and unjustifiable risk as the JSE indices have done and continue to do. Even when the active investor has not beaten the market, the advice offered can be very valuable.

There is incidentally no risk when calculating past performance. Risks apply only to expected performance – not to known past performance. Investing in an index tracker is not a decision that can be made passively because such advice is not easily provided by a robot and is worth paying extra for, or ignored at the investor’s peril.

Note: I am indebted to Chris Holdsworth of Investec Securities who painstakingly undertook all the Index and return calculations that are used and represented in this report. All the indices used in the study are dynamic ones representing the indices and the sector and share weights in them, as they occurred over time.

 A brilliant success story

When the financial history of South Africa in the first two decades of the 21^st century comes to be written, the role played by Naspers (NPN) will surely be a prominent one. Its achievements reflect many of the important themes of our financial times- not only that of outstanding returns to share-holders that made NPN by far the most important contributor to the JSE – with a weight in the JSE market Indexes of about 17% and a market value that rose from R7b in 2003 to nearly R85b by the end of 2016. But as important and interesting is that the value added for shareholders came from participating in the new digital economy and by taking excellent advantage of South Africa’s newly acquired democratic credentials and consequent access to global markets in goods services and capital.

Fig.1; Naspers (NPN) Market Value and share of the JSE Swix Index

Source; Bloomberg, Investec Wealth and Investment

The most important decision made by NPN management was the decision taken in 2001 to purchase 46.5% of Tencent (a Chinese internet business listed in HongKong for USD34m.[1] This stake has since been reduced to a 34.33 per cent holding. As we show below the rand value of Tencent itself, when converted to ZAR at the current rates of exchange, is now over R3000b and the theoretical or potential worth of the NPN stake in Tencent to over R1000b.

Fig 2. Market Value R millions of Hong Kong listed Tencent and the theoretical value 34.33% NPN stake in it. 2007-2016. Month end data

Source; Bloomberg, Investec Wealth and Investment

The theoretical not actual value of the stake in Tencent

The theoretical nature of this estimate deserves emphasis. Firstly because its holding in Tencent is worth more than the value of NPN itself as we show in figure 3- some 22% or R216b less than its holding in Tencent.  This implies that all the other assets of NPN in which it has made very large investments have a large negative value for shareholders of as much as R216b.

Fig 3; The market value of NPN and its stake in Tencent (Rm) (Month end data 2014-2016)

Source; Bloomberg, Investec Wealth and Investment

The link nevertheless between the share value of NPN and Tencent Holdings is very close – notwithstanding the fact that NPN now seems to be worth significantly less than its holding in Tencent. The correlation of the daily level of two share prices measured in ZAR is 0.99 indicating that almost all of the price level of NPN in ZAR can be attributed to its holding in Tencent and the current value of a Tencent share.

NPN is much more than a holding company for Tencent shares- but what is its other business worth?

NPN, as a business enterprise, however is much more than a holding company for its investment in Tencent, as its cash flow statement for the latest financial year to March 2016, demonstrates very fully. NPN reports dividend income in 2016 (mostly from Tencent) of USD146m compared to net cash utilised in investment activity by NPN in FY 2016 of USD1,384m. This investment activity in 2016 was facilitated by additional equity and debt raised in 2016 of USD4470m of which USD2270m was applied to repaying existing debts.

The implication often drawn by investment analysts when comparing the value of NPN to its sum of parts- including the Tencent holding – is that all this investment activity undertaken by NPN management destroys rather than adds significant value for its shareholders. But such a conclusion, or rather the scale of this presumed value destruction, is perhaps not nearly as obvious as it may seem on the surface.

It is firstly not at all clear that NPN would ever be willing or indeed able to dispose of its holding in Tencent.  Even if NPN were willing sellers, such a disposal might well be subject to the approval of the Chinese authorities. These authorities would be concerned about who might acquire these rights to the revenue and income from NPN- for example US internet companies that have a dominant share of the global internet business that might not be welcome in China.

Thus valuing the NPN holding in Tencent, as if it could be easily disposed of a current market prices – or even unbundled to its NPN shareholders- may well be an invalid assumption. In reality the NPN stake in Tencent may well be more conservatively valued in the market place as an illiquid asset and so worth less than it appears on the surface- that is valued at less than the prevailing market value of Tencent- but exactly how much less would be a matter of judgment.

Moreover if there is no NPN intention or ability to dispose of its Tencent stake then its value to NPN shareholders will depend on the uses to which NPN puts the dividend income it receives from Tencent, and perhaps more important the borrowing capacity its stake in Tencent may give NPN and the debt capital it raises to fund investment expenditure.

The NPN cash flow statement for financial year indicates significant investment and financial activity as discussed above. The cash flow statement also refers to NPN dividend payments of USD254m in 2016. That is dividends paid to NPN shareholders in 2016 exceeded the dividends received from Tencent and other investments. Clearly these dividend payments are not valued as highly as dividends paid by Tencent a point to which we return below.

Tencent listed in Hong Kong is no ordinary company

The full nature of the holdings of NPN and other shareholders in Tencent Holdings in Hong Kong deserves full recognition. These holdings do not represent an ownership stake in the usual sense. Tencent Holdings in Hong Kong provide its shareholders with contractual rather than ownership rights. They only have rights to the revenues, earnings and dividends generated by the Chinese owned operating company provided by Tencent Holdings- not to the assets of the company in China that have to be owned by Chinese citizens. Accordingly these right holders have no claim on the assets of the company should they have to be liquidated, unless they are Chinese owners. The contractual right is only to a share of revenues earnings and most obviously to dividends- not to the assets of the company operating in China that is limited by law to Chinese citizens.

Foreign ownership of internet and media companies in China including Tencent is prohibited. These ownership restrictions were however overcome and access to foreign capital achieved by Chinese entrepreneurs, including those who founded and developed Tencent, through contractual arrangements known as Variable Interest Entities (VIE’s) of which Ten Cent Holdings listed in Hong Kong is but one of many such entities listed outside of China. The note from Reuters on Alibaba written in September 2016 – a large rival to Tencent Chinese owned internet company –more recently listed in New York –explains the nature of a VIE.

Report from Reuters on VIE’s September 2016

Sept 9 (Reuters) – When Alibaba Group Holding Ltd sells more than $20 billion in shares on the New York Stock Exchange next week, investors won’t be buying equity in China’s biggest e-commerce company. Instead, they will buy into a firm that owns the rights to participate in the revenue created by a handful of Alibaba’s e-commerce and advertising businesses.

* Alibaba Group is set up as a traditional variable interest entity (VIE) structure – an elaborate legal arrangement designed 14 years ago to help Chinese tech and financial companies that hold restricted government-issued domestic licenses raise money overseas.

* VIE structures allow offshore-listed companies to consolidate domestic Chinese firms in their financial statements by creating the appearance of ownership.

* Of the more than 200 Chinese companies listed on the New York Stock Exchange and the NASDAQ, 95 use a VIE structure and have audited financial filings for 2013, according to ChinaRAI, a Beijing-based business consultancy. They include China’s biggest internet companies, such as Baidu Inc and JD.com Inc.

* VIE structures typically involve offshore holding companies in the Cayman Islands and British Virgin Islands; Hong Kong subsidiary enterprises; Chinese wholly foreign-owned enterprises (WFOEs); and local operating companies. The Chinese operating companies that anchor the arrangement are called the VIEs and hold the Chinese licenses that are restricted to domestic companies – in Alibaba’s case, primarily internet content provider licenses.

* Alibaba’s VIE structure comprises five local operating companies, each of which is 80 percent-held by co-founder and executive chairman Jack Ma, and 20 percent by long-term executive Simon Xie – except for Zhejiang Taobao Network Co, which is 90 percent-held by Ma.

* A series of technical services, loan, exclusive call option, proxy, and equity pledge agreements bind the domestic firms to the WFOEs and create the “variable interest” – allowing offshore Alibaba Group shareholders the appearance of control of the local companies.

* The contracts also are meant to provide a legal framework of checks and balances to guarantee that the ultimate stakeholders of the local operating companies act in accordance with the wishes of the offshore listed company’s shareholders. On occasion, such contracts have been broken. In 2010, for example, Ma unwound the contracts for Alibaba’s Alipay unit, triggering a dispute with major shareholders, including Yahoo Inc.

* The VIE structure has never been tested by courts in China.

* In its pre-IPO filings, Alibaba cautions investors that it can’t guarantee its VIE shareholders “will always act in the best interests of our company”, and that if the Alibaba VIE shareholders breach their contracts, “we may have to incur substantial costs and expend additional resources to enforce such arrangements.” (Compiled by Matthew Miller; Editing by Ian Geoghegan)

Thus the value of these contractual right to the revenue, earnings and dividend streams generated by these VIE’s is subject to significant uncertainty that is surely recognised in the prices of their shares listed outside of China. Thus any negative impact on the value to the beneficiaries of these VIE’s arrangements will however also apply to the rights enjoyed by all owners in Tencent Holdings listed in Hong Kong- including those held by NPN. Any VIE discount attached to the rights in Tencent traded in Hong Kong would already be reflected in the Tencent share price.

The value of the dividends paid by Tencent- valuing dividends to recognise value destruction- and the value add opportunity.

The direct benefits to NPN shareholders have come in the form of dividends received from Tencent. These as may be seen have grown spectacularly both in USD and even more so in ZAR. By year end 2016 the .3433 per cent of the dividends flowing to NPN would have been of the order of USD200m or R2700m at current exchange rates. These dividends have grown spectacularly- at an average annual compound rate of about 42% p.a. in USD and 51% p.a when measured in ZAR since 2017. (See below)

Fig 4. Tencent dividend and earnings flows to shareholders. (2007-2016)

Source; Bloomberg, Investec Wealth and Investment

These growth rates and the expectation they would be sustained, have been reflected in the values attached to shares in Tencent Holdings. As we show below the Tencent shares as at December 31^st 2016 traded at 42.1 times reported earnings and an even more spectacular 403.6 times reported dividends. (see figure 5 and 6 below where we show the trailing Tencent earnings and dividend yields and multiples.) The dividend yield (D/P) as at end December 2016 was 0.247 and the earnings yield (E/P) 2.37.

Fig 5; Tencent Holdings; Earnings and Dividend Yields Daily (Data 2007-2016)

Source; Bloomberg, Investec Wealth and Investment

Fig 6; Tencent Holdings; Price/Dividends and Price/Earnings Ratios (Daily data 2007-2016)

Source; Bloomberg, Investec Wealth and Investment

Were the dividends received from Tencent by NPN shareholders accorded the same price multiples as those accorded to Tencent shareholders themselves this .3433 share of the dividends paid by Tencent would command a value of about USD79b or ZAR1,085b, at prevailing exchange rates, that is well ahead of the ZAR850b of NPN market value recorded at year end 2016. Another way of putting this would be to say that the dividend stream paid by Tencent to its shareholders would now be worth R200b more if NPN shareholders could receive these dividends directly rather than via NPN. As indicated earlier unbundling these shares is not a choice NPN is likely to make- nor may it be a feasible option given Chinese sensitivities. What however might well be possible would be for NPN to create a Tracking Stock to track its Tencent Holding[2]. It could in other words further contract with its shareholders to pay out all the dividends it receives from Tencent directly to them and that these rights to the Tencent dividends could be traded separately in the market place. NPN would continue to own its Tencent rights so no change in control would have occurred and such ownership rights as before would be reflected on its balance sheet. The NPN, Tencent tracking stock would then presumably be a pure clone of Tencent itself and so command the same value- that is 400 times the dividends paid out. NPN shareholders would then be about ZAR200b better off.

Furthermore the shareholders and NPN managers would then know very precisely the value added or lost by the investment activity undertaken by NPN. The rump of NPN- net of the explicit value of its Tracking Stock – would very objectively measure how much the other assets of NPN – in which it has invested so heavily – are actually worth to shareholders. The case for adding to such assets- including raising debt to the purpose – would then presumably have to be a good one. In addition, with dividends flowing through the tracking stock, NPN could make the case for reducing its own dividend payments- and investing the cash. That is if NPN could realistically expect returns that would exceed its cost of capital, above required risk adjusted returns, and so add value for shareholders.

In line with much market commentary, is it unfair to suggest, that the complications inherent in valuing the Tencent stake in NPN has encouraged poor capital management by NPN? The large difference, approximately R200b between the value of the Tencent dividends received by NPN and the value of NPN itself strongly suggests that NPN is not expected to add value for its shareholders through its investment activity.

Recognising objectively the value of the Tencent stake through the market value of its tracking stock will help expose the significant other business of NPN to the essential disciplines that should govern the use of shareholder capital. This surely would be good for NPN shareholders.

Conclusion

For all its past success the management and directors of NPN have a very large problem with investors. The market reveals that NPN would be worth much more to its shareholders if it sold off all its assets and paid off its debts. The assets it has invested so heavily in (in addition to its investment in Tencent) would have significant positive value in other hands- surely many hundred of billions of rands. But such sales or unbundling of assets is regarded as a very unlikely event hence the lower sum of parts value attached to NPN.

What the market is telling NPN management is that its impressive investment programme is expected to destroy many billions of shareholder value. That is the cash to be invested, by NPN, is thought to be worth many billions more than the value of the extra assets the company will come to own and manage. This investment programme is a very ambitious one. In FY 2016 the company reported development expenditure of USD961m and M&A activity of USD1495m.

Clearly the NPN directors and management must believe differently, that the cash it intends to invest on such a large scale will add value for shareholders- that is return more than the cost of this capital- that is achieve an internal return of at least 8% p.a when measured in USD or 14% p.a in rands. If it achieves such returns it will add rather than destroy value for shareholders.

But there is room for an important compromise between sceptical investors and confident managers. And that is to separate the Tencent investment from the rest of the business. If NPN established a tracking stock that passed on the dividends directly to its shareholders this tracking stock would be valued at approximately 400*R2.7b, or approximately R1080b – about 200b rand more than the current market value of NPN itself. This tracking stock would be a pure clone of Tencent- perhaps also listed in Hong Kong and can be expected to trade on the same dividend generating basis as Tencent itself.

Shareholders would surely greatly appreciate an immediate  R200b plus value add – and the growing dividend flows from Tencent- via NPN. And the quality of NPN management could then be measured much more clearly without the complications and comfort of its Tencent stake.

[1] The listing in HK on the Hang Seng exchange is abbreviated as 700HK

[2] For a full analysis of Tracking Stocks and their feasibility see

J Castle and B Kantor,  Tracking stocks – an alternative to unbundling for the South African group, The Investment Analysts Journal, 2001 51(4), also to be found on the website www.zaeconomist.co, Research Archive.