🔒 WEBINAR: How to Calculate the Intrinsic Value of a Stock

Value was a phrase first coined by Benjamin Graham (the father of value investing) but was modernised by Warren Buffett. Buffett’s championed the term, which has been at the root of the fortune he’s amassed with investment holding company Berkshire Hathaway. But how does one determine value, and more specifically intrinsic value? In this the very first Easy Equities, Biznews webinar, publisher Alec Hogg looked at the Intrinsic value of a stock, and applied his calculations to a couple of South African equities. It’s an informative webinar that goes a long way in giving a basic understanding to what the ‘value’ of a stock is. – Stuart Lowman

Welcome. I’m Alec Hogg and this is our Inaugural presentation for EasyEquities, the partner of Biznews in this special seminar for you. I think we just need to make sure. Stuart’s with me in the studio.
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Yes, good afternoon, all.

Stuart’s our Managing Editor at Biznews and he’s going to be picking up your questions. Are people connected there, Stuart?

Yes, Alec. We have about 46 at the moment. The question bar is just on the right-hand tab there. You can just plug the question in there and we’ll answer them as they come through.

Yes, so if you have any questions, please do that. This is interactive. I’m going to take you through a presentation but the idea is to stop me when you see anything that doesn’t make 100 percent sense. Stuart will be there to check that questions are coming through. Let’s get into it.

Intrinsic value is a big word and it’s quite a complicated subject, so I’m going to unpack it for you in a way that we can all understand.

According to Benjamin Graham there are two secrets to investing, which you can read in his book ‘The Intelligent Investor’. It’s the one book, which Buffett says you should read before anything else to do with investing. Those two secrets are quite simple to understand. The first one is to have a margin of safety before you buy a share and the second one is to understand this fellow, called Mr Market. Starting with the second one first, Mr Market is the guy who determines the share price on a daily basis. If you buy a house, nobody tells you that ‘your street is a bit cleaner today, so your house is worth R50.00 more’ but in the share market there are people trading all the time, and they will make the company’s value different on a daily basis, which of course it really isn’t. That’s the way that markets operate. Graham says, “Understand that that share price is there. The recording of the share price is there to serve you. You aren’t there to serve it.”

When Mr Market gets terribly enthusiastic as he does from time to time (we saw it in 1987, 1969, and in various stocks on a daily basis), then the price/value of that individual asset will be excessive (too high). You don’t buy. That’s not the time to buy. You wait for Mr Market to get depressed (for the price to get very lose) and that’s the time you buy. How do you know when the price is high or the price is low? Well, that is determined by intrinsic value, which we’ll tell you in a moment. The second point about the other secret to investing is to make sure that once you’ve worked out this intrinsic value…once you’ve got it in your head (what the company’s actually worth) then give yourself a margin of safety. We’ve got Mr Market, who’s a volatile manic-depressive without any medication, and then once you’ve established that you can take advantage of his erratic moods, and then you have to have this margin of safety. That means you give yourself a cushion…give yourself a reserve between what the company is worth and where you should be buying. The margin of safety: we like to work on a figure of about 20 percent. It’s a very good cushion.

Off we go to Warren Buffett and Charlie Munger. The way Warren Buffett describes intrinsic value – and remember this is where it all starts… Whatever share you buy, you need to understand before you make the purchase what the company’s actually worth. If you were buying a house for instance and going to a house, which is maybe worth R3m and because there’s a lot of activity in the area, somebody says it’s worth R5m (or they quote it at R5m) and you just accept it… Of course, you wouldn’t do that. You’d have a look at the real value f that property. Similarly, with shares. You need to understand what the shares are worth. Buffett says a share/a company is only worth this: the amount of cash that it can give back to you in your lifetime (in the lifetime of that company, as it were).

If the company is generating cash back to you then you can take the value of that cash into today’s money terms and that will give you what is called the intrinsic value. The difficult that comes in here is exactly how much tomorrow’s money is worth today. That brings in something called net present valuing of companies or of those cash flows. It can be a bit complicated. The other thing is, how long is the company going to last for? Buffett says, “The value of that company is the cash flow until judgment day”. We don’t know when judgment day is coming. If you’re investing in the U.S., you might think of judgement day in terms of ten years. If you’re investing in South Africa (because it’s a higher risk), then maybe you’d bring that down to five years. Think of it this way. You buy a little company around the corner. That company is generating R10, 000.00 per month in profit – R120, 000.00 per year.

What is it worth to you to pay for that little company? Well, if you’re going to be able to acquire it today and sell it in a year’s time… If the guy said to you, “Well, you can buy it for the next year’s profits (R120, 000.00) then obviously, you’d buy it because in a year’s time you’d be able to sell it on again. It’s what we call ‘the terminal value/the on-sale value’ after bringing in the cash flow, and the cash flow you have is R120, 000.00. Sell it for another R120, 00.00 in a year’s time. Actually, it’s worth R240, 000.00 each year. That’s what you’d be prepared to pay for it. If you think, “Well, I don’t mind hogging onto the company for two years” then you can get another year’s cash flow in it – and of course, that cash flow is going to grow every year – but let’s just keep it simple. Then it gets to R360m. It’s worth buying the company for, so you understand the concept. It’s the cash you get from the business and then the terminal value – in other words, what you sell the business for after a period of time.

I use five years in South Africa to be conservative. I need to know that it is a very, very conservative figure when we’re looking at the intrinsic value. The reason we have to have intrinsic value is that we need to have a feeling or an understanding of what that company’s worth…not to let Mr Market confuse us. I hope this is all coming through. Are you getting it, Stuart?

Yeah, it’s all good my side, thanks.

All right. I’m going to start off with the first of these Wilson Bayly…because it always works better when you use examples. This is the share price that Wilson Bayly Holmes-Ovcon (to give it, its full name)… It’s the country’s leading construction business, since 2009. As you can see, it’s done pretty much nothing. In the last seven years then, what has happened to this company? Well, they’ve done terribly well. The profits have grown. The company’s base has expanded. I looked at this and thought, “Well, what is this intrinsic value of WBHO? Was it overpriced in 2009 so that the share price hasn’t moved at all, or is it under-priced today? Are there other issues that might have come to play?”

Remember, there was a Competition Commission hearing where the construction companies were forced to pay quite big fines even though in this case, I think it was about 5000 contracts, which WBHO had where someone in the business had been naughty on six of them. It just shows you. It was more of an outlier than a problem within the business. This is the way I worked through it. I took some assumptions. Now, we’re trying to get to Warren Buffett’s approach of cash flow. He starts off with a thing, called free cash flow. Without confusing you too much, you can pick this up in the income statement. Alternatively, it’s best to work from an annual report. Remember, you don’t have to do this on a daily basis. You can do your analysis on a company once you see the annual report. Just look at it down the bottom. You’ll see there – at the bottom – it says ‘free cash flow calculation’.

We take the net income in the company (in other words, the profit after tax). We add back depreciation. What this means is that we add back the book entries, if you like. If you’re running a company, you get profit, which is your after-tax profit. You’ve paid the Government, your employees, and all your suppliers. In Wilson Bayly’s case, it was 513-million (what remained in 2015). Then you add back the book values, which have reduced the profit and that’s 296-million. What amortisation and depreciation really means is that if you make a capital investment, you can write it off over a period of time – over a number of years. Like if you were to buy a car and you had your own business, you can’t write off the total purchase of the car in Year 1. You’ve got to do it over the lifetime of that asset. Companies do the same thing. You’ve already spent the cash. The cash is gone. Where does that cash go?

Well, there it is – capital expenditure. You would then reduce because if you’ve got a cash amount that comes from profits, you write back the book entries but then you’ve to take into account what you’re spending on capital expenditure to remain competitive. That’s exactly, how you work out the free cash flow. After that, it will tell you how much you’ve got that you can actually, manage or that you have got to apply and to allocate. There it is. In Wilson Bayly’s case – 482-million. I put that into the top there. I anticipate that this company will grow at ten percent per year, which is not unrealistic because they’ve grown much faster than that in the past. Then I discount the future cash flows by a figure. If you think the company’s going to grow faster, you can put 15 in there. If you think it’s going to grow slower, you can put five in there. I discounted back…in my case, I used 7.8 percent because that’s the long-term growth of companies on the JSE – 7.8 percent.

I would discount that money back basically, to say that if Wilson Bayly can’t grow faster than 7.8 percent, why am I buying it? I can just buy the ETF via the Satrix 40. I’m bringing that back to today’s terms. Then you put that into this calculation here. It starts off at 482 (as you can see from the top). You add ten percent, less 7.8 down to the bottom and in Year 5 (remember we’re not going to Year 10 as you would internationally, because we’re trying to be conservative) we’re sitting at a number of 526-million. That will be the value at which, you work out your terminal value. In other words, you’re going to sell the business on in Year 5 and that brings you here to this one. NPV Year 5 x 12. Terminal value: R6bn. NPV’s of all five years (that’s the cash flows in all five years, because you’re going to hold this for five years): R2.5bn.

Then, how much cash is on the balance sheet of this company today? Clearly, that cash is not disappearing. That’s also what you own. There it is – nearly 4-billion. You put it together. In this case, you’ve got an intrinsic value of R12.8bn. Then you divide it by the number of shares in issue – R63m here – and it gives you an intrinsic value per share, of R203.00. It sounds complicated but if you work through each of the steps, one-by-one, you can actually work on this net present value quite comfortably to get yourself to a position. We’re saying that Wilson Bayly’s intrinsic value is around R200.00 per share. Remember, you must go with a range. Don’t say it’s R203.22 and I’ll buy the shares up to that point. No. I might be out in my calculations. It might not grow at ten percent. The discount rate might be lower or higher than that, so you need a bit of a range.

In this case, I’d go with a range of say R180.00 to R220.00 just to keep yourself really comfortable. I know that that’s what the business is worth through my own homework that I’ve done and as Warren Buffett says, “If someone walks through the room, you don’t have to know that they’re 315lbs exactly to know that they’re fat.” In this case, is that a fat pitch? Is that a good opportunity if they’re worth R180.00 (minimum) to R220.00 (maximum)? Well, if you look back at the share price this is a company, which is trading today at R114.00 per share. Of course, it’s good value. Do you see where we started on this? We had a look back over the period – a fairly predictable cash flows that you can get from a big business like Wilson Bayly. The company’s share price hasn’t moved anywhere in six years.

I would assert that the reason for that, having done my homework here, is that Mr Market has gotten all depressed, whereas the intrinsic value of this company is around R200.000 (as you can see in the figure there), he’s only pricing it at R114.00 today. That’s the kind of company I like to buy. Would you be paying R200.00 per share for the company? Of course not. We need the margin of safety. You bring that in. You take another 20 percent off it, take it on R160.00, and it still leaves a very nice fat margin between the current share price of R114.00 and R160.00. What do you do? You don’t buy it today at R114.00 and think you’re going to sell it tomorrow at R160.00. You buy it today at R114.00 and you hold.

Alec, just a quick question from Sadir. He asks if you can please explain the discount rate again.

What we’re saying here is that your company (in this case, Wilson Bayly) has – this year – generated R482m in free cash. Next year, R493m, then R504m and then R515m as a present value in today’s money terms. If you take the actual figure, of course it’s going to be higher than that because you’ve got inflation that comes into account as well. I’m using 7.8 percent as a discount rate to take away inflation because that R100.00 you have today is not the same as R100.00 tomorrow. Next year’s R100.00 is going to be worth less because you’ve got inflation and we all know that. It’s just a way to discount the future cash…to discount the money you’re going to get in future, back to what it’s actually worth today. Remember, when you’re buying a share, you’re using 2016 money but you’re going to be getting cash from that share in 2020 terms. You can’t say 2020 money is the same as 2016 money. It’s going to be worth less.

Quickly Alec, Steve wants to go back to the terminal value calculation.

Steve, terminal value is simply…When you invest in shares it’s all about buying the company. Think of it as buying the company. Of course, we buy a very small, little slice of it but imagine you’re buying the whole company. You’re buying the whole company today (Wilson Bayly) and you then to have to try and work out what it’s going to be worth at some point in the future. Hopefully, you’re going to hold the company forever but we presume that you’re going to sell it at some point in future because we’re working on the cash that you get into your hand plus this terminal value. In other words, what you sell it on for – that’s the value of a company. You can’t just work on the cash flow. You can’t say, “Well, okay. This company is going to generate cash from here to judgement day of whatever it is” because we don’t know when judgement day is.

We’ve got to take an estimate of when judgment day is going to be (and I hope there aren’t many people who are going to hold me to this, that in five years’ time, it’s all going to happen). It’s just a figure of speech that I’m trying to use here. In a South African sense, I like to use five years. Clearly, if you use ten years then your valuations would go up significantly, because you’ve got an extra five years of cash flow plus the terminal value would be much higher after ten years than it would after five years if the company keeps growing, which we presume we’re doing our homework and buying the right ones. It’s a way of saying ‘this is the cash I’m going to get in the next five years. Then I’m going to sell the company in five years’ time and that’s what I would get in cash there’.

There are three things, which make up the value in this model of the value of a share. (1) The cash flow you get in the next five years, using a South African conservative sense. (2) The cash that’s already in the company (and in this case, they’re sitting on nearly R4bn). (3) What would you sell the company for in five years’ time? I hope that makes a bit more sense.

Just a follow-up from Steve. He asks why NPV x 12?

Good point. When you get to the terminal value… In other words, when you get to five years’ time you’re going to sell that on a multiple, which is reasonable. When you buy a share on the JSE, you pay a multiple of the current earnings (or of the cash flow). What we’re saying is that someone else would be happy to buy this company at 12 years’ cash flow when you sell it on. Although we’re working on a five-year period to keep it nice and conservative, if you look at the average PE on the JSE it’s somewhere between 15 and 18, depending on which stock you’re talking about. That means you’re buying 15 years’ future profits. We’re getting even more conservative. We’re saying, “You’re buying 12 years’ future profits”. What I’ve tried to do here is keep it conservative. I’ve done about 50 companies in preparation for this webinar. I’ve looked at their intrinsic values and I only came up with a handful that were worth acquiring at this stage.

Remember, I don’t play at all in the resources field. I don’t believe that resources are investments. I knew quite a lot about horseracing. In fact, I bred horses at one stage. If you’re going to go and buy resource stock… My suggestion is ‘rather go to Turffontein’. There’s quite a good ratio between Number 6 in Race 4 and Number 4 in Race 6, coming home. You can go and play on those kinds of odds. When you’re buying a commodity, you are taking away your great advantage of investing in shares. Investing in shares is leveraging human ingenuity. The management of a company should be taking a certain amount of assets, leveraging them, and making them produce a better return for you. If you’re buying a resources company, all you’re doing is buying an inanimate, dumb object – albeit gold, chrome, platinum, or whatever – hoping that at some point in time, you can sell that inanimate mineral to a greater fool (and hoping it doesn’t go down).

That’s really, what I did. I went through about 50 of these companies and came up with a handful of them. Mr Market is real dumb. He’s real crazy. He’s manic-depressive but from time-to-time-, these shares do get out of kilter with the intrinsic value and sometimes they’re a lot lower. Your secret is to buy them when they’re lower and these are the ones I’m focusing on today.

On the discount rates, we understand what it is now but he says, “Why 7.8?”

I use that one Sadir, because that is the 100-year return on JSE shares. If you take the last 100 years then on average, your growth would be 7.8 percent. You can use any kind of figure you want. You can take an estimate of the inflation rate, if you like. I just believe that that’s the best one because if Wilson Bayly is not going to be attractive at a 7.8 percent discount rate then you must just rather buy a Satrix 40 because that will give you 7.8 percent over the long-term. It’s important. Please remember. Investing is very, very different to trading. Investing means that you buy the shares and you hold on forever, or until Mr Market goes silly as he does sometimes.

If a company issues or buys back its shares, does the intrinsic value change?.

Yes, it does and that’s a very important point. When companies buy back their shares, you have to check that they’re buying it back below intrinsic value. Sometimes, some executives are very naughty. They will be buying back shares in the company to boost the share price because they’ve got share options coming up. You have got to assess, “Is this a company that actually knows what it’s doing? “ If it’s buying back its shares at below intrinsic value, it’s adding value to the shareholders overall. Warren Buffett’s very big on this. Remember, he’s got a portfolio of about $120bn. Four of those stocks make up about two-thirds of it and of those four stocks; they all buy back their own shares. IBM, Coca-Cola, Wells Fargo, and American Express. They’re buying back the shares at a lower rate in his mind.

He’s worked out his intrinsic values and he says, “It’s good that they’re buying back shares because they’re doing it below intrinsic value.” If that happens, then the company’s applying its cash the way Buffett says, “It’s buying Dollar bills for less than a Dollar.” There’s no better investment that you can make as a company. My own experience… I listed Moneyweb in 1999. People were all over me. They wanted shares [unclear 0:22:07.0]. A couple of years later, those shares were trading at 17 cents. What did I do? I had quite a lot of cash in the business. We bought back shares at 17 cents. That’s a good deal. We did that a few times through the history of that little company. It’s easy in a little company. There’s always the concern though, that you’re actually buying out your partners. I was never really comfortable about buying out partners in the business but if they really wanted to sell their shares, I guess that was their story.

A claim from SANRAL: does it affect the market price on Wilson Bayly Homes?

A claim from SANRAL? No, he’s got the wrong company. It’s another one.

I think they’re looking for signs across the border on the roads issue – the damage to roads.

I’m not sure. I really don’t know any of that. I think that you’ve got to look past the immediate short-term noise. I did see that SANRAL were claiming… Are you sure it Wilson?

It was more than one.

Is it more than one?

Yes.

Okay. Those are issues that you need to then assess in it. I think we’ve got a big enough margin of safety here. Remember, Wilson Bayly has an interesting point. It gets about half of its revenues from Australia now so you’ve actually got a lovely Rand Hedge there as well. Here’s another one – Blue Label. Last year, after the Berkshire Hathaway AGM, I spoke to a group of people at Standard Bank and said to them, “Blue Label looked just, unbelievably cheap at the time.” It was R7.50 and this goes back to when Blue Label was listed in 2007. You can see there. On the first day it listed, it got to R8.00 and a year ago, it was trading [unclear 0:23:50.7 level. All of a sudden, in the last year, the shares have really caught fire – belatedly. It took them nearly ten years for people to understand the value of this business.

I looked at it again and thought, “I do remember that Blue Label has a sound business model. They’ve got a lovely moat. It’s hard for other people to replicate what they’ve got there. Now that it’s gone up to R16.00, is it still value?” I did the intrinsic value calculation and here, I’ve been extremely conservative again. There we go, with a growth rate of ten percent, a discount rate of seven-point-eight. This company generates free cash flow of about R1bn per year. They sell airtime and prepaid electricity, etcetera, in South Africa, Mexico, and India – expanding rapidly in Mexico and India, so they’ve got more than 300 thousand distribution outlets, lots of little transactions with very small margins. I worked on their R1bn free cash flow and my ten percent growth rate, with that discount rate and saw what would happen to this company.

Where did it come out, and there it is you can see the intrinsic value per share, R29.35, so although Blue Label has done very well in the shares or its share price has risen strongly in the past year, it’s still at a lovely discount to its intrinsic value, in my opinion. I’d buy it at this level, in fact, I’d be very happy to buy it right up until probably R22.00 per share, at which point your margin of safety is now starting to get a little bit tight. I hope that you kind of understand, and you can do these calculations yourself on many stocks. Another one I did was Imperial. It came out really, nicely. There’s the Imperial story. Since 1994, it’s a 20-year story, it would have been nice to have been, bought at around there and, of course there the share price went up, and it’s come back again. I know the new Chief Executive, Mark Lamberti quite well. I’ve got a very, high regard for him.

I’ve seen the Imperial operations internationally and I’m most impressed that by the way that they can compete with the Germans in logistics. My goodness, if anyone can compete with the Germans, in fact by the market leader in Germany, then you’ve got to be doing something right. I did the intrinsic value calculation there again. On this one, they generate free cash flow of just over R2bn per year. Again, using a ten percent conservative growth rate, now particularly if you’ve got big international interests, (the way the Rand is going) that’s very conservative and then a discount of seven-point-eight. Put the numbers in, there they come out. You have an R40m intrinsic value on this share or R199.00 per Imperial share that’s my calculation. I go back to where the share price is and if it’s trading at R145.00, where it is at the moment, you’ve got a nice margin of safety.

Firstly, you’ve got to like the business you’ve got to like the business model. You’ve got to believe that they’ve got a good moat that the business is going to be around for a long time. You don’t want to buy into something where it’s going to fall over next week. It’s a good, solid company. It’s a good brand. Then you work out the intrinsic value to tell you what it is worth today. Clearly, at R220.00 a couple of years ago, you would be paying over the intrinsic value and let ‘mister market’ do that but today, at R145.00, it’s a good, long term holding, remembering that you’re going to hold these shares forever.

Robert de Vos said he missed the NPV definition.

NPV – that is, Robert, it’s taking your cash that you get into the future, and discounting it, into today’s money, so in very simple terms. R100 today or a R100 note today is worth more than a R100 note will be worth, this time, next year, in your buying power because of inflation, so it’s just to try and get next year and the following years R100 notes and to work out what are they worth in today’s money terms. I hope that makes sense.

We’ve done this and this is the most, simple one. This is the one that you go and play around with, start doing it on your whole portfolio. The best thing about investing is to understand where you are and why you are doing certain things. Once you start playing around with these numbers, you get better at it all the time. Nobody is an expert. Even Buffett gets it wrong sometimes but over his 50 years his intrinsic value calculations, I can assure you, are pretty sophisticated. Remember this is the greatest game on earth because it changes conditions, circumstances change. Read those annual reports. Look at what the companies are doing, and then you can work that intrinsic value out.

I’m going to give you, there’s another way though on valuing a share, which is a lot more difficult and this is a concept that is only now starting to be, understood. As human beings, we think in linear basis. We think ‘well we’re going to have one child this year and maybe another child in two years’ time’. It’s very hard for us to think what happens to those children, and their children, and their children, etcetera. Each child that you’re fathering today their generations, in 100 years’ time, they might have 50 people who come from them. If they’ve got maybe more wives, then of course it will be more than 50 people but it’s called exponentiality and exponentiality is something that human beings really battle with.

Moore’s Law. You might have heard of how Moore’s Law works and it was interpreted by Gordon Moore back in 1964. He was at Intel, and what he said was the way that things are developing at Intel, where they made silicon chips for computers, was that every year to 18 months, we will be able to produce something that has got double the capacity, double the power, for the same price. When you start putting that into your spreadsheets the numbers become scary, this is the share price graph of a beneficiary of exponentiality, called Amazon.com. As you can see, going right back to when it was in the mid 90’s, when it was founded, it initially didn’t do a whole lot on the stock market. Then it had that run up in the Dot.com boom. Then the Dot.com bust and it went down to where it was ten years before, and slowly started building up again.

During all of this period, Wall Street looked at Amazon and said, “Jeff Bezos, you don’t really know what you’re doing because you’re not making any profits.” Well, if you understood the Amazon story, and it’s a little bit like Blue Label by the way, a similar kind of thing, where investing heavily in infrastructure. Not worrying too much about the profits but building for the next generation, building for the next year, and what Amazon has done is that it’s transformed retailing in the world. Indeed, that started catching on around about in 2010, where the smart investors got into it. Now, the not so smart investors are trying to jump onto the bandwagon as well, and realise ‘my goodness this is a phenomenon’ and it was assisted, in the last couple of weeks by Warren Buffett. That is where the share price was, the share price was about $650 a share, before the Berkshire Hathaway AGM. It is now $717 a share. It’s a big jump, six percent.

At the Berkshire AGM – that by the way, is a picture of Jeff Bezos, the guy who started Amazon. At the Berkshire AGM on numerous occasions, Warren Buffett and Charlie Munger referred to Amazon.com. They spoke about the Amazon effect. How Amazon has transformed retailing and e-commerce. How Walmart came to some of the Berkshire subsidiaries and said to them ‘look we’re struggling because of Amazon’. Remember, Walmart is the biggest retailer in the United States, a huge company, but they’re starting to have their lunch eaten by Amazon, so they went to Berkshire’s subsidiaries and said, “We need you to pay us quicker, and we will pay you over less time,” in other word, improving their cash flow because they’re struggling. Now, when you get that kind of a conversation going at Berkshire Hathaway, where 40 thousand people go to Omaha to listen to what Warren Buffett has to say.

It’s similar to a conversation he made a few years ago about Google where he said, although he’s not investing in Google because he can’t work out the intrinsic value. He does think that their business model is impossible to break, and his best friend is Bill Gates, who clearly is at risk with Google. The Google share price then started running because value investors bought into that story. They’re doing the same here. He mentioned that we can’t outdo Jeff Bezos, and in another discussion point, he said that the value of Jeff Bezos, to Amazon is priceless. Those are the issues that start coming to play in exponentiality and we had a South African example of this in Naspers. This goes back 20 years, or just over 20 years. You can see the Naspers share did pretty, much nothing for half of that period and then what happened in the late 90’s was that this man, Koos Bekker, decided to do something very different.

He saw that the future of media in South Africa was maybe not that good. He did start MWEB and get into the internet field but he felt that there were bigger opportunities if he went global. He and the late Antonie Roux, had a strategy that they called ‘throwing mud at the wall’ and essentially was that they must go and look at emerging markets, where they could find assets, internet assets that looked like they could win. Of course, they could never pick the winners. Nobody can at such an early stage but they bought a company in Russia, called Mail.ru, which has done very well but the spectacular deal was when they acquired 50 percent of a little Hong Kong company, of 30 people, called Tencent. They paid about $30m for it, at the time. It’s worth 100 times that today, and so is the Naspers share price because that investment in Tencent has been a phenomenal success and the Naspers share price at the moment, as you can see that exponential growth, is due to the exponential growth of Tencent in China.

It was an internet company in the biggest, most populous nation on earth, starting off early on, and South African business is the biggest shareholder. It’s been called the most spectacular, private equity investment in history and that’s why the Naspers share price has done what it has. Some people will look at this and say ‘my goodness but it’s got to fall’. Anything that goes up will go down, and they might be right, but it’s not based on what Naspers has done. It’s based on Tencent and Tencent, in an embryonic market like China, has got a preeminent position. In fact, Pony Ma, who is the Chief Executive of Tencent, is regarded, in China… It’s between him and Jack Ma, the man from Alibaba.com – they’re not sure who he greater entrepreneur is, but that is how the high esteem, with which it held, so exponentiality is something never to discount. It’s impossible to work in intrinsic value on it.

If you find a stock that you believe is going to be growing exponentially into the future. The one that I’m doing my work on at the moment is Facebook. Being in the media industry, I get Facebook. I understand what Facebook is doing. I understand the virility of it and it looks, to me like it’s unstoppable, in the same way as Google is unstoppable and, I guess, in China Tencent is unstoppable, which means Naspers is unstoppable. I’m doing my work on it now. Finding the right time to buy into that stock, if you had bought Naspers, say in 2006, around about this level, at R1000.00 per share, well you wouldn’t believe that it could double again in the next few years, but that’s what exponentiality does. It’s very hard to do a valuation of these companies, until you can sit down and put it on a spreadsheet and say ‘well if it does keep growing at 35 percent a year, what are the numbers going to look like’? Koos Bekker, South Africa’s great entrepreneur.

Alec, just a few requests on if the webinar will be available after this?

Yes, we will. We’re going to be transcribing the entire webinar. It will be on Biznews and I think we’re going to put it on the EasyEquities platform as well, so you’ll be able to read and listen and watch again, at your leisure, if you have to rush out now and go and get that hamburger or salad for lunch. I’m just going to close off with the ‘Cigar Butts’ and this is a big part of the investment strategy that Benjamin Graham began with in the 1930’s. What is a ‘Cigar Butt’? Well, as you can see there, this one’s probably got one last puff. We used to call it a nip, when I, many years ago when I was a young guy and used to smoke. I didn’t have much money, so you’d smoke half the cigarette and then stop it, so that you could have a nip of your cigarette a little bit later. Well in the 30’s, what happened those days with the rich guys, as a status symbol would smoke these big, fat cigars and wanting to help the less fortunate they would flick the last bit of the cigar away, when there was still at least one puff left.

That became a terminology for shares that had been really bombed out but have got at least one little uptick in it. I started looking for some cigar puffs and came up with two. I don’t know if South Ocean is going to be just a one-puff benefit. I think it could be a lot more than that but here’s a ten-year share price graph that shows you it’s a company that manufactures electric cables and lighting equipment, so very basic infrastructural related business in South Africa. It’s got a problem with the Competition Commission looking into it but again that’s not going to kill that company. It will hurt it but it won’t kill it. What will kill it is bad management. As you can see this business has had a pretty rough ride over the last ten years, and indeed since 2012, when it was R2.00 per share, to its current level of in the R30’s. I had a look at the vital stats and you get this from going into the balance sheet and the income statement.

In other words put into Google South Ocean annual report and start reading, and some very interesting things come through here. They’ve got a new Chief Executive, called Koos Bekker, not our Koos Bekker or the Naspers’ Koos Bekker, but this is Koos Bekker, who is a chartered accountant and he’s just taken over from August 2015. That’s always a good sign. Then I had a look at the market value of this company – it’s R56m. Remember buy the company and not the stock, so if you want to buy the whole of South Ocean today, and you had R56m and the owners of the shares were prepared to sell it to you that’s what you’d be able to buy it for. Would the owners of the shares sell it to you – very unlikely because the tangible net asset value and that is a very important thing? When you’re looking at the balance sheet or at the financial statements of a company always look at tangible net asset value and not net asset value.

There could be a lot of goodwill and a lot of nonsense in there, so the tangible net asset value is nearly ten times what the market value of it is at the moment. What that says to you is you can actually buy this company for R56m. Liquidate it and get yourself R556m, or R559m to be exact. That’s already telling us that these shares are a little neglected. Then you look at the size of the revenues. Now, if the whole company can be bought for R56m, the revenues are R1.7bn a year. Already that says to me ‘hang on a minute I don’t mind buying those revenues for R56m’ and the net cash that it’s generated in the past year was R33.5m. As you go through the notes of the accounts, the accounts themselves can be very confusing but look for that number that says where’s the net cash, where do they talk about the net cash? Here we are, buying a company for R56m, when it’s giving us cash this year of R33.5m.

Hopefully, the managers know what they’re going to do with it, we’ve got the new Koos Bekker there, who presumably wants to impress so he’ll take that R33.5m and allocate it properly. What they did last year was they reduced their overdraft, as you can see there, from R109m to R74m, and there is a risk here. There’s a Competition Commission investigation into the electrical cables business, but at R56m, you’re buying a share there, well I think you’re not really doing… You’ve got a ‘cigar but’ that’s probably worth a whole lot more than that. Is the share price down where it is reflecting reality? No, it’s reflecting disaster and it’s not a business, in my opinion anyway that is going to hit disaster, not with the cash flows that it is generating, a nice, little one to go and do your homework on.

Another one is Esor. Look at that share price – R9.00. That was about seven years ago, and it is now 29 cents. You can pick it up on the market today, so it shows you that this is a company that really has had its share of challenges. Again, I had a look at the statistics. They’ve done quite a lot of changes there. They sold out a big part of the business – the Franki part of the business. You can see in fact, on this graph here where it falls quickly. That was with the sale. They paid quite a big dividend at that time, about R38m, and Esor is a restructured (as they call it, back to basics) business. They cut their headcount in the past year by about 20 percent. That’s quite apart from the Franki pile getting rid of that and that is always a good sign. When a company is prepared to button down, do the necessary, take the retrenchments, take it on the nose, and streamline their business for the future.

Where are their revenues? At R1.4bn, the market cap of this company is R115m. Okay, already I was getting quite interested because if they can do things on an R1.4b revenue stream and your market value is only R115m, you’re getting yourself quite a nice business. Then you have a look at net current assets and what this is, you take the (looking at the balance sheet), you take the money that’s owed to the business today, and the money that it owes, so it’s essentially the debtors, we all understand that – people who owe you money, the accounts outstanding. As against the accounts, you’ve got to pay. The difference there is about R180m. Then you’ve got cash of another R36m on top of that, sitting in the balance sheet, and there’s odds and sods that carry on. For a market cap of R115m you’re getting net current assets, stop it today, liquidate everything, you’ll get R313m.

Actually, more than that because when you take all their plant and equipment, property and everything else they own, the tangible net asset value is R584m. Hello, now I’m interested. How about the cash flows, well in the last year there’re a lot funnies in the figures because there were retrenchments and they some money in from selling certain things and they got the working capital down by, well as you’d expect. If you’re starting to make the business more efficient, you reduce your working capital, but they generated a cash flow last year of R98m and that reduced their gearing, in other words the debt level, to 24 percent. Don’t worry too much about that excepting if your debt is 24 percent of your equity then you’re not exactly over borrowed. It’s when you get to 100 percent plus that you’ve over borrowed, so I look at the whole thing and I say to myself, “My goodness this is a stock that is well worth it’.

It’s on the recovery path. It’s got lots of assets there. It has been around for a long time. It’s priced for disaster. Let me read a little bit more about it and I think this is another ‘cigar butt’. How far will the ‘cigar butt’ take you – maybe to R1.00 or maybe to R2.00? Who knows? Certainly, it’s got value in this business that is a whole lot more than the 27-odd cents that it is trading at, at the moment.

Alec, just  a quick comment, South Ocean is up 38 percent in two days on low volumes.

We’ll stop it. Then don’t get crazy. You know what’s happened was I did a road show, post Warren Buffett, and clearly some people have now thought exactly what I told them not to do. I said, “Don’t go, and buy the share. Please, do your homework. Understand what is going on in this business. Just don’t rush into now. Just sit vas.” Hold it a little while. It is obviously, it’s still value at that level, but what tends to happen in these cases is that somebody decides to share tip and they rush in, hoping that they can sell the stock to a greater fool. You don’t have to buy anything. You take your time. You identify opportunities and really, this is just to show you an opportunity that is possible. It’s not to say to you go and buy the stock. What you now know is these are the things to look for. Please don’t go rushing into this as a share that you can add to your portfolio.

Maybe take a small slice of it. It’s still… If it’s gone up 38 percent that means that the market cap would have then gone to, say R80m or R90m. Tangible net, add value of R550m. I can still live with that and I think you can too. That’s my story for today. I know we’ve gone over a little more than the half-hour that we anticipated but I guess, this is quite a complicated subject, and it’s a lovely basis from which to start understanding investing. Investing is easy, it really is easy, and EasyEquities makes it even easier because they make it really cheap to do the investing. These are kind of the ground rules. Read that book of Benjamin Graham. Read my book on Buffett as well and I know if you’re with Easy and you’ve done your [inaudible 0:46:49.2], you’ll be able to get well we’re sending it to quite a few people in the email. Just read the book, understand it better, and it will give you those basics because this is the greatest game.

When you understand equities and you can buy them and make long-term investments, for low costs, and just leave them there. Don’t trade them. You will always be a winner. Thank you for being with us. Stuart thanks for fielding those questions and we will have everything on. It will be transcribed. We’ll get the presentation onto the Biznews site and also onto the Easy sites, if there’s no more questions, Stuart…

No that’s it. It’s gone all quiet this side.

All quiet, great. I’m glad we could answer all of those. There’s our contact details on Facebook, Twitter, LinkedIn or you can always drop me an email. It’s been a privilege to be with you today. We’ve had a good turnout of people live and I hope, if you are accessing this after the event, you also find that it’s been worthwhile. Thank you.