The Ingham Analytics Weekly Letter on Sunday - 13 September 2020

Sunday, 13 September 2020

Welcome to another Ingham Analytics Weekly Letter on Sunday in which we aim, inter alia, to take a step back to see the wood for trees.

Several results were published on the Johannesburg Stock Exchange this week, the most notable including Shoprite, Sanlam, Aspen, FirstRand, and AVI.

Bell Equipment also reported interim results. This is a high-quality business with impressive world-class products. Bell is a 39% majority family-owned company that hasn't enjoyed the rating it truly deserves, but not alone among many small and mid-sized companies on the JSE that languish on unloved valuations.

Going private is one option to consider for Bell. In this regard, we note with interest the memorandum of understanding in respect of a possible purchase of John Deere's 31% shareholding by the family through I A Bell & Co - named for the founder Irvine Bell.

Family businesses have differing track records - clogs to clogs in three generations is an age-old adage but it doesn't necessarily always apply. Bell is an example of a business with strong family roots, but it is professionally managed through proven principles of governance, an ethos that hasn't changed much since its founding in 1954 and a passion for innovation. Pick n Pay and Richemont have similar positive family influences.

Outside of the JSE listed sector, there are many family businesses quietly going about their business, some remarkably large in their sectors - packaging and steel spring to mind.

Germany is the largest economy in Europe but its equity market is relatively small. The Dax top 30 is less than a quarter of GDP. For historical reasons, there isn't the same equity culture you find in Anglo countries. Of the top 500 German companies by revenue, only 10% of them are listed, with the balance all privately-owned. One family-owned business, the Schwarz Gruppe, is the second largest company by revenue in Germany.

There is a phrase "integrity is doing the right thing, even when no one is watching." This is often credited to the British writer and lay theologian C.S. Lewis but even his foundation says that this is a misattribution. Nevertheless, the point made is revealing and often forgotten in this day of institutionalised "corporate governance."

Environmental, social and governance or ESG now features to a lesser or greater extent in integrated reporting. But listed companies are a fraction of the companies in existence worldwide. The majority, therefore, go about their business with the integrity definition above as their only compass.

ESG is a factor that analysts and fund managers are increasingly taking cognizance of but it must be lived, it cannot be measured with an abacus alone.

Just this week BHP publicly declared that the mining group will partially link the chief executive's bonus to the lowering of greenhouse gas emissions at both its own operations and those of its customers. Here is a quantitative guideline, not necessarily easy to gauge but at least the thinking is there.

Also, in mining news is Rio Tinto, a BHP competitor. 90% of earnings in the latest interim were from iron ore and during the past five years over 60% was from iron ore. This week, the price of 62% Fe fines climbed to $128/ton, the highest in several years. The share price of Kumba on the JSE is at five-year highs, closing at R542 on Friday.

But Rio Tinto is in the news not for a skyrocketing iron ore price but for rocky reasons. Its CEO and two other execs fell on their swords this week over the contentious destruction of the Juukan rockshelters in May 2020 in Australia. This is despite the fact that the company had permission to mine there. Legally, Rio Tinto did no wrong.

But local custodians of the land, the Puutu Kunti Kurrama and Pinikura people, fought a tenacious battle against it. It was the ethical dimension of Rio Tinto that was questionable. Integrity was absent.

Growing numbers of people around the world deliberately shop with companies that they believe are ethical and sustainable. It doesn't matter whether you're selling baked beans or insurance the customer base is becoming increasingly discerning with their hard-earned money. Tick-box ESG also doesn't cut it for long if it is perceived to be disingenuous.

We issued notes this week on Capitec ("Looking for dips") and Softbank ("The devil incarnate, Softbank?"), the latter entity being confusingly named because it could understandably be thought of as a bank rather than a telecommunications and much else besides Japanese conglomerate.

The Capitec name carries positive connotations within its growing customers base. Capitec is an example of a management team that continues to build and reinforce confidence in their business, which in the banking sector is imperative. Their reporting is timely - typically a month after cut-off. The timeliness and quality of disclosure are key to depositor, borrower and shareholder confidence.

Yes, Capitec will report lower earnings but it'll get through and investors and their customers too will look though this black swan event. The froth was taken off the share price and Capitec began once again to offer value for new money, as we pointed out in "Rating retreat." The share's up 20% since.

Softbank, on the other hand, has been involved in what we see as engineering, manipulating is another word, a fractured tech market in the US. Listed on the Tokyo Stock Exchange since December 2018 we point out that its segmental reporting disclosure gives new meaning to the word opaque and would challenge even the most imaginative analyst to unpack.

Softbank has been the buyer of enormous quantities of leveraged call options on US mega-tech shares such as Tesla with the result being a distortion of the usual internal dynamics of the equity markets.

Bets on call options have been rising of late to record levels. Options bets that the S&P 500 will keep going up have doubled, far exceeding trading in securities that would be used to bet on an imminent decline in stock values. The gap between call volumes and put options is the largest since the dotcom.

The mathematics behind this is complex so we've tried as best we can to explain the mechanics of what Softbank has been up to in the note, including a case study to illustrate how enormous the profits can be. But on the flip side, someone is taking a loss. We believe that the processes put in play explain why tech has exploded and why tech has the ingredients to implode.

Context in life is useful and in the inflated US stock market currently there is no better context than comparing Tesla and Volkswagen.

Last week, Tesla boss Elon Musk, seeing as he was in Germany, made a brief stop-over at Braunschweig Airport to have a meeting with the VW CEO Herbert Diess and have a drive in the new VW ID.3 electric car.

The comparison with Tesla is astonishing with a vast chasm in scale between the two.

COVID-19 aside, VW makes real money, is cash generative ("13.5 bn in net cash flow), makes a return on sales ("252bn or 10x Tesla) of 7.6% with ROE at 11% and ploughed 6.7% of its automotive revenue into R&D ("14.3bn over 10x Tesla).

VW volumes sales last year were 11m units across all brands which is 30x what Tesla managed to make.

VW has total asset of "488bn or $575bn that are 17x that of Tesla whilst shareholder equity of "122bn or $144bn is 22x that of Tesla.

VW pays a dividend and on last year's payout gave a nice dividend yield of 4.4%. Sure, the dividend will be impacted this year because of COVID-19 disruption, it may even be waived, but it shows investors what it'll be in a normalised world. The trailing PE ratio is a laughably low 5.5x currently. Yet, even after last week's sell off Tesla has a market cap 4x that of VW.

Volkswagen has also teamed up with Amazon Web Services and Siemens in an Industrial Cloud venture so it's not devoid of what is shaping the tech economy either. The VW electric vehicle programme looks like a winner too.

But integrity transgressions have come to bite VW through "Dieselgate" which has hit it financially, bruised its reputation and resulted in VW being removed from several sustainability indices.

The fact that Softbank is listed on the Tokyo Stock Exchange is an interesting coincidence given that Berkshire Hathaway has just recently taken a shine to Japanese listed entities. The group best known for its founder Warren Buffett has taken stakes of over 5% ($6bn) in five top Japanese conglomerates - Mitsubishi, Mitsui, Sumitomo, Itochu and Marubeni.

Getting a clear handle on such Japanese conglomerates with widely disparate interests can be a challenge and also makes for tricky valuation, which partly explains their relative cheapness. Investors need to do their homework. And as we've seen with the Renault-Nissan "alliance", all sorts of unseemly stuff can emerge, as was the case with Carlos Ghosn scandal which is a witch-hunt or a failure of oversight of a recalcitrant individual depending on which version you read.

Reed Hastings, co-CEO of Netflix and founder, has just published a new book called "No Rules Rules: Netflix and the Culture of Reinvention." The man is a farsighted person who has reshaped the way people watch television and how the entertainment industry operates. He grasped early that the internet was the future of distribution.

Netflix is a stock we rate and although a bit pricey currently believe it'll serve investors well over time. The company is forecastable within reason and is reporting rapidly growing earnings with ever lower forward PE multiples the result.

The name Netflix loosely gets bracketed in "tech" along with the Amazon's of this world, but we see this as an incorrect categorisation. It is classified by MSCI under the communication services overall sector and the media and entertainment sub-sector.

Hastings offers several fascinating insights in a recent interview about his book. He's no fan of work-from-home it seems. Asked if he'd seen benefits from people working at home, he answered "No. I don't see any positives." Hastings reckons the post COVID world will bear striking similarities with the pre COVID world stating that "if I had to guess, the five-day workweek will become four days in the office while one day is virtual from home. I'd bet that's where a lot of companies end up."

We tend to agree with Hastings so don't dump those overseas listed office REITs you may hold just yet. They may be down, but they probably won't be out.

Back to Capitec, we cautioned on Friday against ebullience in any of the banks, coming off relatively deflated levels, and that profit taking should be considered now.

Thank you all for visiting us.