The “true” value of the Rand? How about R6=$1; JSE-listed heavyweights trading at double true value. Adrian Saville sure doesn’t go for fashion.

Adrian Saville
Cannon Asset Management CIO Adrian Saville: Sounding the warning bells about overpriced JSE stocks

Some great investment analysis to get your teeth into. Adrian Saville is the CIO of Cannon Asset Managers and an associate professor at GIBS, Africa’s top ranked business school. Fascinating interview below. How’s this for an appetiser: a realistic value for the Rand is R6 to the US Dollar; some of JSE heavyweight stocks are more than double the price they should be. Talk about swimming against the tide. But you dismiss Saville at your peril. His arguments are rational. He knows what he’s talking about. Take note. – AH  

To watch my interview with Adrian Saville on CNBC Africa’s Investment 360 programme click here.

ALEC HOGG: There are a wide range of factors that can affect the performance of your investments, but the impact of the changing value of the Rand is itself multi-faceted. Despite this, having insight into the influence that changes in currency values have on investments provides opportunities to benefit both in the short and the long-term. Adrian Saville is the CIO of Canon Asset Managers. He joins me now to talk about the Rand and a second subject that we’ll be touching on – the disconnect between market drivers and valuations and the JSE getting ever higher despite the sluggish economy. Let’s start with the Rand because that’s kind of a good news story. Many South Africans are of the opinion that the Rand is again now a one-way bet; that it will be falling indefinitely. You did some research to suggest that’s not actually the case.

ADRIAN SAVILLE: Well, we think there are a number of reasons to believe the exact opposite. There are various arguments that suggest the Rand should be/could be substantially stronger than the current R10.00 level, not least of which is the fact that whilst many of the world’s biggest central banks have been printing money with wild abandon for the last couple of years since the onset of QE (Quantitative Easing), the South African Reserve Bank has displayed the most remarkable discipline and has managed the currency impeccably.

 ALEC HOGG: Explain Quantitative Easing. Because wherever one talks with people from the investment world it’s thrown out – QE – as though it’s something that is very scientific and very well put-together and measured and thought and processed. What’s Quantitative Easing in your mind?

 ADRIAN SAVILLE: If you are the United States you undertake a policy called Quantitative Easing. If you are Zimbabwe you undertake a policy called printing money. They are essentially one and the same thing.

ALEC HOGG: So what Governor Gono did in Zimbabwe to get hyper-inflation is very similar to what America’s doing.

 ADRIAN SAVILLE: It’s just the difference in terms of the magnitude. Obviously Zimbabwe printed money furiously and we’ve seen other examples of where furious printing of money leads to massive inflation. You can go back to Germany in the 1930’s or some parts of Eastern Europe just after World War 2, Latin America in the 1970’/1980’s… Quantitative Easing as we see it today is in the same form and it reflects or represents the printing of money. But the term ‘Quantitative Easing’ I suppose does suggest that there is a greater discipline and a more scientific approach.

ALEC HOGG: Is there?

 ADRIAN SAVILLE: Look, I’m on the side of the cynics on this one. I’ve yet to see a case where wild printing of money or extensive printing of money – perhaps ‘wild’ is unfair – extensive printing of money doesn’t translate into inflation. And if you have an economy of a given size and you print substantially more money in that given economy then it has to follow that the same money is chasing fewer goods and the net result is inflation.

ALEC HOGG: Why hasn’t it happened? I’ll take you back to Hathaway this year. Even Warren Buffett said he was flummoxed. He doesn’t understand why, with all this printing of money, inflation has not risen yet.

 ADRIAN SAVILLE: I think that’s a great question and there are a couple of factors that are at play here. The first one is that whilst the Reserve Bank – whilst the Fed US Central Bank or Reserve Bank has printed money; it’s gone into the banking system and then it stalled in the banking system, so the banks haven’t on-lent which means the typical credit extension that is associated with the printing of money hasn’t come about. There has been some credit extension, but not wild lending that you would conventionally get. The second – I’m going to be cynical again – and my cynicism says that there is inflation and it comes in two forms. The one is that certain assets have displayed remarkable inflation. The oil price in 2007/2008 was $30.00. It’s now $100.00. The gold price has ramped up materially, so the price of commodities has lifted substantially. I would describe that as inflation. And the second is that I think in the US inflation is under-reported and so there is more inflation than we see in terms of official headline inflation.

ALEC HOGG: Adrian, just to bring it back to the Rand: The Rand as you said in the beginning; here’s a commodity that has been well-controlled. We haven’t created a whole lot more of it. The major trading partners have been doing exactly the opposite. If you take a three to five year view, are you suggesting then that the Rand in fact might be stronger at that point than it is today?

 ADRIAN SAVILLE: It may well be. And one of the greatest guides on currency…currency is notoriously difficult to forecast over almost any period. But if you allow for five years you should have enough time for economic forces to play and for political forces to rinse themselves out and sentiment to be washed out of the system. And if you use purchasing power parity, which I argue is one of the clearest guides on currency, purchasing power parity simply says that if a basket of goods costs so much in South Africa – R10.00 for this basket of goods (a Big Mac index) and if the basket of goods costs $1.00 in the United States then the exchange rate should be 10-1. And using that tool – purchasing power parity, we estimate that the Rand is more fairly linked at about R6.00 to the Dollar.

ALEC HOGG: That’s an interesting long-term view to start working into your portfolios. The other bit of research that you have done recently is having a look at the JSE hitting new records despite most of the economic news being glum. I was fascinated by your unpacking of the index itself, or the all-share index itself which is hardly what many people think; a reflection of the whole market.

 ADRIAN SAVILLE: The index is dominated by a small number of large companies as almost any capital-weighted index would be. In the case of the Johannesburg Stock Exchange over the last 12 months almost all of the lifting has been done by just a handful of large loved companies, which means that much of the acclaim of these substantial returns is not really broad-based and well-founded, but rather anchored in a small basket. Perversely, the Rand has a lot to do with this because currency has translated into companies like SAB, Naspers and Richmont which have substantial offshore earnings and/or offshore assets. Translating those back into Rands you get a lifted share price.

ALEC HOGG: So if you take the big two out, SAB Miller and Richmont: if you had a portfolio of shares and you had the market generally, excepting those two – you left those two out – how much would the difference have been?

 ADRIAN SAVILLE: Well, I think if you look at the All Share Index over 12 months, in our report the 12-month return is in the order of 27%. If you take just the two biggest out the number drops to just under 20%. And obviously the further out you push to capture more of the stocks, the more you can explain away. But in essence about ten companies explain almost all of the JSE’s return.

ALEC HOGG: Isn’t that a dangerous situation? Because if those ten companies have been outperforming and if they just have a normal year then the reverse that that would cause in the index generally would be quite serious if you’re heavily weighted towards it.

 ADRIAN SAVILLE: Well Alec, I’d say it’s only dangerous if the companies… Outperformance is gorgeous. It’s what we all want, but it becomes dangerous when that outperformance is fed by over-valuation and this is our concern about these large loved companies: is they have gone from being pretty richly priced 12/18 months ago to areas that… I now want some more animated adjectives to describe this over-valuation. SAB Miller is a great case in point. If you take, sort of, conventional metrics that would explain the performance of a company, growth and revenue, return on equity and operating profit margin; if those metrics had lifted substantially in the last year or two then you could say ‘well, this company is going to be worth a whole bunch more’, but they haven’t. The metrics that we see today are very similar to the metrics that we saw 5/10/15 years ago. SAB Miller however, has gone onto an enterprise value to EBITDA, which is essentially total value of the business against its mid-line profit. It now sits on a ratio of 23 times. As a value investor I start to get worried at about 10 times, at 15 times you wouldn’t see me and at 23 times – where it is now – this is remarkably stretched and I don’t think it represents investment opportunity. I think it represents risk.

ALEC HOGG: But Mr Market can change.

 ADRIAN SAVILLE: And when he changes he becomes grumpy very quickly. Now where could I be wrong in this? I could be wrong in that the financial or fundamental drivers have lifted permanently so that SAB Miller is going to start to produce or Richmont is going to start to produce much better return on equity/much higher permanent profit margins and/or they could be about to walk an arena in which their profit becomes substantially elevated and that 23 EBITDA falls to 10 times, which is rational, but I don’t see either of those coming about.

ALEC HOGG: If you overlay your view on the Rand or your longer-term view on the Rand then it becomes perhaps even more disconcerting given that those two stocks in particular and some of the others have been boosted by a weaker Rand.

ADRIAN SAVILLE: Absolutely. Although given my earlier observations about the impossibility of forecasting currency near-term it may well be that the Rand goes to R15.00 to the Dollar because of perverse sentiment or some unanticipated event – war – and emerging market sentiment runs away, it could transpire that the Rand goes to the R15.00 to the Dollar in which case this 23 EBITDA would unwind quite quickly.

ALEC HOGG: It would look wonderful.

ADRIAN SAVILLE: Ja.

ALEC HOGG: When you’re in the investment game though, the rule number one is ‘don’t lose money’ and rule number two is ‘don’t forget rule number one’. That, I guess, is what’s shaping your views here.

ADRIAN SAVILLE: I think that the single biggest…or the point of departure in investing, I don’t think is about ‘how much upside is there in this?’ but rather ‘how much downside is there?’ and in the worst case you have permanent destruction of capital and no subsequent brilliance recovers you from permanent destruction of capital. One hundred times zero is zero. So I think your rule one and rule two there are absolutely spot on and what we see here is that whilst there may be some upside, the risks that you’re taking and the multiples that you’re paying to participate in that upside, to me seems speculative in nature.60.

ALEC HOGG: Adrian Saville, thank you for coming through to the studio today. That was Adrian Saville, Chief Investment Officer of Canon Asset Management.

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