Quality: the relentless driver of high compounding returns

Investors these days are quick to draw parallels between broad headlines in the financial press and companies on their investment horizon, to the extent that they are willing to base their buy or sell decisions on this information. In the process, they ignore the fact that market behaviour drives news flow, which augments their own emotions towards their intended investment actions. It is therefore not surprising that ownership periods of listed companies offshore has shrunk from years to months.

South Africa with its prevailing political and economic climate is of course fertile soil for cultivating such disparate financial headlines. Focusing on the factors that distinguish a great company from its poor cousins has never been more important. Investors ignoring this and blindly following headlines obviously do so at their own risk.

We are not propagating an all-or-nothing capital allocation strategy in favour of South African stocks. However, at this stage the South African market is a prime example of how financial headlines disguise reality. They do not highlight the exceptional quality businesses, seeing the individual companies for what they are and their ability to compound cash flows for shareholders despite the general economic malaise.

This is not a debate about value stocks versus growth stocks. There are South African companies that have been compounding cash flows for decades, with financial metrics comparable to some very well respected offshore multinational corporations.

One of our portfolio companies, used for illustration purposes, is a good example of the extent to which high quality businesses have been neglected by investors. This business has compounded free cash flow available to shareholders (cash flow after capital requirements to maintain its competitive position) at almost 15% per annum over the past 10 years, with growth at more than 20% per annum over the past five years. It has consistently generated returns on invested capital close to 30%. It currently generates a 20% operating margin, 4% higher than 2015. Investors who bought this business back in 2015 would by now have recouped more than a third of their capital in dividends. Yet, its share price is 15% lower than five years ago despite the fact that it is a financially stronger business today. The business can be acquired on an earnings multiple of 14 times (i.e. an earnings yield of 7%).

Graph 1: Share prices often lag operational performance

Some offshore companies operating in product categories similar to our South African example are trading at earnings multiples 40% to 70% higher. Our South African example’s free cash flow yield is also almost double that of its offshore peers.

While it is often said that it is better to buy a great business at a fair price rather than buying a fair business at a great price, it is evident that investors often correlate price with business quality resulting in the passing of often great investment opportunities when share prices decline or, at best, stagnate for reasons completely unrelated to the underlying business fundamentals.

While the number of high-quality businesses in South Africa has dwindled over the past few years there are a remaining few that deserve attention. They have unique market positions, very strong management and a track record of generating consistently attractive returns on capital.

These companies are facing similar headwinds as most other SA companies, but management of these businesses have been able to extract shareholder value despite these impediments. These operational traits do reflect in share price performance over time. Acting on these opportunities requires conviction, homework and, most importantly, patience.

Solid long-term performance seldom makes the news headlines.

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The opinions expressed in this article are the opinions of the writer and not necessarily those of PSG. The information in this article is provided as general information. It does not constitute financial, tax, legal or investment advice and the PSG Konsult Group of Companies does not guarantee its suitability or potential value. Since individual needs and risk profiles differ, we suggest you consult your qualified financial adviser, if needed.
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