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Tutorial 5 - Industrial analysis

Tutorial 5 - Industrial analysis

Executive Summary

After completing the first part of this tutorial, an investor will have understood what the financial sector is, including the banks and financial services sectors; the insurance, the investment trust sectors and private equity fund sectors, as well as the property sector.

In the second part of the tutorial, we look at the industrial and resource shares, which represent a large portion of the market capitalisation of the entire share market. Several of the biggest companies listed on the share market are included in these two sectors and they are often used to gauge the health of the overall market. After completing this section, an investor will understand what the industrial sector is all about, as well as what shares make up the industrial index (INDI 25).

Industry and competitive issues

In the previous tutorial we have analysed strictly according to the financial statements and valued a company accordingly. Before buying into the company we have to ascertain how sustainable the historical financial data is. We do this by analysing the profit drivers, business risks, core competencies, competitive advantage, threats and opportunities of both the specific company and its industry.

By doing the detailed historical financial analysis (use as many years' data as is available), and studying the financial statements in detail (including all the statements by management) we would have already formed a very good idea about the company and its history. The historical profit drivers would by now be known to us.

There are two key profit drivers: turnover and profit growth, and the return on capital or equity. We have analysed these ratios and determined the direction they are heading. We should also now compare them to other companies in the same or similar industries. The object is to develop an integrated historical perspective to aid you in forecasting the future. This perspective is a combination of the financial analysis and the analysis of the industry. It remains difficult to generalize with a kind of checklist, as this is not a mechanical process.

One example will include commodity companies (oil, paper, mining steel etc.). These a cyclical industries we one needs to calculated the average operating margins, ROE's etc. over a longer period to ascertain some kind of normalised level. You should furthermore study the short-and long-term supply and demand situation within the industry. Competitor behaviour at both ends of the cycles must be understood. Does the company have competitive advantages like economies of scale or proprietary technology?

Another example can be consumer companies with strong brand names such as Coca Cola. These companies normally have high ROE's and high operating profit margins. Here the key issues are likely to be growth in revenue. Therefore look at market penetration, markets share, and new products. On the cost side these companies should be compared with their competitors.

The purpose of the above is to forecast future performance

The only way to sustain ROE's above the cost of capital is for a company to develop and exploit any competitive advantage it may have. As investors we must identify current and potential future competitive advantages, within the industry and own balance sheet boundaries.

These advantages can basically be categorised into the following:

  • Providing superior value to the customer via price and/or product characteristics, which may be difficult to replicate by competitors
  • Lower cost base than competitors
  • The more productive use of capital

There are different ways to identify the aforementioned competitive advantages. The most commonly used of which are customer segmentation analysis, competitive business system analysis and industry structure analysis.

Customer segmentation analysis

By identifying the need of customers or why they will choose one product above another, a potential market share can be estimated. Customer profitability by type can be established and the investor can form an idea of how difficult it will be to differentiate one competitor from another.

Competitive business system analysis

A business system starts by product design and ends by after sales service. By analysing this system an investors endeavours to ascertain how a company can achieve a competitive advantage through better cost management, more product use of capital or superior customer satisfaction.

Industry structure analysis

The investor also has to look outside the industry at forces that will have an impact of the industry's future profitability. These external forces can be substitute products, supplier bargaining power, customer bargaining power and barriers of entry or exit.

An example of substitute products is transport by rail or road, communications via fixed or mobile phones, poultry versus red meat etc. Supplier bargaining power is normally determined by size. Huge companies can force discounts through due to their suppliers' dependence on them. Barriers to entry can be technological skills, difficult to obtain assets, high set up costs, patients, economies of scale. Barriers to exit include capital intensive industries where more than marginal costs are achieved making it a difficult decision to exit.

Once we have analysed the competitive and industry issue we should be able to forecast the future growth of a company. This will lead us to a valuation based on this forecast and finally a recommendation to buy or sell the share. But as the future will always remain uncertain one should take cognisance of the fact that such a forecast and therefore valuation can at most be an educated guess. This is why experienced investors develop a number of scenarios for a company such as, low growth, medium growth, and high growth. An average (may even use probabilities) can then be used to determine the value of the company. The scenarios should, however, be well thought out. One can be if a newly introduced product fairs very well. Another can be if a substitute product enters the market. Other factors that could affect the future include:

  • New products or technological breakthroughs
  • Changes in government policy or regulation
  • Changes in consumer tastes or demand
  • The availability of raw materials
  • Changes in the economy
  • Large foreign competitors entering the market
  • Changes in currency exchange rates.

Market capitalisation

Market Capitalisation is calculated by multiplying a specific company's current share price by the number of shares it has in issue.

Market Capitalisation = Current Share Price x Number of Issued Shares.

For example: Company A has a current Share Price of 2250 cents per share and 5-million shares in issue. Market Capitalisation = 2250 x 5 000 000 = R112.5 million.

Market Capitalisation is therefore the current total market value of the company.

Market indices

Indices are used as a yardstick on which to measure the performance of the market against the performance of portfolios. The FTSE/JSE Africa Index Series was launched on 24 June 2002 and represents yet another step in the JSE's drive to provide world class products and services to its clients. This move will makes the JSE more attractive to investors and particularly to international investors who will for the first time be able to track the movement of the JSE's market using indices with which they are familiar.

The object underlying each of the indices is to present a sample of the performance of companies in a specific sector (e.g. Gold Index or Industrial Index), or the market as a whole (e.g. All-Share Index), in such a way that the movement in a share would be relative to the movements in that sector or the market as a whole. In short an index is merely a barometer, or average, of share prices in a certain sector or group of shares.

With this in mind, indices fulfil two functions for the private investor:

  • They provide the private investor with a standard against which to measure the performance of his own portfolio. He can compare the performance of his shares against the market as a whole or against its own sector.
  • They provide the private investor with a clear and concise description of the market according to its price levels, dividend and earnings yield.

Introduction to Financial Shares

This section is aimed at introducing you to the dynamic environment of the financial sector and the various economic phenomena, which have an impact on the sector as well as the shares within it. We also include a brief discussion of the property sector.

Fundamental analysis and valuation of most of the companies in this sector cannot be done based on our explanations in the Lesson on Micro Fundamentals. Under each sub-sector we will give explanations in respect of their analysis and valuations.

The financial sector comprises a few main sub-divisions:

  • Banks and Specialty and Other Finance
  • Short-term Insurance
  • Life Assurance
  • Investment Trust Companies
  • Real Estate

Before we discuss the banks it is important to get a quick overview if the functions of the Reserve Bank. Thereafter we will address each sub-sector in turn.

The Financial 15 Index

Only a selection of the financial shares listed and traded on the JSE are actually included in the Financial 15 Index. Various criterions are used in order to determine whether a particular share should be included in the index. The primary factor is market capitalisation (i.e. share price x no. of shares). This is the reason why most heavyweight blue-chip shares are included in the calculation, instead of other perhaps faster growing shares which may well draw our attention as a good investment.

Example: In February 2010 the constituents of the JSE FINI 15 Index were:

Code

Share Name

Sector

ABL

ABIL

General Financial

ASA

ABSA

Banks

DSY

Discovery

Life Insurance

FSR

Firstrand

Banks

GRT

Growthpoint

Real Estate

INV*

Investec LTD

General Financial

IPL*

Investec PLC

General Financial

LBH

Lib hold

Life Insurance

LBT

Lib-int

Real Estate Investment Trusts

NBK

Nedbank

Banks

OML

Old Mutual plc

Life Insurance

RDF

Redefine

Real Estate

REI

Reinet

Investment Instruments

RMH

RMB Holdings

Banks

SLM

Sanlam

Life Insurance

SBC

Stanbank

Banks

*Note: The two Investec companies would count for one share in the JSE Fini 15 Index.

Banks - Speciality and other finance

Banks are the custodians of the general public's money, which they accept in the form of deposits and pay out on their client's instructions. Banks can be divided into commercial, merchant and general banks, although the distinction is no longer statutorily recognised. Our discussion here will be restricted to the primary functions of commercial and merchant banks.

Commercial banks

A commercial bank can be defined as an institution carrying on a business of which a substantial part consists of the acceptance of deposits of money withdrawable by cheque, draft or order. Although this definition covers the primary facility offered by commercial banks, they currently fulfil a wide spectrum of additional facilities. As profit-making institutions, commercial banks derive their profit from two major sources. Firstly, revenue is derived from loan activities which represent the difference between income on funds lent and the cost of deposits. The second source is commission, and the fees recovered for financial services rendered. Although loan activities still constitute the major source of commercial banks' income, commission and service fee income are increasingly assuming greater significance.

The primary functions of commercial banks are:

  • The acceptance of current account, notice, term and savings deposits from the public to fund their loan activities.
  • The "creation of money" through the offering of credit facilities in the forms of bank overdrafts, credit card advances, home loans, term loans etc.
  • The collection and settlement of cheques, notes, postal and money orders, bills, and postal, telegraphic or electronic transfers, through the ACB.
  • The rendering of a wide variety of financial and personal services against payment of service fees.
  • Acting as authorised foreign exchange dealers and providing advice on exchange rates and foreign financial market conditions.
  • Assisting in the execution of monetary policy - the rates charged by the Reserve Bank for accommodation or assistance impact on the bank's rates for call funds, other money market instruments and term rates.

Merchant banks

Merchant banks direct their services primarily at large corporate clients and generally divide their operations into the following separate but complementary categories:

  • Corporate Finance - advice on corporate structuring, mergers and acquisitions, debt management and equity issues, and project finance.
  • Corporate Lending - provision of short and medium term credit to the public and corporate sector.
  • Money and Capital Markets - acceptance of short and medium term wholesale deposits, investment and trading in money markets, municipal, public corporation, and government securities, placement of municipal and public corporation issues, and options trading in various securities.
  • Derivative Markets - hedging and speculating in futures, options and swap markets.
  • International Services - trade finance, overseas funds raising, spot or forward foreign exchange trading, currency advisory and review services.
  • Investment Management - management of large-scale investment portfolios of pension funds, institutions, unit trusts and individuals.
  • Making Markets in Financial Assets - quotation of firm buying and selling prices for financial assets and derivative instruments, and maintenance of adequate portfolios or increase of holdings for this purpose.

This list is not exhaustive - it cannot be complete because merchant banks operate in a dynamic environment. Examples of companies in the banking and financial services sub-sector include, Nedbank, Standard Bank, ABSA, and Investec.

Banks - Financials and valuation

The financial statements of a bank differ from the industrial companies' statements, but banks can still be valued based on P/E or P/NAV as the industrial companies.

A bank's Income Statement looks more or less as follows:

Current

Previous period

Growth

Interest Income

125

110

14%

Interest expense

101

88

15%

Net interest received

24

22

9%

Provision for bad debts

2

3

-33%

Net interest Income

22

19

16%

Non-interest income

20

15

33%

Operating Expenses

25

22

14%

Profit Before Tax

17

12

42%

Taxation

5.1

7

-27%

Profit After Tax

11.9

5

138%

Advances Growth

12%

Net Interest margin

3.5%

3.7%

Non-interest income ratio

48%

44%

Expense Ratio

60%

65%

Banks - Ratio analysis

Advances growth - Advances Growth can be calculated from the Balance Sheet and can be compared to other banks as well as growth in the country's money supply (M3) or credit extension. Where this growth is lower than the other banks and the M3 or credit extension this means that the bank is probably losing market share to its competitors.

Net interest margin - The traditional view is that interest margins widen when interest rate decline and narrow when interest rates rise. This is due to the fact that most banks' funding costs are linked to continually changing money market rates while the assets are linked to a more stable prime or Bank Rate. Money market rates tend to lead the Bank Rate in direction. This is illustrated graphically below, the margin being expressed as the difference between the average NCD rate and prime.

Increasing interest rates during 1988 and 1989 led to interest margins falling below 2% and declining rates from 1990 to 1994 led to a widening to above 4% at times. Since 1994, margins have been under pressure again, although not to the same extent as in 1988. Although this reasoning is vindicated by the historical graph, the view is a bit simplistic, as the benefits of equity are not taken into account. A bank usually has a higher asset than liability base, which means that increasing rates can also lead to higher net interest received. Depending on the time lag between an increase in money market rates and the banks increasing their prime rate, an increase in interest rates can therefore also lead to an increase in net interest received.

The interest margin is normally given in the results as with the limited information available it will be difficult for the analyst to calculate. If interest paid increases at higher rates (15% above) than interest received (14%), this is a clear indication of the pressure on margins. Another way to measure this margin pressure is to compare the growth in net interest received (9%) with the growth in advances (12%). Where (as in the example above) advances grow faster than net interest received, margins are under pressure. A bank normally has a bit of leverage to place itself in a better position with regard to its view on future interest rates. If the view is that interest rates will decline, it will be beneficial to have as much funding as possible in short-term deposits.

Non-interest income ratio - In order to lessen their exposure to credit extension and interest margins, banks are always concentrating their efforts on increasing the non-interest portion of their total revenues. This can be measured by dividing the non-interest income by the total income received. The higher the ratio the more diversified the bank's income streams. The easiest way to achieve this is by the cross-selling of products. Most of the banks either have insurance licences or are linked to insurers and have extensive broker divisions. What can be easier than, while granting a mortgage loan, to sell the prospective client house [insurance or vehicle insurance when financing a vehicle] (link to be confirmed). Other services offered are estate planning, savings in the form of unit trusts and financial planning. These services will be enhanced by making better use of databases to stratify the population groups of clients into common areas and thereby determine what products to market to specific clients. Specialist banks actually have more income from non-interest sources than the other way around.

Expense ratio - The expense ratio is a further important ratio for analysts to calculate. This is done by dividing the operational expenses by the total revenue. As long as this ratio is in a declining trend (like in the above example), the bank are keeping costs under control. Most SA banks will be looking to reduce the expense ratio to below 50%.

For example: Expense Ratio = Operating Expenses / Total Revenue (i.e. Net-interest income and Non-interest income) = 25 x 100%/ 22 + 20 = 25 x 100%/ 42 = 59.52%

This was a huge improvement compared to the previous year.

For example: Expense Ratio = Operating Expenses / Total Revenue (i.e. Net-interest income and Non-interest income) = 22 x 100%/19 + 15 = 22 x 100%/ 34 = 64.71%

Valuation - The next ratios to calculate are the Return on Equity (ROE) and growth in EPS, which are calculated in the same manner as with industrial companies. A bank can then be valued similar to industrial companies either based on EPS growth and P/E ratio or based on ROE and the P/NAV ratio.

Short-term insurance

The philosophy behind all insurance is the sharing of risks by many to safeguard against unexpected misfortunes such as fire, accident, death, disability or simply living too long! There are two main forms of insurance, namely, short-term and long term insurance.

Short term insurance embraces a wide scope of possible risks such as fire and accident, house-owner's, householders or all risks, personal accident, public liability, marine and aviation, and motor vehicle insurance. Short term insurance contracts generally operate on an annual basis with both the insurer and the insured retaining the right to cancel the contract at any time. Premiums are calculated on the basis of the extent of the loss if the risk realises. There is a huge amount of confusion over the importance of underwriting results relative to investment returns for short-term insurers.

Share prices generally have responded positively on signs of underwriting profits and negatively in times of losses. Historically underwriting results were responsible for less than 15% of the growth in shareholders' value. Investment income (including the normal income in the form of dividends and interest as well as the realised and unrealised profits due to the mark to market valuations of investments) were actually responsible for the bulk of shareholders' value. An insurer is primarily in the game for investment returns. Theoretically, with the highly competitive nature of our insurance business (55 direct insurers registered in 1995) it will be difficult to maintain material underwriting profits without above average priced premiums. Therefore to remain competitive and maintain market share prices have to be very competitive. Insurers are effectively selling a commodity and therefore underwriting margins will always be under pressure. A margin of between 2% and 3% is common over a long period and thus underwriting profits should remain small relative to investment income.

Furthermore an insurer should manage to outperform any normal investment company. It is a well-known fact that any company that can borrow funds at a lower cost than the return the company can achieve in investing such funds will thereby increase their overall return. For example, an ungeared company with a normal return of 30% will increase this return to 35% simply by gearing 50% at a cost of debt of 20%.

A company that in the same example can gear at no cost will increase this return from 30% to 45%. The second company demonstrates exactly what an insurer is doing. It is receiving funds at no cost in the form of premiums. In a break-even underwriting environment there will be a substantial lag between receiving these funds and paying them out in the form of claims. This is in essence free money that can be invested during the interim period. Short-term insurers should therefore be valued more in line with investment trusts. There is a school of thought that believes an investment trust should always trade at a discount to its underlying value (NAV). Their reasoning is, why invest at NAV if one can invest directly in the underlying investments?

We differ from this view because, firstly, the exact details of the underlying investments are not known, and, secondly, some of the investments might not trade on public exchanges - and even if they were trading publicly an individual investor might not be able to purchase in the correct quantities. But most importantly one invests in an Investment Trust or Unit Trust for the quality of the asset management team. We believe that in a bull market these trusts should trade at a premium and in a bear market at a lower premium or even at a discount. This is due to the expectation theory, that if you believe an investment will be worth, say, R120 this time next year, and you are willing to accept a 20% return per annum, then any opportunity of buying into this investment at R100 or below should be taken. What is therefore the difference from an investor's point of view between a Unit Trust investment and an investment in a listed short-term insurer?

Unit Trust

Short-term Insurer

Always buying in at a premium to NAV due to average of 4% entrance fee.

Frequently has the option of buying in at lower than NAV.

Average growth in NAV.

Due to gearing superior returns can be achieved.

Assured of average growth in NAV.

Extra risk of underwriting losses which may negate gearing effect, however should remain positive over longer term.

Exit price guaranteed to be at NAV level.

No guarantee of NAV price at exit.

The higher risk in short-term insurers will be compensated for by higher returns due to the gearing effect of insurers. The secret is, however, to only invest in a listed short-term insurer when it is trading at a discount to its NAV (normally after underwriting losses) and to sell the investment once it is trading well above NAV (normally after excellent underwriting profits).

Short-term insurance ratios

Return on equity (ROE) - The most important ratio is the Return on Equity (ROE). However, this ROE is calculated differently from those at industrial companies. The ROE for short-term investors measures the growth over 12 months in shareholder value. The calculation is (current NAV less Opening NAV) plus Dividends paid throughout the year divided by opening NAV.

For example: ROE% = ((Current NAV - Opening NAV) plus Dividends paid)/ Opening NAV

A good investment would be a company with a ROE% in excess of the equity market's return.

Premium growth and underwriting profit margin - Calculated from the income statement premium growth gives you an idea of how fast the underlying insurance business is growing. This is important purely from a comparative point of view. Underwriting margin is the net underwriting profit/(loss) expressed as a percentage of net premium income. Break-even indicates that net premiums received are equal to claims, commissions and management expenses. This ratio is similar to the operating profit margin calculated by industrial companies. Again this ratio is of more importance for comparative purposes.

Solvency margin - Solvency margin is calculated by dividing the aggregate shareholders' funds by net premium income. Most companies actually publish their solvency margins with their results. The solvency margin is a measure of the financial strength of an insurer. The statutory requirement is 25%. Most listed short-term insurers are well above the statutory level. The higher the solvency ratio the safer the policyholders are. However, the lower this ratio the higher is the gearing and the higher the potential return (and risk) to shareholders. From an investor's point of view we would prefer Solvency Ratios below 80%.

Short-term insurers in summary

The insurance industry works in cycles, everybody makes underwriting profits, they then cut the premiums to gain market share, and underwriting losses follow. However, underwriting profits/losses historically only contribute between 10-15% of the value added to shareholders and are therefore normally not material from an investor's point of view. Short-term insurers can be seen as leveraged investment trusts. The premiums they receive from policyholders are invested until such time when claims are paid out. This free gearing are used to enhance the return on shareholders' funds. Unfortunately all the investment results (unrealised profits and losses) normally don't go through the income statements. The EPS figures are distorted and of little value to an investor. As an investment trust the NAV and average growth in NAV (incl. dividends paid) is of utmost importance.

This growth in NAV is illustrated by the ROE. Fast growing (NAV or ROE) insurers should trade at a premium to NAV and slow growers at a discount.

Long-term insurers

Life assurance covers a narrower field. In essence it consists of life, health, business, funeral and sinking fund insurance. Life offices generally provide benefits to individuals, although some policies may be company owned (e.g. pension and provident funds). Once a life assurance insurance contract is entered into, it cannot be cancelled by the insurer. Premiums are based on a variety of factors such as the age, health, disability and risk of death, duration of policy, operational costs and investment returns. Thus, short-term insurance is concerned primarily with risk assessment, while life assurance and pension and provident funds are concerned primarily with investment results and risk assessment.

Life assurance policies represent contractual savings and are one of the four main ways in which savers accumulate capital over the longer term. The other three are unit trusts, pensions and home mortgages. Although most life policies have surrender values after they have been in force for a number of years - in other words, the policy can be traded in for cash - the initial costs are relatively high and surrender values in the early years may be lower than premiums paid.

The contractual liabilities undertaken by life assurers are valued against the accumulated fund on an annual basis by an actuary and summarised in the Actuarial report. Good management, careful underwriting and shrewd investments result in valuations showing a "profit" i.e. a surplus of money in the fund over the liabilities that have to be met. The major portion of this surplus is available for distribution to with-profit policy holders.

Life offices are either proprietary, with shareholders and policyholders (e.g. Liberty Life and Sage), or mutual societies, which are owned entirely by policyholders. Mutual offices can distribute the full extent of their surplus to with-profit policyholders. Proprietary offices that have been set up using shareholders' capital to provide the initial reserve funds take into consideration in the distribution of surpluses both policyholders and the dividends that are to be paid to shareholders. The surplus is allocated to each with-profit policy and are paid as bonuses in addition to the specified sum insured in the case of reversionary bonus policies and as an addition to the investment account for universal life policies.

Life Assurance companies are of the most difficult companies to analyse and value. The main reason being that life companies normally have substantial reserves and reported earnings can accordingly be smoothed by management. This allows management substantial discretion in determining the level of earnings they wish to report. EPS based valuations are therefore of no use. Neither is discounted cashflow valuations. NAV might be used but substantial adjustments will have to be made. For valuation purposes the income and balance sheets can basically be ignored. What must be used is the actuarial report and embedded values. Following is an example of an actuarial report.

Statement of actuarial value of assets and liabilities

Current Year R000

Previous Year R000

Growth

Assets

#1

Total value of assets per balance sheet

1 000

800

25%

Less: Liabilities

800

635

26%

#2

Actuarial value of policy liabilities

750

590

27%

Long-term and current liabilities per the balance sheet

50

45

11%

#3

Excess of assets over liabilities

200

165

21%

#3

Represented by

Share capital

2

2

0%

Non-distributable reserves

50

45

11%

Distributable reserves

70

55

27%

Balance of excess

78

63

24%

200

165

21%

Valuation of assets (#1) - The value of the assets is normally as stated in the balance sheet. The growth in these assets is of importance to the investor.

Actuarial value of policy liabilities (#2) - This note normally reads as follows: The valuation of the policy liabilities is conducted on a basis consistent with the valuation of the assets.

Realistic assumptions are used together with prescribed margins in accordance with guidance notes issued by the Actuarial Society of South Africa, to allow for adverse deviations from the realistic assumptions. The gross valuation rate of discount was determined based on market interest rates at the valuation date and the asset mix of the fund. Second-tier margins exist to the extent that the gross valuation rate of discount is less than the return implied in the value of the assets.

Assumptions regarding tax payable, mortality, morbidity, withdrawals, expenses and expense inflation were based on the company's recent experience and on best estimates of future expected experience on an ongoing basis. Allowance was made for the effect of future expense inflation. Additional liabilities were held for the impact of AIDS claims. Due to the lack of further information investors have no choice but to rely on the value as ascertained by the actuaries. Excess of assets over liabilities (#3)

The excess (R200 000) is the difference between the assets and liabilities and is represented by shareholders' funds of R122 000 (2+50+70) and the balance of excess. The shareholder's funds are also known as the NAV. The question that has been debated extensively is to who does the balance of excess (R78 000) belong. Is it the shareholders or the policyholders? Although not conclusive the general consensus seems to be that the total excess actually belongs to shareholders. So an adjusted NAV of the company would be the total excess of assets over liabilities, in the above example R200 000. The company should therefore be at least worth R200 000. This amount, however, only includes the liquidation value of the company, what about the current business worth. For this we move onto embedded value.

Embedded value and embedded value profit - The embedded value is determined by adding to the excess of the assets over the Financial Soundness liabilities, the value of the expected profits likely to arise from business already written, net of the cost of capital reserves held in relation to the business.

Embedded value report

Current Year R000

Previous Year R000

Growth

Excess of assets over liabilities

200

165

21%

Value of the life business in-force

125

100

25%

Cost of capital reserves

(5)

(4)

25%

Embedded value

320

261

23%

The embedded value therefore includes all the current business and again the investor has to rely on the actuaries to calculate this value. This R320 000, however, does not include any new business or policies the company might enter into in the future. This is therefore an extremely conservative valuation for the company as it assumes that no new business will be written. Any life company trading below embedded value can be purchased. Calculating the premium over embedded value or value of new business still to be written is an extremely difficult task and largely guesswork. Investors may look at the growth in embedded value from year to year to get an idea of a future embedded value.

Investment companies

Unlike other JSE-listed companies, investment companies hold their assets mainly in the securities of other companies. Instead of owning shops or factories, their major business is to invest in the shares of other companies. The investment trust manages its investments for the benefit of its shareholders to whom it pays dividends out of its income after expenses. So, the shareholder of an investment trust effectively acquires an interest in all the companies in which the trust itself owns shares.

Investment trusts, in a sense can be seen as "miniature unit trusts". However, whilst investment trust companies enjoy a wide degree of freedom as regards the kind of investments they can undertake, they have a fixed number of authorised shares, which cannot readily be changed or repaid to shareholders as in the case of ordinary unit trusts (termed a "closed-end-trust"). The shares are usually bought and sold by investors on the JSE at market prices determined by supply and demand. The share price of an investment trust usually trades at a significant discount to the value of the underlying assets (its market NAV) - also very different from an ordinary unit trust where the unit price exactly mirrors the underlying net asset value of the share in which the unit trust invests.

Note: Investment Trusts should be valued purely on their market NAV and PE ratios must be ignored.

Real estate

The two most widely accepted methods of investing in property are:

  • Direct investment by way of ownership either as an individual or member of a syndicate; or
  • Indirect investment by means of buying shares or units in a public property owning or development company, or in a real estate investment trust.

We are only concerned here with indirect investment in property. Let us examine the two broad systems of indirectly participating in property:

Quoted real estate companies

Property companies can be divided into two broad groups:

  • Those who own and develop properties which they hold for income, and only occasionally sell off an investment which is unsuited to their requirements; and
  • Those that develop townships by buying virgin land and building residential units, thus bringing it to a state of sale. This category is generally more volatile than the previous one.

The ordinary shares of quoted property companies are traded on the JSE in the same way as other quoted shares, and their prices are influenced by exactly the same principles, with one possible exception. Property share price volatility is generally offset by the underlying market values of the various properties owned partly or entirely by the company. On the whole, property companies tend to outperform property trusts because they are more entrepreneurial in nature. However, one should be cautious, as property companies are subject to numerous pitfalls and dangers and are often only as good as the skills of those who manage them.

Real Estate Investment Trusts (REIT)

Real estate investment trusts or REITs came into existence in the mid-1970's. A real estate investment trust is a company which holds its assets in the form of property. A Real estate investment trust provides an opportunity for investment in a portfolio of properties which would otherwise be out of reach of the average individual investor, a spread of risk which would be impossible for the individual investor to achieve and access to sound investment and management expertise at a very low relative cost.

They are 'closed end trusts' just like investment trusts, and therefore, the number of units remains the same until such time as the company decides to make a new issue. As a result, the number of units in issue often remain unchanged for long periods, and investors who wish to become unit holders after the first issue has been made must buy units from investors who wish to sell them. Unit prices are determined by supply and demand and can be either higher or lower than the actual underlying value of the units.

Investing in real estate investment trusts is a sound and stable investment option for the long term. As rental income from the properties in the trust increases, so the income distribution to the investor grows, resulting in an increasing income yield on his original investment. In addition, increasing rental income leads to the increased market value of the properties and hence the unit value increases, resulting in net growth in the market value of the original investment.

Companies holding property as loan stock

Companies who hold property as loan stock are companies who purchase property and raise loans against such property thereby reducing the effects of taxation on shareholders.

Conclusion to analysing financial shares

It is important to grasp the concept that the balance sheet a bank is the exact opposite to that of a normal trading company. This makes sense if you think of it in the following terms. When a trading company makes a bank deposit, this is reflected as a debit in its books; whereas in the bank's books, it is reflected as a credit.

Banks work opposite to normal trading companies, where the money that a trading company deposits with a bank belongs to the company, while it is a liability to the bank as it 'owes' the money to the company.

From a bank's point of view, when it makes a loan, this is reflected in its books as an asset. Consequently when it is owed by debtors, this is also reflected in its balance sheet as an asset. This must be understood when analysing banking shares. Analysing financial shares are different to analysing industrial and resource shares, not only because of the way certain items are reflected on their balance sheets, but also when it comes down to different financial ratios and valuation methods.

Introduction to industrial shares

This section of the tutorial is aimed at introducing you to the various components of the industrial sector of the JSE. Further current information regarding specific companies can be obtained from various sources at your disposal. Fundamental analysis and valuation of most of the companies in the industrial sector can be done based on our explanations in the tutorial on Micro Fundamentals. However, sub-sectors such as Forestry & Paper and Steel & other Metals, might be better valued as a non-mining resource stock. This will be covered in the next section of this tutorial on resource shares.

What is the industrial sector?

The industrial sector represents more the majority of the companies listed on the JSE. In simple terms, it represents business, and for this reason we are familiar with many of the companies listed therein. The industrial sector comprises numerous sub-sectors:

Basic Industries

Chemicals
Construction & Building Materials
Forestry & Paper
Steel & Other Metals

General Industries

Aerospace & Defence
Diversified Industries
Electronic & Electrical Equipment
Engineering & Machinery

Cyclical Consumer Goods

Automobiles
Household Goods and Textiles

Non-Cyclical Consumer Goods

Beverages
Food Producers & Processors
Health
Personal Care & H/Hold Products
Pharmaceuticals & Biotech
Tobacco

Cyclical Services

General Retailers
Leisure, Entertainment & Hotels
Media & Photography
Support Services
Transport

Non-Cyclical Services

Food & Drug Retailers
Telecommunication Services

Utilities

Electricity
Gas Distribution
Water

Information Technology

Information Tech Hardware
Software & Computer Services

Industrial 25 index (Indi 25)

Only a selection of the hundreds of industrial shares listed and traded on the JSE are actually included in the industrial index. This explains why industrial shares may be moving in opposite directions to the index at times. Various criteria are used in order to determine whether a particular share should be included in the index. The primary factor is market capitalisation (i.e. share price x no. of shares). This is the reason why most heavyweight blue-chip shares are included in the calculation, instead of other perhaps faster growing shares which may well draw our attention as a good investment.

Example: In February 2010 the constituents of the JSE INDI 25 Index were:

Code

Share Name

Sector

1

ACL

Arcelor Mittal

Iron & Steel

2

APN

Aspen

Healthcare

3

AEG

Aveng

Construction & Materials

4

BVT

Bidvest

Support Services

5

CFR

Compagnie Richemont

Personal Goods

6

PLC

7

IPL

Imperial

Industrial Goods & Services

8

KIO

Kumba Iron Ore

Iron & Steel

9

MUR

M&R Hold

Construction & Materials

10

MSM

Massmart

General Retailers

11

MND*

Mondi LTD

Paper

12

MNP*

Mondi PLC

Paper

13

MTN

MTN Group

Telecommunications

14

NPN

Naspers -N

Media

15

NTC

Netcare

Healthcare Providers

16

PIK

Picknpay

Food & Drug Retailers

17

PPC

PPC

Construction & Materials

18

REM

Remgro

Diversified Industrials

19

SAB

SABMiller

Beverages

20

SAP

Sappi

Paper

21

SHP

Shoprite

Food & Drug Retailers

22

SHF

Steinhoff

Personal & Household Goods

23

TKG

Telkom

Telecommunications

24

TBS

Tigerbrands

Food Products

25

TRU

Truworths

General Retailers

26

VOD

Vodacom

Telecommunications

*Note: The two Mondi companies would count for one share in the JSE Indi 25 Index.

Although the INDI 25 Index is generally accepted as being an accurate reflection of the performance of the industrial sector as a whole, it is not conclusive evidence of such, and should not be considered in isolation especially when one is holding shares which are not included in the calculation thereof.

Introduction to resource and mining shares

For valuation and analytical purposes resource stocks can be divided into:

  • Mining Stocks - Coal; Diamonds; Gold; Platinum; Mining Finance; and Other Mineral Extractors.
  • Non-Mining Stocks - Chemicals, Oils and Plastics; Paper; and Steel.

Notwithstanding the above according to the JSE sector classification the non-mining shares fall under the Basic Industries Sectors and not the Resources sector.

Resources 20 index (Resi 20)

The FTSE/JSE Resources 20 is an index comprising the major 20 resource companies listed on the JSE, based on market capitalisation, free float and liquidity of these resource companies. The Resi 20 provides a balanced exposure to the global mining holding companies, gold mines, platinum, uranium and base metal mines, mining resource companies and Sasol listed on the JSE.

Code

Share Name

Sector

1.

ARI

African Rainbow Minerals

General Mining

2.

AGL

Anglo

General Mining

3.

ANG

Anglogold Ashanti

Gold Mining

4.

AMS

Angloplat

Platinum Mining

5.

BIL

BHP Billiton

General Mining

6.

DRD

DRD Gold

Gold Mining

7.

EXX

Exxaro

General Mining

8.

GFI

GFields

Gold Mining

9.

HAR

Harmony

Gold Mining

10.

IMP

Impala Platinum

Platinum Mining

11.

KEH

Keaton Energy Holdings

Coal Mining

12.

LON

Lonmin

Platinum Mining

13.

MRF

Merafe

General Mining

14.

MTX

Metorex

General Mining

15.

NHM

Northam Platinum

Platinum Mining

16.

PET

Petmin

General Mining

17.

SOL

Sasol

Oil and Gas Products

18.

SNU

Sentula Mining LTD

General Mining

19.

SIM

Simmers

Gold Mining

20.

WEZ

Wesizwe

Platinum Mining

Although the FTSE/JSE Resources 20 Index is generally accepted as being an accurate reflection of the performance of the resources sector as a whole, it is not conclusive evidence of such, and should not be considered in isolation especially when one is holding shares which are not included in the calculation thereof. However, it still gives direct exposure to the resources sector of the JSE, which enables investors to benefit from trends in global commodity cycles.

Mining shares

The analysis of mining shares is extremely complex. The analyst needs to be a "jack of all trades" - part mining engineer, part geologist, part accountant and part economist. It is important to note that, due to the difficulty in analysing these shares, they must be considered as highly speculative for the average private investor.

Following is an example of how in depth gold share research should be. As most private investors will not have access to the resources needed for such an analysis, most mining shares should not form part of a DIY investment portfolio. Speculators can, however, use technical analysis for trading these shares.

Gold mining fundamentals

After studying this page, it is hoped that the learner will be in the position to basically analyse the quarterly results of gold mines and apply this information to enhance an investment decision.

Operating Results

Quarter Ended

Area Mined -m2 000

113

Tons Milled 000 - Reef

535

- Waste

8

- Total

543

  • Area Mined is expressed in square metres (also known as centares).
  • Tons Milled is in metric tons.
  • Reef Tons is the tonnage sourced from underground operations from the reef horizon.
  • Waste Tons is the tonnage generally sourced from surface dumps.
  • Density of gold ore from the Witwatersrand is approximately 2.73.

The following calculation can be made on the above data:

Total Mill Width = (Total Tons Milled / Area Mined) / Density = (543 000/ 113 000)/ 2.73 = 4.80 /2.73 = 1.76 metres or 176 cm.

Operating Results

Quarter Ended

Yield -g/t - Reef

7.99

- Waste

0.50

- Total

8.49

Production - kg

4 610

  • Yield is expressed in grams per ton.
  • Reef Yield is the average yield of the reef tonnage obtained from underground.
  • Waste Yield is the average yield of the waste tonnage sourced from surface dumps.
  • Total Yield is the weighted average of the reef and the waste tonnage yield.
  • Production is expressed in kilograms and represents the amount of gold produced by the mine.

Gold production is calculated as follows:

Gold production = Total Tons Milled x Total Yield = 543 x 8.49 = 4610 kg

There are 32 151 troy ounces in one kilogram and therefore 4610 kg is equivalent to 148 216 oz (troy).

Operating Results

Quarter Ended

Costs - R/m2 mined

967.02

- R/ton milled

201.24

- R/kg produced

25 531

Total costs - R 000

109 237

Revenue - R/kg

41 010

  • Costs (R/m2 mined) are the cost associated with mining one square meter or one centre of ground. This is calculated by dividing the total costs by the area mined.
    For example: Costs (R/m2 mined) = 109 273/ 113 = R967.02/m2
  • Costs (R/ton milled) are the cost associated with milling one to through the mill. This is calculated by dividing the total costs by the total tonnage milled.
    For example: Costs (R/ton milled) = 109 273/ 543 = R201.24/t milled
  • Costs (R/kg) are the cost associated with producing one kilogram of gold. This is calculated by dividing the total costs by the gold production.
    For example: Costs (R/kg) = 109 273 x 1000/ 4610 = R23 703/kg
  • Total costs are the total cost associated with running the mine and includes labour, power, stores and other costs.
  • Revenue (R/kg) is the average amount received per kilogram of gold produced.
Converting grades to yields

Grades are normally quoted alongside a width (i.e. a channel width or a stopping width) and this grade is called the in situ grade. In order to convert the in situ grade to a yield the following procedure is adopted (the 1500 cmg/t example will be used).

The Effects of various widths on grades

The in situ grade expressed in cmg/t is divided by the mill width and in this case 1500/ 180 = 8.33 g/t. This grade is then multiplied by the Mine Call Factor (MCF) for the mine expressed as a percentage. This factor accounts for possible sampling errors which can occur in the initial sampling of the in situ grade and represents the ratio between the gold received and the gold called for. In this example 95% will be used and this results in a value of 7.91 g/t (8.33 x 95% = 7.91). This grade is called the Head Grade.

This product is sent to the mill and the head grade will again be subjected to the extraction process of the metallurgical plant. Applying an average Metallurgical Recovery Factor (MRF) of 95.5% to the head grade results in a yield of 7.55 g/t (7.91 x 95.5%).

Practical example (Development values and yields)

The sampled development values have been extracted from a fictitious gold mine's annual reports. The weighted average value over this period is 1261 cmg/t and this was calculated from over 6400 m of sampling development. The average mill width is 185cm, suggesting that the average head grade of the ore body could be 6.82 g/t. The average MRF is 95.5% and assuming a MCF of 95%, then an average yield of 6.2 g/t could be achieved. For comparison purposes, let us say that the mine in fact achieved an average yield of 6.4 g/t.

There is a strong correlation, i.e. 75% between the development values and the yield, which is achieved. There is, however, a lag period. In this example, around two years. It is critical that the development values as published by the mines are carefully analysed in order to determine potential future trends. Note that in our example, the latest figures are the highest recorded since the mine started.

Costs on a gold mine

There are various cost measurements which can be applied to a mine such as R/m2, R/t and R/kg. Some measures can be misleading, an example of which is shown below:

It can be observed from the example below that it would be misleading to believe that Mine A would be more profitable than Mine B based on the cost per ton of ore milled since Mine B produces gold at a lower cost. A quick way to calculate the cost of gold production is to divide the R/t by the yield and multiply by 1000.

Mine A

Mine B

Cost- R/t

100

200

Yield -g/t

4

10

Cost - R/kg

25 000

20 000

Breakeven cost of production

There are other cost measurements which are vitally important and which will indicate if a mine is operationally sound or not. One of these would be the Breakeven Cost of Production. Quite simply this cost is the gold price. At the current gold price of around R47000/kg then all mines in South Africa have a breakeven of R47 000/kg. Some mines, however, will be producing gold at a cost lower and some will be producing at a cost higher than this level. What is important, therefore, is to measure the difference between the breakeven cost of production (or the Rand gold price) and the actual cost of production. Extensions to these measurements would be to express the cost and the gold price in real terms (i.e. adjusted for inflation).

Practical example of breakeven costs

The graph below illustrates the historic relationship between the breakeven cost of production and the actual cost of production. It can be observed that this mine has a healthy situation whereby the gap between the breakeven cost of production and the actual cost of production is continuing to widen. The gap can be defined as the operating profit margin expressed in R/kg.

Image: Tutorial5-image005

The concept of breakeven yield

As with the concept of the Breakeven Cost of Production, the operation can be analysed in terms of Breakeven Yield. The breakeven yield is calculated by dividing the R/t cost by the breakeven cost of production multiplied by 1000.

For example: Breakeven Yield = 201.24 / 47 000 = 4.28 g/t

Remember this can be taken one step further by expressing the R/t cost and the Breakeven Cost of Production in real terms, which is a difficult concept to grasp, i.e. a gold yield in terms. The graph below illustrates the gap between the Breakeven Yield and the actual yield achieved.

For the most current quarter, the gap between the breakeven yield and the actual yield is 3.0 g/t. This means that the yield can drop by 3.0 g/t or decline by 38% and the mine will still not make a loss.

In conclusion, when investing in the shares of gold mining companies, a little bit of basic fundamental research will ensure that your investment will be safe. Do not be fooled by costs or grades when making an investment. Analyse them carefully. Have fun using technical analysis on historic production data.

Factors influencing the current position
Supply and demand

It is an extremely difficult task to analyse the supply and demand for gold. This is an ever-changing scenario. Below is an example of such an analysis done quite a few years ago. Although this analysis may no longer be valid it will give the reader a good idea of all the factors to be taken into consideration.

The early 1990's saw a shift in production output from the traditional major gold producers to emerging countries. In 1993, world gold mining production rose 2% to 2 281 tons. Although South Africa remained the largest producers of gold world-wide, its share of the total world production continued to fall, with its output accounting for only 27.2% (619.5 tons) of total gold production. But, while the major first world gold producers, like the United States and Australia, saw only modest increases, the largest increases were recorded by countries such as Ghana, Guyana, and Bolivia. In fact, Ghana moved up to tenth position in the worldwide ranking displacing Chile. This production shift from first-world countries to emerging countries is largely a product of both economic and political factors.

The strict environmental and tax regulations in first-world economies have caused many world exploration companies to shift their emphasis to emerging countries which are largely unexplored and offer generous investment and tax incentives. As long as these countries continue to be the objects of aggressive resource exploration and exploitation, their total production will continue to grow at a rate above the world average.

Supply and demand for gold generally emanates from two sectors - the official sector, and recycling of scrap. By "official sector" we are referring to movements in the general reserves of central banks. The general trend in the nineties seems to be to sell gold reserves. An estimated 626 tons of gold reserves were sold in 1992. This figure dropped, some 151 tons, to around 475 tons in 1993/4. South Africa has also sold of significant reserves in line with this trend.

In contrast, scrap recycling seems to have been on the increase, particularly in the Western world, with recycling increasing to a record 516 tons in 1993. This trend seems to have been largely a result of increased gold prices. Various factors were responsible for a general decline in overall fabrication demand in the early 1990's including a generally poor international economy, a lower oil price which decreased Middle Eastern demand, political instability in Italy which is a major fabricating centre, and the introduction of austerity packaging in China. Fabrication demand dropped by some 7% in 1993, representing a decline of 4-5% in Europe, 6% in the Middle East, and 9% in China. Italy, India and China represent the three largest gold consumers for the manufacture of jewellery. Demand for gold in all three countries dropped in 1993. China, India and the USA, on the other hand, are the three major consumers of gold jewellery. Gold jewellery purchases rose significantly from 1991 to 1992. China's purchases grew from 220 tons to 335 tons, India from 212 tons to 277 tons, and the United States from 253 tons to 275 tons.

Investment demand seems to be exhibiting general growth, with demand from Western investors rising to its highest level since 1974 in 1993. In fact, this proved to be one of the major causes of a rise in the gold price during that year. Bar hoarding experienced a general decline in the early 1990's. Traditionally, North Africa, India, and the Middle East have all been gold hoarders. All three experienced a decline in hoarding in 1993, largely in response to an increasing gold price.

Exchange rates

The gold is sold by mines to the Reserve Bank which, in return, pays the average of the previous days gold price, which is immediately converted at the prevailing rand: dollar exchange rate. For this reason, exchange rates are an important determinant of the gold price. For example: Gold Price (R/oz) = Gold Price ($/oz) x Exchange Rate

The South Africa rand has experienced considerable pressure over the last few years. South Africa's high inflation rate has resulted in natural downward pressure on the value of the rand, causing a depreciation of the value of the rand against the dollar. This depreciation is expected to continue for some time yet.

For instance, weakness in the rand during 1996 was such that despite a fall in the dollar price of gold from over US$400 to below US$380, the rand price of gold actually rose from around R1 500 per oz. to nearly R1 800.

Future prospects

A mine's future value depends to a large extent on its probable future output. This requires an examination of the mine's life, reserves, production rates and recovery rates, amongst other factors. A mine's life can be divided into three phases:

Phase 1: Development or start-up phase

Due to the high development costs involved during this phase of a mine's operations, expenditure often exceeds revenue, resulting in an assessed loss.

Such development costs relate to exploration of the orebody, the erection of infrastructure, and the purchase of equipment. Geological geo-statistical knowledge is invaluable during the exploration phase. Potential anomalies are tested by way of borehole drilling. Samples are analysed and reserves, recovery rates and gold grades are estimated on the basis thereof. It is important to bear in mind that such assessments are merely estimations, and sometimes turn out to be incorrect. Most orebodies in South Africa tend to be conglomerate representing high reserves. Once such conglomerate reserves are exploited the mine has to rely on peripheral deposits which tend to be erratic and of varying grade. Once such assessments are complete and the reserves, recovery rates and grades are found to be sufficient to justify exploitation, the necessary infrastructure, such as shaft systems, haulage levels etc. is put in place.

Phase 2: Full production phase

The mine can now access the ore body and begin exploitation thereof. The mine's production capacity will steadily increase during this phase until it reaches its peak output.

Annual gold production can be calculated by multiplying the total number of tons milled by the recovered grade. Gold Output (kg) = tons milled x recovery grade.

Revenues will increase as output increases, whilst working costs will tend to decrease slightly and become more consistent as machinery and plant are utilised to an increasing degree. This stage tends to coincide with lower development capital expenditure.

Revenue is calculated by multiplying gold output by the gold price: Revenue = gold output x gold price

By "working costs" we mean the costs incurred in recovering the gold output in a particular period. This is calculated by simply multiplying the output by the cost per kilogram mined:

Working Costs = output x cost per kilogram

In light of the highly labour intensive nature of South African mining, approximately 50% of the working costs of local mines consist of wage expenses. Future increases in wage expenses will depend to a large degree on inflationary pressure and labour relations.

Other working costs would be aspects such as travelling time in deep shaft mines, increased power consumption, overlying strata, the need to keep the mine dry by pumping out water etc. All these factors play a critical role in the evaluation of the company's future.

Mines also often make use of futures to hedge themselves against possible drops in the gold price i.e. sell a portion of their gold production forward in order to lock in a strike price. Such hedging is a relatively new feature in the evaluation of gold mines.

Depending on the profitability of the mine, and the level of the unredeemed capex (previous tax losses), profits realised will be subject to taxation. During this period earnings will thus tend to decline, although dividends will normally be paid out.

Phase 3: Closing down phase

This "running down" phase of a mine will occur when the operation has exhausted ore reserves contained within the lease area, or the costs of extracting the gold exceeds the potential revenue making the venture uneconomical.

Capital expenditure will fall away during this phase and, in fact, assets will be disposed of. Operations will become increasingly scattered and as throughput decreases, unit working costs will increase and revenue decreases. Funds are generally retained to finance environmental rehabilitation and severance costs and dividends are often reduced or non-existent as a result.

Quarterly Analysis of Working Results of SA Gold Mines for the July - September 2009

Note: Reproduced from Chamber of Mines website ( http://www.bullion.org.za/).

Non-mining shares

For fundamental analysis purposes the non-mining resource stocks can be divided into:

  • Pure Commodity Stocks - these can be identified by having extremely low returns on equity and capital and normally very volatile EPS records.
  • Other - these companies have higher returns and more stable EPS growth trends.
Pure commodity shares

Pure commodity stocks are high risk investments. Many a private as well as professional investors have burnt their fingers with commodity stocks. How should one value these shares?

According to the dictionary a commodity is a mass-produced unspecialized product. What this means in investment terms is that a true commodity company will never be a good long-term investment. Why is that? Let's look at a paper company. Do you even know which company provides the paper for your photocopier at work? More important do you really care? Paper is paper. So you will not be willing to pay a premium for ordinary photocopy paper, the cheapest will do. The result: very low profit margins and normally return on capital and equity. A Company with no pricing power is a company that is at a distinct disadvantage. These companies' products are priced by the market, themselves do not have much control over the prices. That is why product prices are extremely volatile, as is the operating results of commodity companies.

When the prices are high most commodity companies increase production. Because of more products (increased supply with stable demand), prices drop. When prices drop most commodity companies decrease production. The result of this lower supply results in increased prices. This cycle never ends and that is the major reason for extremely volatile operating results. If you can guess when the cycle will bottom and when it will peak you can make a huge amount of money. We use the term guess because unfortunately this is extremely difficult to do and we are yet to learn of anybody who consistently achieves this feat. But why can't long-term investors just buy these shares, place them beneath their mattresses and after 10 years retire on the fortune they have made? Simply because there most likely will be no fortune to retire on. More than likely the value of the shares would after the ravishes of inflation have diminished in real terms.

Below is a table showing certain averages of two commodity shares, Iscor and Sappi over a 10-year period. The return on capital and equity basically shows you what return the providers of capital and the shareholders would have achieved on an after tax basis per year.

1990-1999

Iscor

Sappi

Average Return on Capital

9%

9%

Average Return on Equity

9%

10%

Average P/E

15

15

High P/E

21

38

Low P/E

4

6

Average P/NAV

1.0

1.0

High P/NAV

1.3

1.6

Low P/NAV

0.4

0.4

Having such low returns on capital and equity figures translate into very low shareholder value added. The above single figure returns are lower than the almost risk free returns an investor could have received over the last 10 years by purely leaving the money in the bank. That is why most commodity companies are not suitable for long term investments. Do not buy and hold these shares for extended periods. The only way to achieve a good return is to buy them when they are very cheap and sell them when they are expensive. A sort of medium (between 1-3 years) term trading strategy. If their returns remain at these same levels the share prices should be at relatively the same levels 10-20 years from now.

What confuses most investors is that they are taught that shares are cheap (and should be bought) when they are trading at a low P/E (price divided by earnings per share) relative to its own history and sell when the P/E is high on the same relative scale. This might work with most other shares but try this technique with commodity shares and you can forget about early retirement as you watch your savings disappear. EPS (earnings per share) figures differ markedly from year to year. In the above table you will see how volatile the P/E multiples are. Sappi's highest PE was 38 times and its lowest only 6 times. Often when the share price is at a low level the EPS is even at a lower level. In such a case the P/E would be relatively high, but the share actually undervalued. At other times after the share price have doubled, EPS might have increased 4 times from its previous low level. The result a very low P/E but an overvalued share. So when it comes to commodity shares please ignore EPS and P/Es from a valuation point of view. You are likely to buy and sell at exactly the wrong times.

So how to decide when to buy or sell commodity shares? The textbook answer is that you should analyse the commodity cycle, which includes such factors as world economic growth, current as well as the possible future supply of the commodity. The demand for the product and the history of the commodity's raw prices. And so the textbook continues. Let's save time and skip the other 332 pages of this particular boring textbook because as with most other textbook investment theories, in practice this is unfortunately totally unfeasible.

An easier method to use is the Price/NAV level compared to history. From a textbook point of view one knows that companies with sustainable returns on capital and equity below the risk free rate should be worth less than their NAVs (net asset values). So you already know that a Price/NAV of above 1 is expensive and below 1 cheap. You can see from the above table that the average P/NAV for these two companies were close to 1. The highest level was 1,3 and 1,6 times respectively and the lowest levels 0,4 times NAV. So you should set a buying level somewhere between 0,4 and 1 times NAV. A selling level should be between 1 and 1,3 or 1,6 times respectively. This method will ensure that you do not overpay for these investments and also that you take profits at a certain level. Unfortunately timing remains a problem as the share might go even lower before it actually starts picking up.

From the graph you will see that if you had bought Iscor in 1992 at about 0,4 times NAV, the share would have dropped further during 1993, but you would have sold above NAV during 1995. Your share would have increased over these 4 years from 1500cps to 4200cps, a return of 180%. Likewise had you bought Sappi during 1997 trading at 0,6 times NAV, the share price would have continued down during 1998, before going past its NAV during 1999. Over three years from 4000cps to over 5700cps, a return of 43%.

In both cases returns not to be sneezed at. Unfortunately in practice this type of medium term trading is extremely difficult. Because psychologically buying these shares in the manner described above means going against the crowd. At your buying levels, the companies' profits are usually very low and everybody around you will be extremely negative towards the company. When you sell, profits would have hit a new high and everybody will only have praise for the company. So at both ends you must be willing to go against the crowd and most probably in the short term look extremely stupid as the share prices are likely to, at least for a while, move against you.

Other

The stocks with higher returns on equity and capital as well as more stable EPS growth trends can be valued exactly as normal industrial companies. Refer to the tutorial on micro fundamental analysis. Sasol is a good example of such a stock.

Conclusion

The industrial and resource sectors are the backbone of the South African economy and most of the daily trading takes place in these sectors. They are easy sectors to follow as much is written about the companies in the financial press.

When it comes to industrial companies, you can make money very easily if you combine your skills in assessing a company's financial statements and working out the ratios and valuations to compare different companies with each other.

Support

If you have any further queries, please feel free to contact our educational team on shaunvdb@psg.co.za or call 0860 PSG PSG (774 774).

Thank you for your support and happy trading!

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