Today's menu

• South Africa’s dual nature

• The expected return

• Extraordinary South African companies

  • PSG Financial Services

South Africa’s dual nature

South Africa is a developing country.

In investment terms that means higher risk because democracy is iffy, the financial system is underdeveloped and the rule of law doesn’t exist.

But that isn’t true. The rule of law does exist in South Africa based on a strong Constitution. Democracy and free speech are alive and well. The financial system is solid and well regulated.

In other words, South Africa has a dual nature. It is both developed and developing. It has big cities and towns that are first world and it also has huge rural areas.

For instance, consider Johannesburg and its surroundings, it’s a megalopolis - a large, heavily populated area. If you didn’t know better, you could drive 100km (62 miles) from Johannesburg to the neighbouring city of Pretoria, and never realise that you left Johannesburg.

On that journey, you would be driving on a large highway, past hundreds of companies. (You would also probably be speeding because South Africans drive too fast).

Therein lies our first clue. Most South African companies are situated and operate in the developed part of the economy.

The expected return

In order to find the opportunity, we have to understand a little financial theory, specifically something called the expected return.

The expected return is a financial concept which implies that the higher the risk in an investment, the higher the return you should get to compensate you for that risk.

For example, if you own stocks in a low risk company, you might be happy getting a 9% return. But if you own stocks in a higher risk company, you might want 13%.

Capital Asset Pricing Model (CAPM)

For stocks, the expected return is calculated using something called the Capital Asset Pricing Model (or CAPM for short).

Don’t let this fancy name throw you. Finance people love using grand names for simple things and CAPM is very simple. Here’s the formula:

Expected Return = Risk-Free Rate + [Beta (β) * (Market risk premium)]

• Risk-free rate is usually taken from the yield on a government bond.

• Beta is a measure of risk, which quantifies how much a company’s stock price moves in relation to the market. The market has a beta of 1. If a company is more risky, its beta will be above 1. If less risky, its beta will be below 1.

• Market risk premium (MRP) is calculated as the difference between the return on equities compared to the return on government bonds. The MRP is usually around 6%.

Let’s see how this works with some real numbers for the South African market:

• Beta = 1

• Risk free rate = 10.5% (which is the yield on 10-year South African government bonds)

• MRP = 6%

Expected Return = 10.5% + [1 × 6%]

Expected Return = 16.5%

That means investors expect South African companies to give them a return of 16.5%, because they consider South Africa to be risky.

That’s a very high rate of return - 10% is a decent return for most companies.

Valuing a company

The expected return is used in valuing companies.

Valuing a company can be very simple or very complex. We’ll make it simple.

To value a company, all you need is three things: 1) the free cash flow 2) the growth rate and 3) the expected return.

If you plug these numbers into a formula, you get a stock price.

Here’s the formula:

• V = estimated stock price

• FCFE₀ = free cash flow to equity

• r = the expected return

• g = expected growth rate of the free cash flow to equity

Take note, the symbol r is the expected return. The larger r is, the smaller the stock price V becomes.

In other words, because South Africa is risky, the expected return is higher and that makes stock prices lower.

(By the way, I discussed the above formula and how to extract information from stocks here)

Leap of faith

What happens if the expected return was lower?

If expected returns were lower (smaller r), South African stock prices would be higher.

Here's where you need to make a leap of faith.

If you consider the whole of South Africa to be a developing country as the markets do, then you get high expected returns and low stock prices.

But if you recognise that South Africa has both developed and developing country aspects and that most companies operate in the developed part of the economy, then you can change your expected return number.

The US expected return is 10.4%. We know the South African expected return cannot be that low. But what if we set it somewhere in between by reducing it by about 3%?

Now, investors would only be expecting 13.5% instead of 16.5%. That means, when you analyse South African companies, they look much more interesting and their valuations are higher (because r is lower).

Extraordinary South African companies

South Africa has a small-ish stock market (i.e. about 270 companies), but there are a few Extraordinary Companies.

These companies tend to be in “old school” sectors. They are not technology companies. They are in financials services or industrial products or services businesses - sectors that have been around for a long time.

Let’s look at one such Extraordinary company.

PSG Financial Services

PSG Financial Services (PSG) does three things. It does wealth management (i.e. financial advisors), asset management and insurance. The company has no debt at all, which means if their business has a wobble, they won’t be in trouble. You cannot go bankrupt if you don’t owe banks money.

Over the past five years, PSG has returned 25.2% per annum in Rands. That is amazing. For comparison, here’s what US tech did in the last five years:

• Amazon 9.9% per annum

• Apple 20.9% per annum

• Google 17.2% per annum

• Microsoft 19.7% per annum

In that time period, the South African Rand held its value against the US Dollar. That means you can compare PSG’s return directly to these companies.

Basically, PSG kicked the butt’s of the world’s best companies.

I won’t go into too much detail on the financials, but look at those juicy returns with ROCE above 20%. Also look at the valuation numbers - high for a South African company, but cheap compared to a US company. Pay less, get more?

Conclusion

Generally speaking, I am not bullish on South African companies (bullish means positive in stock market lingo). In fact, in the past I struggled to find many extraordinary South African companies. I thought they were few and far between.

Then I realised that I was being too demanding as an investors and that I could view the economy as comprising two pieces - a developed economy and developing economy.

When I re-framed what I was evaluating, it made sense to be more generous (i.e. lower expected returns) and evaluate South African companies more positively. That’s when I found that there are more extraordinary companies than anticipated.

Don’t get me wrong, I am not suggesting that you should bodge your numbers to make the companies look better.

Rather, I am suggesting that the usual numbers may be too pessimistic. If you adjust your numbers, you might get a different picture.

I would like to hear what you’re up to.

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