South African Listed Property – Better Value, but the Growth has Disappeared

SA Property has been a consistently high performing asset class for the last two decades, with returns only briefly interrupted by the financial crisis of 2008. SA property investors have experienced annual dividend growth of 8% since 2005 and this has driven capital growth in the sector.

This year the property sector has experience a significant draw-down with a fall of close to 30% year to date. The first quarter saw the collapse in value of the Resilient stable of companies. The extent of fraudulent activity within these companies remains to be seen, but the price fall is largely due to the fact that these stocks were trading at large premiums to their Net Asset Value. We avoided all the Resilient related stocks as they were extremely expensive, and we believed that the growth reported was unsustainable.

Once the Resilient story had played out, the rest of the sector came under pressure as the market began to realise that growth had vanished.

The Quality of Earnings Growth has Fallen Sharply

The reality is that most companies in the sector have been struggling to grow earnings for a number of years due a lack of economic growth and low business confidence. Lower rent escalations and negative reversions (lower rent) on expired leases have become the norm. Property companies have been under pressure to continue showing high dividend growth and they have engaged in a number of financial “shenanigans” in order to report a higher growth number to investors. These financial engineering strategies include:

• Highly leveraged offshore acquisitions
• Debt/Swap Restructurings
• Cross Currency Swaps
• Distributing Fees and Once off gains (at expense of property values)

Property companies have also increased the concessions they have been willing to give tenants for both new leases and renewals. They are giving longer rent-free periods and have increased their contribution to tenant installation costs. The effect of these concessions has been to overstate rental levels and hide some of the weakness in the sector.
We have been cautious on the property sector for the last three years given the deteriorated letting prospects in a poorly performing economy. The market has finally realised that much of the growth in recent years has been an illusion.

Valuations are Beginning to Catch Up with Reality

The decline in growth prospects for the sector is finally being reflected in valuations as the starting yield on the sector has increased significantly. Since the beginning of 2017, the trailing yield on the JSE REIT Index has increased from 6,5% to its current level of over 9%. While this is partially attributed to the derating of the Resilient stable, the yield on all stocks has shifted higher to compensate for the diminished growth prospects.

JSE REIT Yield

With the headwind of lower, or even negative growth from property companies, we continue to remain cautious on the sector. SA investors have been spoilt with very attractive returns for a long time, and the adjustment to a lower growth environment will take time. However, much cheaper valuations warrant some additional exposure and we have been adding SA property to our funds at these cheaper levels.

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An Uber Valuation for Uber is Unwarranted

Uber is preparing for an IPO and the bankers are delivering initial valuation estimates of around $120bn. While investment banks compete to secure the deal by pitching increasingly unrealistic valuation numbers, the IPO is likely to be pitched well above the last valuation level of $68bn.

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The $68bn valuation is a fictional starting point

The story around how UBER maintained its $68bn valuation, even as its sold shares at a $48bn valuation, reflects the irrational state of the market. Summary: Softbank wanted to buy $10bn worth of UBER while it was theoretically valued at $68bn on the private market. Softbank bought $9bn at a $48bn valuation and after that bought $1bn at a $68bn valuation. Uber gets to maintain the illusion of being worth $68bn. Softbank gets an immediate gain on the $9bn it bought at the cheaper price. Everyone wins.

What is a realistic valuation for UBER?

Professor Aswath Damodaran of NYU has done a number of valuations of UBER  and he shares the spreadsheet used to calculate the his value of $36bn.  The spreadsheet has very useful data on a operating margins in a range of industries. Damodaran uses a sustainable margin for UBER of 20%, which is almost twice the market average of 10,5%. Even with his generous assumptions he gets a valuation well short of what the banks are indicating for the IPO.

What if people stop using the UBER app?

UBER has spent almost $11bn over the last years in building a strong lead in the car service market. However, it is not clear that they have a sustainable competitive advantage. Despite its current dominance, there are no network effects, so they don’t “own” the customer. Using UBER in Europe I have seen many taxi drivers with 3 phones who are happy to pick up any passenger whether its UBER/Lyft/Mytaxi, depending on what is most profitable. Recently, Taxify has integrated with google maps in South Africa so it is very easy to do the comparison of taxi services in terms of cost and time to pickup. These are screenshots of the google maps app looking for a taxi from my work to the waterfront. I see that in the UK google maps gives you three options (UBER/Mytaxi/Gett). With this integration there is no longer any reason to go straight to the UBER app when you need a taxi.

Ride Hailing Will be a Commoditized Service

You now have a commodification of the ride hailing service on both the drivers and the rider side. The cost of developing a competing app is trivial, and if google maps (or apple maps) is the new access point for passengers, then new entrants will be able to compete directly with UBER from day one. All they need to do is give google a cut. In this environment a high margin for ride sharing companies is unsustainable, and it is likely to be lower than the average in the economy. If that is the case, then UBER is only worth only a tenth of the $120bn that its bankers are currently pitching.

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Is the South African Reserve Bank Behind the Curve?

Higher US rates are putting emerging markets under pressure
Emerging markets are coming under pressure as higher USD interest rates expose their poor fundamentals. The Rand has depreciated by 17% in the last 3 months against the USD. Only Turkey and Argentina have performed worse as they deal with high levels of foreign currency debt.
To date, the narrative around the Rand is that it is collateral damage from Turkey and Argentina, as well as local political noise surrounding Land reform. However, the real issue may be that our rates are too low. With South Africa now “officially’ in a recession and inflation at 5,1% (within the 3-6% target band), the consensus is that SA does not need to hike rates. However, I think this belief that the SARB can remain on hold is based on misunderstanding about the nature of emerging markets.

 

Emerging Markets have to respond to currency depreciation with rate hikes
However, one of the defining features (if not THE defining feature) of an emerging market is that a currency devaluation is a tightening of policy, as the central bank is forced to hike rates in order to contain inflation. Eric Lonergan recently wrote an excellent post outlining how this process works

“Emerging markets are not poor countries, nor are they countries which are making economic progress. They are defined by a very specific set of macroeconomic properties, which financial markets are conscious of, but are rarely clearly articulated. The overriding characteristic of an emerging market is that a currency devaluation is a tightening of policy.”

This primary trait of emerging markets has recently been highlighted by the extreme examples of Turkey and Argentina, who have both hiked rates by around 20 percentage points since the beginning of the year in response to currency depreciation. Turkey’s short term rates were around 12% a year ago and are now around 30%.

Confidence in the Central Bank is essential
While South Africa does not have large foreign currency debt risk, it is still highly dependent on capital flows to finance the twin deficits (current account and fiscal deficit). Foreigners have purchased large amounts of SA bonds in recent years and this has helped finance higher levels of SA debt. It is essential that confidence is retained in order to prevent capital flight.
A large part of this confidence based on the belief that an independent central bank will act to contain inflation and protect the purchasing power of the currency. The main tool to contain inflation is interest rates. Investors need to be confident that interest rates will rise if inflation becomes a problem. Without this belief a currency ceases to be a store of value. The long term negative economic consequences of a loss of confidence are far more severe than the short term pain inflicted by rate hikes.
Turkey is a recent example where the confidence in the value of the currency was damaged due to political interference. President Erdogan directly instructed the Central Bank not to hike rates in response to higher inflation. This damaged faith in the Turkish Lira as a store of value, and meant that both locals and foreigners were not willing to hold it as an asset. The currency has halved in value over the last 2 years and rates eventually had to rise dramatically so as to contain the damage.

Are there parallels between Turkey and South Africa?

The market lost faith in Turkey as they had a central bank which lacked independence and kept rates too low despite currency weakness and rising inflation.
While the SARB is independent, they do operated in a difficult political environment where their mandate, inflation target and ownership is attacked by opposition parties and trade unions. While they talk hawkish, they have betrayed a a dovish bias in recent years as they have tried to support a struggling economy. Recent attempts to talk inflation expectations down by saying they are targeting 4,5% inflation have been unconvincing.

Despite their consistently hawkish talk, the SARB cut rates in July last year and then again in May this year. We are in a US rate hiking cycle where the FED has hiked 4 times over the same period. During this time we have also seen rate hikes from a number of EM countries. Our “Real” rate (nominal rate minus inflation) is now looking quite low relative to our emerging market peers.

EM Real rates

 
Hike Rates, or the market will force you to do it

The SARB’s rate cutting cycle is beginning to make it look like an outlier in the global context. I think that a large part of the recent Rand depreciation is due to this realisation.
The South African Reserve Bank (SARB) is in a difficult situation as higher rates will be an impediment to an already weak economy. Recent speeches by Governer Lesetja Kanjago and other members of the Monetary policy committee (MPC) indicate that they do no believe that they need to raise rates as inflation (currently 5,1%) is within the target band. Unfortunately, global developments often force emerging markets into a rate hiking cycle even when it will inflict pain on the local economy. This is the price we are forced to pay in order to reap the long term benefits of maintaining confidence in value of the currency.

There is an MPC meeting in two weeks time on the 20th of September 2018. None of the 16 analysts on Bloomberg expect a September hike and only 2 out of 16 expect the SARB to hike before the end of the year. I think both the analysts and the SARB are too optimistic. Our Repo rate at 6,5% looks about at least 1% too low in in an EM context. In a rising global rate environment, the Rand will continue to be a relative under performer until we get a reaction from SARB.

 

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Diamonds Are Not Forever

“Large numbers of strangers can cooperate successfully by believing in common myths. Any large-scale human cooperation – whether a modern state, a medieval church, an ancient city or an archaic tribe – is rooted in common myths that exist only in people’s collective imagination.”
― Yuval Noah Harari, Sapiens: A Brief History of Humankind

The recent move by De Beers to manufacture and sell lab grown diamonds has sparked some debate about the future of the diamond industry and the investment case for Anglo American. Anglo American own 85% of De Beers and diamonds contribute around 25% of the company’s revenue. For years, De Beers dismissed lab grown diamonds as not “real”. Just two years ago they were trying to sell a $60,000 infrared detector to jewelers as even experts could not differentiate between natural and lab grown diamonds. The efficacy of this equipment is questionable and the most common advice online is to insist on a certificate of authenticity.  In 2015 Simon Lawson, head of Technologies U.K. at De Beers said “De Beers’ focus is on natural diamonds, We would not do anything that would cannibalize that industry.”

That strategy failed as the share of lab diamonds grew and began to leak into the global supply chain undetected. With the launch of Lightbox, De Beers’s strategy is to manufacture and sell lab diamonds themselves, at a price 90% below natural diamonds. This severely undercuts their competitors who in recent years have been selling lab diamonds at around 30% below natural diamonds. Biz news describe De Beers as having dropped an “Atom Bomb” on the lab grown diamond industry.

This aggressive move is a risky attempt to fully segment the market into “natural” and “lab” diamonds. It is loudly proclaiming to the world that natural diamonds are ten times as valuable as lab diamonds (according to De Beers that is).

This aggressive strategy will severely hurt other lab grown diamond manufacturers who until now were making good margins selling lab diamonds at a 30% discount to natural diamonds. The question is whether it this “cannibalization” strategy will end up killing De Beers in the process. The problem that De Beers faces is that lab diamonds and “natural” diamonds are essentially the same thing. Lab diamonds have the same chemical composition, crystal structure, optical and physical properties of diamonds found in nature.
Throughout history, alchemists attempted to turn lead into gold in search of riches. It never worked. The recent progress in technology has achieved alchemy for diamonds.

 

A little bit of history

Diamonds have been valued by humans for thousands of years for their beauty and scarcity, but the discovery of massive diamond deposits in South Africa put all that at risk.

“Until the late nineteenth century, diamonds were found only in a few riverbeds in India and in the jungles of Brazil, and the entire world production of gem diamonds amounted to a few pounds a year. In 1870, however, huge diamond mines were discovered near the Orange River, in South Africa, where diamonds were soon being scooped out by the ton. Suddenly, the market was deluged with diamonds. The British financiers who had organized the South African mines quickly realized that their investment was endangered; diamonds had little intrinsic value—and their price depended almost entirely on their scarcity. The financiers feared that when new mines were developed in South Africa, diamonds would become at best only semiprecious gems.”

In 1938 Harry Oppenheimer enlisted New York–based ad agency N.W. Ayer to help increase the demand and perceived value of diamonds. In one of the greatest feats in marketing history, they took a small but growing tradition of giving diamond engagement rings and made it a standard social requirement. Between 1939 and 1979, De Beers’ wholesale diamond sales in the United States increased from $23 million to $2.1 billion. It is now $43bn in the USA and $82bn worldwide. They created the story of diamonds as being scarce and valuable and successfully planted it into the human narrative. They maintained the perception of value through extensive marketing and the ability to tightly control the supply chain, which ensured scarcity (or at least the perception of it).

A new strategy

 
De Beers is now attempting to pull off another great marketing feat by entering the lab grown diamonds, but trying to differentiate them as being different and “not as valuable” as natural diamonds.  Given that the diamonds are identical and very difficult (some say impossible) to tell apart, it is not clear to me why the value should be any different. The lab diamond industry has also made a very strong case that the supply chain for natural diamonds facilitates large scale human suffering (blood diamonds).

 

Status Symbols Will Endure and Evolve

 
Humans have an evolutionary need to display success and status, a purpose which diamonds have served for a number of years. But the choice of display has changed over time. At points in human history, copper, silk and even pineapples were scare status symbols. Humans are competitive social creatures so the jewellery industry will endure, but the significance of diamonds will slowly diminish. While people might be able to boast about having natural diamonds for now, if no one can tell the type of diamond, the social benefit of a natural diamonds will surely lessen over time.

 

An Audacious Strategy

Its quite audacious to attempt to differentiate identical products. Will De Beers be able to pull of this marketing feat and maintain the value of natural diamonds? I am very sceptical. After spending years denigrating lab diamonds, they were forced to enter this market themselves as lab diamonds have continued to take market share. They have massively undercut competitors, who will now be forced to match its pricing.

Commodities which are easy to produce, can’t possibly maintain value, regardless of what story you tell. Diamond prices have fallen since 2012 in line with gold as the fear of inflation has eroded. Going forward I believe that diamond prices will fall faster as the market is flooded and the belief in the higher value of natural diamonds is worn down.

diamond and gold

 

A good test of whether or not you share my view is whether you find this article compelling, or utter nonsense.

 

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South Africa’s Renewable Energy Misadventure

It is a truth universally acknowledged that South Africa’s Renewable Energy Independent Power Producer Procurement Program (REIPPPP) was a great success.

The renewable industry has done one the most phenomenal public relations jobs I have ever seen. The frequency and quantity of articles promoting renewable energy and proclaiming the success of the REIPPP programme have been astounding. Their job was made easier due to the disintegration of Eskom. The PR machine kicked into high gear last year when Eskom declined to sign REIPPP contracts associated with the fourth round of the programme. The reason for the delay was due to a combination of maladministration and Eskom’s dire financial position. The contracts were eventually signed in April 2018 by Energy Minister Jeff Radebe. He left it to NERSA and Eskom to work out the cost implications.

Yesterday, Radebe released the draft Integrated Resource Plan (IRP) and the allocation to renewable energy sources continues to increase. I believe that the REIPPP programme will go down in history as one of the great financial swindles perpetrated on a developing country. Renewable energy and financial firms have made billions of Rands, leaving SA’s treasury covering guarantees of R200bn and South African consumers with higher electricity price increases. We have not been the only ones who have been fleeced as renewable energy has seen $800bn in subsidies globally over the last decade with very poor results.
The narrative backed by the media and (aided by amazing PR firms) is that renewable energy is a complete and proven technology whose cost is now below that of nuclear and fossil fuels. The truth is very different:

 
Renewables are more expensive

 
One of the main reasons people dont realise how expensive renewables are is that it’s not easy to measure the difference in value between intermittent and dispatachable (on demand) energy. So while renewable costs have fallen below coal/nuclear in theory, the reality is that they make electricity a lot more expensive. Electricity when you DONT need it is worth a fraction of electricity that is needed when you do. Rob Jeffrey attempts to show how you need to incorporate the capital cost and load factor to get a true cost of renewable electricity, which is much higher than the Levelised Cost of Electricity (LOCE) that is touted in support of renewables. Throughout the world, “low cost” renewables have only managed to drive up the cost of electricity

 
Renewable energy is an incomplete and imperfect technology

Intermittent renewable energy without proper storage is an incomplete technology; solar power without the high capacity and cost-effective battery technology is NOT a viable source of mainstream power.

 

A Solar future has been promised to us for years, but has never been delivered:
When I was young the highlight of a visit to my grandparents was the access to my grandfather’s library of “Popular Science” magazines. It was exciting to read about how we would drive, fly and live in the future. That was around 30 years ago and unfortunately the way we drive and fly has remained pretty much unchanged. There was always great excitement around the potential for solar energy to power our homes, cars and even planes. None of that is even close to fruition four decades later even as the technology has supposedly progressed substantially. Solar power companies around the world have struggled to reach commercial viability even with great incentives and subsidies, and when those subsidies are removed they tend to go bankrupt very quickly (Solyndra, SunEdison, Solarcity). The truth is that predicting how technology will evolve is very difficult. However, there are plenty of people incentivised to make those predictions and lobby accordingly. The following are popular science covers from the 70’s and 80’s:

While solar panels have improved, the fantastic predictions on our energy future have not come to fruition. The media has little understanding of how technology evolves.

Today there is a widespread belief that renewables are the future of energy generation, even though though they cannot deliver the type of power necessary for an industrialized economy. The technology necessary to advance renewables for mainstream purposes is years, if not decades away. As a poor country, South Africa does not have the resources to contribute to this project of unknown cost and horizon. Countries like Germany have aggressively pursued renewables, and pushed up their electricity prices to among the highest in the world. Germany can make that choice as they are one of the richest countries in the world. South Africa should not.

I am not “anti” renewable energy. There is no reason not to want clean power. I just believe that South Africa should wait until the technologies are perfected before considering implementation. Judging by how poor the predictions of technology have been, we do not even know whether the current renewable strategies (solar/wind) will be the ones that prevail. Given that solar has been a failure for the last 30-40 years, it would not be my bet for a primary energy source. My understanding of the science is limited, but my intuitive belief is that nuclear or “clean” fossil fuels are more likely to be the dominant power technology in the future. Meanwhile, there exist massive vested interests who aim to capture the explicit and implicit subsidies that renewable energy generation business provides. This means that we will continue to be subjected to a barrage of misleading science and economic opinions and predictions. Given that we don’t know which technology will prevail, and how long it will take for the next generation of power technology to be perfected, poor countries like SA should not be risking scarce resources by betting on an uncertain outcome.

On the positive side, we know that South Africa specializes in economic plans that never get implemented; the latest IRP will likely be one of them. It is a consolation that no further renewable projects will be signed for the next four years, by which time it will be more apparent that REIPPP was a disaster.

 

 

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The “Scourge” of Low Inflation

According to the world’s major central banks, low inflation is the main problem facing developed economies. Inflation is a measure of the increase in the cost of living, so the problem as defined by Central Banks is that the cost of living is not rising quickly enough.

A recent economic paper by the San Francisco Fed analysed which sectors are to “blame” for low inflation. It concludes that lower healthcare inflation is primary contributor. For most people this would be described as an unalloyed good. The article’s focus is on the drag to inflation from lower healthcare inflation, and how this makes it more difficult of the FED to reach its 2% inflation target.

I can’t help but feel that something has gone terribly wrong in the world of finance and economics for us to have ended up at this point.

The reason for the Central Bank viewpoint is that developed economies have high debt levels and need inflation to reduce the “real” value of debt. The current policy may be justified in the interest of economic stability. The problem is that the cure (low interest rates) just leads to debt levels rising even further.

There is no easy fix for the current predicament. However, economic policy makers have consistently favoured wall street over main street and the current obsession with higher inflation is a continuation of this pattern. We need to get to the point where policy makers are actively looking to reduce the cost of living in order to raise living standards. The world of finance should be a secondary consideration.

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