Steinhoff: how we make investment calls
The spectacular collapse of Steinhoff last month has cost South African investors – among them our clients – dearly. Many of you have questioned how we at Sanlam Private Wealth (SPW) could have continued to hold the share amid public allegations of fraudulent activity within the company. We’d like to take this opportunity of setting out our position against the backdrop of our investment philosophy – why we buy or sell financial assets – and process – how we make investment calls.
According to our calculations, the combined exposure to Steinhoff and Steinhoff Africa Retail (STAR) detracted 5.9 percentage points from our client portfolios in 2017 after what had looked like a very good investment year. This has understandably led to disappointment and anger – some believe that SPW shouldn’t have risked clients’ money when everyone knows that ‘where there’s smoke, there’s fire’.
Our position is as follows:
The foundation of any of our investment calls is price or valuation. Simply put, we want to buy assets that are cheap relative to their intrinsic value, and we want to sell assets that are expensive relative to intrinsic value based on our analysis and assumptions. We believe that over the longer term, financial markets are quite efficient. Assets are generally correctly priced, as a wide spectrum of investors will digest the available information, and this cumulative knowledge will under normal circumstances result in the ‘correct’ price.
But there are often circumstances when prices of assets are not correct. First, when the average investor overestimates the growth prospects of a company or, conversely, underestimates its growth prospects. Second, prices can deviate materially from the correct price if news flow drives greedy behaviour or causes investors to panic.
Opportunity to buy or sell
In short, investor sentiment can lead to irrational investment behaviour. For active managers like ourselves, this irrational behaviour creates opportunities to acquire assets when they’re sold off in panic, and it provides opportunities to sell assets when greedy investors overpay.
Our clients often question a purchase when we buy an unloved share or sell a share when the underlying investment story associated with the asset is positive. A contrarian call is not uncommon for us at SPW, however, since price is the dominant factor dictating our calls.
The difference between what our analysis reveals to be the intrinsic value of a share, and the market price of that share, provides the so-called margin of safety. However, we need to add at the outset that the intrinsic value we calculate is a function of in-depth, asset-specific analysis – not only a function of historic operational performance.
Back to Steinhoff. When the of rumours of fraudulent activities surfaced – strategically planned from a timing perspective – investors panicked and sold off shares, and the price fell from levels of R80 to below R60 a share. The rapid sell-off reflected the panic in the market. We reviewed our company models based on information at source – the official financial statements. We also reviewed management’s response, and we made the call that the ‘margin of safety’ justified the holding in the company.
As it turned out, the auditors weren’t prepared to sign off the 2017 results, and the company later also declared the results for financial years 2015 and 2016 unreliable. In short, the ‘facts’ on which we based our results were incorrect, and our valuation of the company based on the new information was no longer valid.
How did we miss it?
We believed Steinhoff’s audited financial statements, and did not price for fraud. Auditors are paid by the shareholders to provide assurance on the company’s financials and in the process are given full access to all the internal accounts, yet they were unable to discover the fraud.
By basing our investment case on the audited financials, we were thus less concerned by the allegations of impropriety coming from the former joint venture partner, which related to years where the firm had received unqualified audits.
Going forward, our investment process will ensure that we take a conservative view of companies with potential red flags. (When we made the initial investment in the company we indeed used very conservative assumptions.) The most pertinent of these are increased scepticism around vain or flashy chief executives, repeated equity raises and any regulatory investigations.
No reliable information
Investors currently have very little trustworthy information on which to base any investment decision concerning Steinhoff. This creates two outcomes. First, without proper information, we cannot make informed, rational investment decisions on whether to buy or sell Steinhoff stock. Second, the market (correctly) values the group using extremely conservative assumptions. We nevertheless need to value the group as best we can, given the information limitations.
The fact that historic information is no longer reliable means our previous Steinhoff valuations no longer apply. We now value the group based on the values of its various parts. The key differences from our previous valuation are the materially higher estimated net debt and the lower value of the European operations, to which we now attribute far lower valuation multiples to compensate for impaired reliability of the profit figures.
Our latest estimates
Valuing Steinhoff’s listed assets at 10 to 15% discounts to their current market prices, we get a value of around R14 per share. To this we can add R14 a share for the €4 billion European property portfolio.
Next, we add the R7 per share for the group’s most recent acquisitions, where we assume realisable values will be 30% lower than what Steinhoff paid. We then deduct R37 a share for the group’s €10.7 billion of gross debt as disclosed at 14 December. To this we add back R4 per share for the debt in STAR, which is already accounted for in its market price, and R9 per share for the group’s expected gross cash, which includes the proceeds of the recent partial sale of its stake in PSG.
Together, this gives us a value for the ‘trustworthy’ portion of the group’s valuation of around R11 per share, which excludes the European operations. This points to the group having more assets than liabilities, but the market price isn’t much more than half this value, due to concerns around Steinhoff’s short-term liquidity.
The apparent fraud in the group appears to have taken place in the European operations, and any valuation of these assets is therefore largely speculation. Our conservative estimate for the European operations is R3 per share, but this could be substantially different.
The extreme uncertainty means we won’t be buying or selling Steinhoff shares until the group publishes its audited results and the results of the forensic audit by PwC are made known. Only at that point will we be able to make informed investment decisions and act accordingly, as always, within the framework of our investment philosophy.