A dangerous trend to watch out for on the JSE - and Warren Buffett's advice

by , 28 February 2018
A dangerous trend to watch out for on the JSE - and Warren Buffett's advice
In the past month or two, I've realized a worrying trend on the JSE.

This trend has been behind Sibanye Gold's 58% drop in the past year.

It's also been behind Woolies losing 25% of its value since 2016, and Brait dropping 41%.

What is this trend? Well, it's “making offshore acquisitions at ALL costs”…

And Warren Buffett has just warned investors against the trend.

Let me explain:

 
 
Expensive acquisitions could lead to financial catastrophe
 
According to a recent article on Warren Buffett, he has a message for investors:
 
“Be patient.
 
After a year in which he was largely frustrated on the acquisition front and saw cash pile up at his conglomerate, Berkshire Hathaway, he used his annual letter to shareholders to remark on the “all-time high” cost of buying businesses and how the “ample availability” of cheap debt has fueled unwise deals. Berkshire, Buffett wrote, will still occasionally get opportunities to make large purchases at sensible prices.
 
‘In the meantime, we will stick with our simple guideline,’ he said. ‘The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.’”
 
In short – because interest rates are low, companies are more likely to use debt to fund big acquisitions.
 
And, in addition to this, the availability of this cheap debt has inflated asset prices. So companies are often overpaying for the assets they buy.
 
A number of South African companies could end up in trouble thanks to these deals
 
Right now, there are a number of SA based companies that have stepped in this trap Buffett warns about.
  • Sibanye-Stillwater: Sibanye recently acquired the US based Stillwater mining. While Stillwater is a decent company, making good profits, the deal could be a big problem. Sibanye purchased Stillwater for $2.2 billion. The deal was done via a combination of equity and debt. Sibanye’s total Long –Term Liabilities have increased from R14 billion in 2016 to a massive R35 billion when it reported results in December 2017. This has also seen the company’s solvency and liquidity ratios (indicative of whether it can pay its debt) deteriorate.

    And even though the basket price for platinum, and the dollar price for gold has increased, the sharp weakening of the rand following Cyril Ramaphosa’s election as president will leave the company in trouble. Currently the rand price of gold sits at R496,000 per kg, compared to a 2017 average of R549,064. Sibanye’s all-in production cost sits at R480,000. So the profit margins will slim down in 2018, and the company’s ability to repay debt will worsen further.

    This acquisition is an example of a good acquisition that is at risk, because of the company’s high debt levels…
  • Woolworths: Woolies acquired David Jones in the second half of 2014. Back then analysts were worried about the R21.4 billion price tag on the acquisition price of the Australian company.So far, the worries have proved true as Woolies had to impair around R7 billion in the value of its holding in David Jones.

    This is effectively the result of being over confident in growth prospects, and over paying for the acquisition. Further impairments are still likely – which is quite sad, as Woolies is doing fairly well in its South African operations.
     
  • Brait: Following the sale (and big profit) of its holding in Pepkor Brait purchased a business called New Look in the UK.It paid £780 million for the acquisition. And in 2016, New Look had a value of R35 billion on Brait’s books.
Today Brait has impaired this value to ZERO.
 
The hasty acquisition at a premium price has clearly come to haunt Brait.
 
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So what’s the lesson you should learn from this?
 
To me there are a couple of take-aways investors should pay attention to:
 
1. Watch out for companies making over-enthusiastic offshore acquisitions
 
The South African market differs completely to that of the US, UK or Australia. Not many companies have made successful forays into these markets. Billions have been lost this way, and it is likely to remain the case into the future.
 
2. Just like companies should watch out for expensive acquisitions – so should you
 
These companies management made acquisitions at all costs – even though if things turned down, it could mean the end of the company or its investment. You should ensure you don’t do the same.
 
Watch out when you buy companies on PE’s of 100’s – for if even a single growth plan doesn’t pan out – they could easily drop 30%, 50% or even more in price. In early 2017 Curro traded on a PE of around 100 – and a share price of R50. And whilst it has grown revenue by 22% and earnings by 17% the share price is down 26% in the past year as investors realise they bought too high for the reality of the growth to come…
 
3. High debt levels will become an increasing problem
 
Instead of being patient and using their own capital companies have done too many acquisitions using high debt levels. As lending costs increase – or even just the rate of lending slows, these companies will get in trouble. Refinancing debt will become tougher in the coming two years (with increasing interest rates in the US). And so will the cost to service debt.
 
And, if a company is highly geared, it will have to sell assets to stay afloat. My advice is to steer clear of highly geared investments right now.
 
Lastly – be patient when you look for shares. Rather wait for the right share with a great buying price. You’ll always end up in a better position than when buying at a high price.
 
Just this week I shared FIVE small cap shares with my Red Hot Penny Shares readers, all on single digit PE ratios and with record high levels of sales or profit growth. These are the kind of investments you should consider right now!
 
Here’s to unleashing real value
  
Francois Joubert
 


A dangerous trend to watch out for on the JSE - and Warren Buffett's advice
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