Why disruption risk and pricing power is important and whos doing it right.

30 November 2014&nbsp22:29

Marc Ashton: Good afternoon and welcome to the Moneyweb market commentator podcast. My name is Marc Ashton and Im joined on the line by Clyde Rossouw, a portfolio manager at Investec Asset Management. Clyde thank you for joining us.

Clyde Rossouw. Thanks very much Marc.

Marc Ashton. Clyde one of the interesting things for me at the moment is I try and trade the market on a day-to-day or week-to-week basis and I looked at the announcement out of China last week with the loosening of the monetary policy. Gave a short-term spike to the market. We re all the way back to where we started a week ago. There just seems to be no real catalyst for any real direction at the moment. Maybe give us some idea of what youre kind of looking at in terms of overall market sentiment and some of the indicators that you re watching for.

Clyde Rossouw. Yes certainly. If you looked at that announcement bearing in mind that the shares that reacted most favourably initially on that announcement were in fact resource companies which, up until then were dramatically underperforming the market conditions and the perception in the market was that this would definitively change the outcome in terms of the growth momentum in China for the next year or two. That re not entirely surprised that the market has in effect given up on the dynamics thereafter.

If I look at the readings, I think what really matters with regards to China is the on the ground volume of transactions of goods moved, the actual expansion of the money base and ultimately their consumer orientation around retail sales and exports. Those are the figures we watch very carefully and not the numbers that the Central Bureau sends out and what that has been indicating for us is that China, the real underlying growth in that economy is surprisingly low and probably no more than 2% and 3% at the moment, which is a long way away from the official numbers of 7% to 7.5% that the authorities have been reporting.

So its not unsurprising for us that many of the other market free indicators like the price of oil or the price of platinum, or bond yieldsyou know, these are parts of the market which cannot be manipulated through data, have been suggesting to us that the worlds economy and in fact the emerging market complex in China in particular have been slowing probably more dramatically that what people have thought. So thats a very important consideration.

Of course this doesnt mean that China can do nothing about the outcome, and Im not for a moment suggesting that the growth rate will be permanently impaired because China does produce a ton of savings and it probably is able to continue to keep that economy afloat. But they do have to do more than cut rates. I think some significant policy action is probably required on that front.

Marc Ashton. In your correspondence to your clients, you identified two distinct categories of business those that are able to embrace disruption risk and those with pricing power. Maybe give us some indication of what youre looking at there and maybe some examples of businesses that naturally stand out in these sectors.

Clyde Rossouw. Yes sure. I think firstly looking at pricing power, I know it s often a strange thing for South Africans to be concerned about. Businesses lack pricing power because weve been used to, for many many years of having a continuous inflation tailwind. In other words, inflation is always above zero and in fact normally between five and ten and sometimes our perception is that our own inflation baskets are ahead of that. So it might seem a bit strange for people to be harping on the fact that businesses are lacking pricing power, but I think more importantly than that, is if you think firstly about what s been happening in the local economy and the rand has been depreciating and its created the illusion of inflation, whereas the price of any goods outside or for a dollar investor investing in South Africa, he sees negative returns in the reporting currency.

So investors have been experiencing price deflation. But if you think about what that means more broadly, if there s no inflation in the economy, wages aren t increasing, balance sheets aren t increasing, house prices aren t increasing it s tough. And that s the situation that Europe finds itself in. Japan has been there for many years and many other parts of the world are starting to face similar constraints, not only Australia. So when we look for stocks with true pricing power we actually are looking for business that have the ability to raise prices in a global context in a constant currency where ultimately they re able to increase those returns.

And the only category of stock, truth be told, where we can see significant signs of pricing power, is still within the tobacco complex. So tobacco shares like British American Tobacco (BAT) in South Africa. Every year when excise taxes go up they re able to increase their prices to consumers, and yes there is a volume loss so people tend to smoke a little bit less at the margin but they re still able to produce a positive income statement effect. What I mean by that is that if prices go up by 10% they lose 4% in volumes so your revenue still grows at 6% and then because of operating efficiencies, youre able to grow your income a little bit faster than that. So tobacco companies still interest us. BAT in South Africa is one that we like. We like to plan tobacco in our global portfolios where cigarette prices in Japan are actually the cheapest in the entire developed market world and that interests us as well. So those are some of the stocks we would definitely see as having pricing power.

With regards to disruption risk, we are all very well aware of the fact that technology is changing the way things are being done. There are massive disruptions. If you think about online business models where particularly in the UK, retailing is being changed. People are now clicking and having goods delivered at home, so bricks and mortar businesses are under pressure. High street shop rentals are under pressure, and that s a phenomenon which is spreading more broadly. It s alive in the US and it s alive in Europe. I think in South Africa we re probably very slow to adopt that trend because ultimately our internet activity is still lagging way behind that of the rest of the world. So when you talk about disruption, we re really thinking about the way technology is changing and what businesses are leading that particular charge.

So generally the businesses that are very well positioned on that front, like Naspers for example which is leading ecommerce with their holding in Tencent. But we find that typically that is the only South African stock that really is able to capitalise on that trend, clearly you have to have a fairly long expectation of growth in the future in order to be comfortable with the share price today. So in our portfolios we own for example eBay which is the leading ecommerce market place business that also owns one of the best online-offline payment platforms through PayPal. That s a stock we like and it s able to withstand disruption risk.

Another stock that we like in our portfolios is Microsoft which again most people when they hear the word they think of a company that s outdated and possibly is not relevant in a mobile world, and yet they re able to survive every single mutation successfully. They ve been able to defend their Windows operating platform. Office 365 is still relevant today and as a result is a business that as they move more and more to Cloud activity, will be relevant in tomorrow s world as much as what it was relevant in the last couple of years. And what s interesting about a stock like that is that people the market offers you despite the stock having done very well over the last two years, still a reasonable price for that expectation, so again that s why we re quite interested in that particular idea.

Marc Ashton. I think the technology sector is one that s really interesting, particularly for South Africans because we don t have a particularly broad universe in which to invest. How do you end up in the situation that youre not chasing a fad, a trend Alibaba has obviously been very topical for a moment, but then you ve seen the impact on Yahoo where the business hasn t been able to adapt at the same speed that a business like Alibaba has yes its benefited from the shareholding within it, but it hasn t. Yahoo as a core business has failed to adapt. How do you not end up in a situation where you end up following a fad that doesn t necessarily translate into a sustainable long-term business model?

Clyde Rossouw. Look, I think it s fair to say that if you look at many of these internet businesses the people who are the most successful investors in those companies follow one very simple item and that is incremental revenue growth. So if these companies are able to grow their top line, that s good enough. So you ve obviously mentioned Alibaba which has global aspirations. It clearly wants to dominate the ecommerce world, it s fair to say that it is well and truly behind a business like Amazon and if they re wanting to operate in the States, they have to do some sort of major acquisition to strengthen their critical mass there and I don t think they re going to achieve that any time soon. So it is a difficult space for the average investor to get their minds around and there are a lot of different business models.

One of the interesting things I guess about some of the etailing and ecommerce business models that Naspers is trying to pursue these are good businesses that are high margin and cash generative. But to pull that off and to entrench your network advantage is very difficult and sometimes along the way there will be a lot of casualties. So it is an area where you almost have to expect that the probability of success is going to be less than 50% for a big company you look at and ultimately the winner is going to be a R10,000 return and the loser can very much lose all of their money. So that s a very much the type of risk reward trade-off one has to take, if you want to invest in these type of companies and that s not necessarily the way we choose to invest.

So whilst we re very excited about how these things will change the way we do business and improve our lives as investors and as consumers, one has to be very careful about extrapolating a cash flow in this particular regime. For example, we have owned Google in our portfolios in the past. We made a lot of money out of the share. Weve currently exited our entire Google position. It s still a fantastic business, but one has to always weigh the risks against the potential returns going forward.

Marc Ashton. I think one of the big deals thats kind of marked the South African market in the last week has been this deal thats seen Steinhoff, Pepkor, Brait shuffling some of their assets. And you talk about a simple retailing business like Pep, Steinhoff has been a big contributor to your portfolio or significant performer for your portfolios. What do you make of the deal and do you think Steinhoff still offers value on a three to five year timeframe?

Clyde Rossouw. Certainly, we have been supporters of Steinhoff s international expansion and acquisition strategy over the years. I think if you look at what Steinhoff is today, it s ultimately dominated the value retailing segment. It does have significant market shares in Europe and that s where, effectively before the transaction with Pepkor, 90% of their business revenues came from. So if you look at this transaction, what Pepkor does is even though it doesn t add an obvious synergy in terms of an overlap between clothing and furniture, and Pepkor is obviously very strong in the furniture and mobile phones, prepaid cards, and that sort of merchandise. It does certainly solidify their position within the value retail space, and it does build on that particular strategy which is what they ve been trying to achieve over the years.

The transaction doesn t materially skew away the non-South African earnings massively, it s still a business probably 75-25 with 75% probably offshore and 25% South Africa. I think Pepkor does have some interesting opportunities in terms of their own international expansion in Poland and in Australia. In Australia they re making no money at the moment, so there s a margin opportunity for a successful rollout of the format on that front. So in essence, you know, the sceptics will say, at the end of the day, Steinhoff trading on 12 times earnings is buying a business trading on 22 times trading earnings and that s a very high price to pay and that might not make sense. But the way we look at it is we think that the ultimate the asset is complementary. We think there s a huge overlap in terms of the management culture between Pepkor and Steinhoff. And forget about the ambitions of other large shareholders in Pepkor and Brait who might be exchanging their stocks, like Mr Wiese for Steinhoff shares.

At the end of the day the important point here is that it does compliment the strategy and Steinhoff is the better business with a cash generative business of Pepkor in the fold. So we certainly think that the transaction does make sense. It s a stepping stone, it s not the end of the road for Steinhoff and ultimately it s a slightly larger business with a bigger critical mass. It does position them well as they move into the Frankfurt listing potentially early next year and that s obviously the next opportunity. So us as shareholders, we still see upside and in a market which generally is fairly expensive, most of the South African stocks trade on high multiples and any stock with a decent growth opportunity you have to pay for that extensively, this does offer some relative value for us.

Marc Ashton. Excellent, Clyde thanks for chatting to Moneyweb.