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Global Advisors’ Thoughts: Outperforming through the downturn AND the cost of ignoring full potential

26 Aug 2020

A JSE share price decline from 2016 to 2019

By Innocent Dutiro, Marc Wilson and Stuart Graham

Innocent and Marc are partners, and Stuart is a manager at Global Advisors

All are based in Johannesburg, South Africa

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Overview

Press drew attention last year to a slew of JSE-listed companies whose share prices had collapsed over the past few years. Some were previous investor darlings. Analysis pointed to a toxic combination of decreasing earnings growth and increased leverage. While this might be a warning to investors of a company in trouble, what fundamentals drive this combination?

In our analysis, company expansion driven by the need to compensate for poor performance in their core business is a typical driver of exactly this outcome.

This article was written in January 2020 but publication was delayed due to the outbreak of Covid-19. Five months after South Africa's first case, we update our analysis and show that core-based companies outperformed diverse peers by 26% over the period.

Management should always seek to reach full potential in their core business. Attempts to expand should be to a clearly logical set of adjacencies to which they can apply their capabilities using a repeatable business model.

In the article 'Steinhoff, Tongaat, Omnia… Here’s the dead giveaway that you should have avoided these companies, says an asset manager' (Business Insider SA, Jun 11, 2019), Helena Wasserman lists a number of Johannesburg Stock Exchange (JSE) listed shares that have plummeted in recent years.

Figure 1

JSE-listed shares experiencing significant declines in value – 2015 to 2020

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis

In many cases these companies' corresponding sectors have been declining. However, in most of the sectors there is at least one company that has outperformed the rest. What is it about these outperformers that distinguishes them from the rest?

The outperformers have typically shown strong financial performance – be that Growth, ROE, ROA, RONA or Asset Turnover – and varying degrees of leverage. However, performance against these metrics is by no means consistent – see our analysis in Excerpt 1 below.

EXCERPT 1

Outperformers have achieved their results in different ways…

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis

What is consistent is that the outperformers all show clearly delineated core businesses and ongoing growth towards full potential in these businesses alongside growth into clear adjacencies that protect, enhance and leverage the core. In some cases, the core may have been or is currently being redefined, typically through gradual, step-wise extension along logical adjacencies. Redefinition is particularly important in light of the digital transformation seen in many industries. The outperformers are very seldom diversified across unrelated business segments – although isolated examples such as Bidvest clearly exist in other sectors.

Analysis of the over- and underperformers in the sectors highlighted in the article shows that those following a clear core-based strategy have typically outperformed peers through the initial months of the downturn caused by the Covid-19 outbreak.

As detailed in the Appendix, four of the outperformers leading into the downturn across the six sectors considered (REITs, Health Technology, Construction & Engineering, Chemicals: Major Diversified, Telecommunications Equipment and Construction Materials) appeared to be following a core-driven strategy. Of the underperformers, Aspen had initiated a core-based strategy in 2018 for which the early indications appeared positive while Ascendis had stated plans of going 'back-to-basics'.

In the period from January 2020 to July 2020 the companies following a core strategy outperformed the remaining companies by 26%, delivering total share returns of 14% compared to a decline of 12% – as shown in Excerpt 2 below.

Of the core-focused companies only Equites and Adcock Ingram delivered negative returns over the period, although Equites' 12% decline is in contrast to a decline of about 40% across the REIT sector. Aspen's impressive returns were boosted by the discovery of the Covid-19 treatment potential of Dexamethasone of which they are a key manufacturer.

EXCERPT 2

Core-focused companies outperformed peers through the first 6 months of downturn

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Figure 2: Core versus diverse companies – total 6-month total share returns (January 2020 – July 2020)
Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Figure 3: Core-based companies – 6-month total share returns (January 2020 – July 2020)
Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Figure 4: Diverse companies – 6-month total share returns (January 2020 – July 2020)
Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
In many respects, the basis for underperformance is the exact reverse of that for outperformance. Underperformers typically lose focus on reaching full potential in the core, allowing the strengthening of competitors, the pressurising of margins, the loss of market share leading to unwieldy fixed costs. On top of this, underperformers typically look to expansion as a remedy to compensate for declining core performance – diversifying away from the core and prizing distance rather than similarity – and then raise debt capital to fund this.

EXCERPT 3

Outperformers have often implemented core-based strategies

REITs

Outperformer: Equites

Equites is a logistics real-estate specialist. It has focused on growing its logistics core through ownership and development of facilities to tenant specifications. Adjacency growth has been into the UK logistics real-estate market through partnership with developers (after initially struggling with an acquisition-driven entry).

Underperformer: Rebosis

Rebosis is a diversified REIT with exposure to retail, office and industrial properties. It has struggled after the failure of its debt-funded entry into the UK retail market and has been forced to sell assets to fund its debt repayments. It has indicated it will refocus as a retail property REIT – although it is pursuing a merger with Delta Property Fund who have considerable government office exposure.

Health Technology

Outperformer: Adcock Ingram

Adcock is executing a strategy focused on execution excellence, efficiency and culture in its core (foundation) and growing and expanding from this position of strength. It is seeking product diversification away from regulated pricing.

Underperformer: Ascendis

Ascendis executed an aggressive acquisition-driven strategy to diversify across currencies, markets, sales channels and customer groups. Numerous acquisitions have failed to perform. Ascendis has backtracked and is disposing of bad acquisitions in a 'back-to-basics' strategy.

Construction & Engineering

Outperformer: WBHO

WBHO has executed a diversification strategy across both offering (within the sector) and geography. WBHO entered the Australian market in 2000 in which it has grown consistently to now contribute more than 50% of total revenue (although currently a roads project is under strain). A key element of its success is a strong culture and a principle of 'management continuity' – always promoting from within.

Underperformer: Aveng

A 2018 strategic review highlighted that the business struggled with the 'complexity of multiple business units'. It has since initiated a core strategy and is actively disposing of non-core assets while restructuring its over-indebted balance sheet.

Outperformers have understood that adjacency expansion and redefinition of the core are not strategies to save declining businesses – this is of critical ongoing importance. The best time to expand from or redefine the core is when it is performing well. Cash generated in the core business is used to support step-wise expansion into logical adjacencies. Logical adjacencies typically strengthen and often reinvigorate the core business.

 

Figure 5

Core business and adjacencies

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Outperformers use repeatability to extend their 'right to win' that they have built in the core to new channels, products, geographies, customer segments and other adjacencies. This repeatability is typically underpinned by a well-defined set of frontline activities supporting a strong, differentiated core; strong feedback systems from customers, operations and employees providing current information to the business; and a shared and consistent culture supported by clear non-negotiable principles that are embodied by the organisation. Decreasing earnings growth and increased leverage are a common combination present in struggling companies. Our analysis suggests that this may just be a symptom of companies seeking expansion on the back of poor performance in their core business. Companies have a far greater probability of success if they have a strong core from which they expand into logical adjacencies applying their capabilities using a repeatable business model. Management should actively seek to reach full potential in the core.

Appendix

Eight shares are highlighted:

  1. Steinhoff (JSE:SNH)
  2. Tongaat Hulett (JSE:TON)
  3. Group Five (JSE:GRF)
  4. Basil Read (JSE:BSR)
  5. Aveng (JSE:AEG)
  6. Omnia (JSE:OMN)
  7. Aspen (JSE:APN)mkl
  8. Brait (JSE:BAT)

Peter Armitage (founder of Anchor Capital) finds that the above companies share a similar combination of declining earnings growthand increasing leverage. Based on this analysis, Wasserman expands the list to include:

  1. Netcare (JSE:NTC)
  2. Mediclinic (JSE:MEI)
  3. Blue Label (debt via holding in Cell C) (JSE:BLU)
  4. Construction Infstrastructure Group Ltd (JSE:CIL)
  5. Rebosis (JSE:REB)
  6. Resilient Group (JSE:RES)
  7. Redefine International (JSE:RDF)
  8. Intu (JSE:ITU)
  9. Hammerson (JSE:HMN)
  10. Calgro (JSE:CGR)
  11. Balwin (JSE:BWN)
  12. Ellies (JSE:ELI)
  13. Ascendis (JSE:ASC)

Figure 6

JSE-listed shares experiencing significant declines in value – 2015 to 2020

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Some of the above companies have experienced significant corporate governance issues. For the purposes of this analysis, we will exclude Steinhoff, Tongaat Hulett and Resilient although many of our conclusions might also be applied to their strategies too. Equally, if a stricter exclusion based on corporate governance failures were applied, many of the construction companies would be excluded due to their conviction and penalties paid for bidding collusion in the 2010 FIFA World Cup build program, although this shouldn't be taken as the only reason for declining share prices

It is also apparent that there appears to be sectoral clustering – construction, medical and property. Are these sectors as a whole facing headwinds? If so, are there standout performers in each and how are they distinguished from the companies listed above?

 

Beyond declining earnings and increasing leverage

 

The highlighted companies are in the following sectors (industry level):

  1. Engineering & construction (GRF, AEG, BSR)
  2. Construction materials (CIL)
  3. Homebuilding (CGR) (not shown)
  4. Real Estate Development (BWN)
  5. Real Estate Investment Trusts (REB, RES, RDF, ITU, HMN)
  6. Hospital/Nursing Management (NTC, MEI)
  7. Health Technology (ASC, APN)
  8. Chemicals: Major Diversified (OMN)
  9. Investment Banks/Brokers (BAT) (not shown)
  10. Other Consumer Services (BLU) (not shown)
  11. Telecommunications Equipment (ELI)

What is clear from plots of relative share price performance of the highlighted companies versus their industry-level sectors from 2015 to 2020, is that they are not alone in their poor performance. The sectors have largely performed poorly. What is more remarkable is outperformance – how have leading performers differentiated?

 

The basis for outperformance

 

The outperformers in each sector have been the following:

  1. Engineering & construction – Raubex (RBX) and WBHO (WBO)
  2. Construction materials – Afrimat (AFT)
  3. Real Estate Development – Sirius Real Estate Ltd (SRE)
  4. Real Estate Investment Trusts – Equites Prop Fund Ltd (EQU)
  5. Hospital/Nursing Management – None
  6. Health Technology – Adcock Ingram Hldgs Ltd (AIP)
  7. Chemicals: Major Diversified – AECI (AFE)
  8. Telecommunications Equipment – Alaris Holdings Ltd (ALH)

Outperformance characteristics

 

Outperformers show clearly delineated core businesses, ongoing growth towards full potential in these businesses and growth into clear adjacencies that protect, enhance and leverage the core business.

They optimally generate cash and reinvest in the core business to maintain and enhance strategic position. This is reflected by good and stable performance in core economic metrics and ratios such as Growth, ROE, ROA, RONA, Asset Turnover and Reinvestment Rates.

Adjacencies are removed from the core business by typically no more than one of the following dimensions and by no more than a few steps along a dimension:

Figure 7

Core business and adjacencies

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
Continuing good performance in the core business funds the expansion into adjacencies, and good adjacencies have the effect of further improving the core business and highlighting new growth potential. Where outperformers have moved from their core business to define a new core, they have done this while the old business is still sufficiently healthy to support the costs of redefinition. The move to a redefined core is through a optimal adjacency. The need for such redefinition is rarer than might be thought (not every product and every industry faces cataclysmic disruption tomorrow), but nevertheless necessary where products face commoditisation, etc. Outperformers are very seldom diversified, in the sense that their businesses are made up of multiple businesses with little adjacency. Optimal diversification is typically through a single dimension, such as geography. Naturally, there are exceptions to this. Companies such as Bidvest (South Africa) have operated diverse businesses and have produced excellent results over a long period of time. These have proved to be very rare exceptions. Why does the above behaviour lead to outperformance? For a few simple reasons:

  1. Focus on reaching full potential in the core business protects strategic position prolonging economic performance and preventing commoditisation.
  2. Continued economic success funds growth and expansion, limiting the need to raise debt capital.
  3. A clear core business and adjacent expansion is rewarded with optimal capital allocation – non-core businesses are spun-off, divested from or closed.
  4. Expanding via clear adjacencies limits strain on scarce and valuable resources and management bandwidth.
  5. Clear adjacencies leverage values, culture, institutional knowledge and capability, limiting the potential for poor decisions and unknown risks.
  6. Clear adjacencies highlight new opportunities in the core business, reinvigorating it and offering natural redefinition as required.

Figure 8

The virtuous circle of full potential

Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
It can be seen that reaching full potential in the core business and expansion via clear adjacencies begins to meet the definition of a virtuous circle relationship – one of the ultimate targets of great and effective strategies.

The basis for underperformance

 

In many respects, the basis for underperformance is the exact reverse of that for overperformance.

Underperformers typically lose focus on reaching full potential in the core, allowing the strengthening of competitors, the pressurising of margins, the loss of market share leading to unwieldy fixed costs.

In contrast to outperformers, core economic metrics and ratios such as Growth, ROE, ROA, RONA, Asset Turnover and Reinvestment Rates are typically in decline.

On top of this, underperformers typically look to expansion as a remedy to compensate for declining core performance, diversify away from the core prizing distance rather than similarity – and then raise debt capital to fund this.

This quickly results in fires on all fronts as the core begins to require emergency attention or merely dries up cash generation. New expansion areas are unfamiliar and take time to move towards optimal returns. The increased leverage created by debt for new expansion and decreased earnings from the core creates a liquidity crisis. And due to lack of similarity to the core and strained management attention and organisational capability, unseen or poorly understood risks begin to manifest as failures in expansion projects. This creates further pressure on the core business as it is squeezed for cash. The resultant lack of reinvestment and attention harm its strategic position.

Instead of a virtuous circle, underperformers create a death – or at least dwindling – spiral.

At the very basis of this, we typically see differences in management philosophy and psychology.

Outperformers tend to see further potential in their core and critical to their future adjacencies. They tend to see adjacencies as an opportunity to unlock further potential in their core.

Underperformers tend to see their cores facing commoditisation / decline and expansion opportunities as the future for earnings and returns potential. This tends to become a self-fulfilling prophecy.

Company reviews

REITs

 

Outperformer: Equites

Equites is a specialised REIT focusing on logistics in South Africa and the UK. Equites was formed as the merger of three Western Cape industrial property developers in 2014. In line with its vision on becoming South Africa's most successful specialist industrial property fund, Equites immediately started a process of disposing of office real-estate properties it had inherited through the formative merger. Equites focuses on developing facilities fit to A-Grade tenant specifications on long-dated leases in key logistic nodes. Due to the variability of standards on existing facilities in South Africa, acquisitions form a smaller, speculative portion of the portfolio. In 2016, Equites made the decision to enter the UK logistics property market in order to diversify against the instability and uncertainty in the South African market. While the initial entry was acquisition-driven, Equites subsequently made the decision to partner with UK developers on a pre-let basis to mitigate risk. Equites maintains its clear focus on logistics real-estate and has positioned itself to capitalise on the expected increased demand for logistics space resulting from continued growth in e-commerce and supply-chain changes in the retail sector.

Underperformer: Rebosis

Rebosis is a diversified REIT with exposure to retail, office and industrial properties. It has struggled after the failure of its debt-funded entry into the UK retail market and has been forced to sell assets to fund its debt repayments. It has indicated it will refocus as a retail property REIT – although it is pursuing a merger with Delta Property Fund who have considerable government office exposure.

 

Health Technology

 

Outperformer: Adcock Ingram

Adcock is executing a strategy focused on execution excellence, efficiency and culture in its core (foundation) and growing and expanding from this position of strength. It is seeking product diversification away from regulated pricing.

Underperformer: Aspen

Aspen highlights three phases of growth: foundation, global expansion, specialty focus. Over the past five years Aspen has moved away from its original generic-medicine foundation. Aspen's acquisition-driven growth saw expansion simultaneously into new products and markets leading to a highly-levered balance sheet. The increased leverage and slowing growth saw dramatic decline in share value starting in 2015.  A 2018 strategic review led to the decision to focus on a pharmaceutical core as a global specialty company and to dispose of non-core assets while reducing debt. While the market initially responded very poorly, particularly given delays in the sale of the Nutritionals business, share price has started to recover as debt levels have started decreasing (although the share price is still 75% down from historic highs). Aspen's performance over the next few years will determine whether its core redefinition was appropriate.

Underperformer: Ascendis

Ascendis executed an aggressive acquisition-driven strategy to diversify across currencies, markets, sales channels and customer groups. Numerous acquisitions have failed to perform and cover debt. Ascendis has backtracked and is disposing of bad acquisitions in a 'back-to-basics' strategy.

 

Construction & Engineering

 

Outperformer: WBHO

WBHO has executed a diversification strategy across both offering (within the sector) and geography. WBHO entered the Australian market in 2000 in which it has grown consistently to now contribute more than 50% of total revenue (although currently a roads project is under strain). A key element of its success is a strong culture and a principle of 'management continuity' – always promoting from within.

Underperformer: Aveng

A 2018 strategic review highlighted that the business struggled with the 'complexity of multiple business units'. It has since initiated a core strategy and is actively disposing of non-core assets while restructuring its over-indebted balance sheet.

 

Chemicals: Major Diversified

 

Outperformer: AECI

AECI is a diversified group of companies operating regional and international businesses across its five growth pillars: Mining Solutions, Water & Process, Plant & Animal Health, Food & Beverage and Chemicals. Formed as a provider of explosives and detonators to the gold and diamond mines in South Africa in 1924 (and a producer of phosphoric fertilizer as a natural bi-product), AECI diversified its product portfolio over the years and started expanding internationally in the late 1990s. In 1999 AECI announced a strategy to focus on three core clusters: Mining Solutions; Specialty, Fine and Industrial Chemicals and Specialty Fibres – disposing of a number of non-core assets in the process (such as plastics, fertilizer and paint). By 2014, AECI had defined the current five growth pillars around which its strategy is now based. AECI's strong performance relative to its sector provides an example of a company diversified across both product and geography outperforming its peers. AECI has however lagged the JSE ALSI over the past 5 years.

Underperformer: Omnia

Omnia's double-digit revenue and operating-profit growth started to slow in 2015 while operating margins also came under pressure. From a practically unlevered balance sheet, Omnia initiated substantial expansion efforts in 2018 with the acquisitions of Umongo Petroleum and Oro Agri. Umongo Petroleum provided Omnia vertical integration exposure to the petroleum sector while Oro Agri extended Omnia's international presence significantly. Omnia has struggled to deliver against both of these investments and has seen its leverage increase well beyond desired levels. While both acquisitions seem to be along logical adjacencies, they may have potentially incorporated too many adjacency steps at the same time leading to difficulties in effectively implementing its business model in the new businesses. Omnia is currently implementing a short-term stabilize and fix-the-business strategy which includes capital and debt restructuring alongside cost-cutting initiatives. Alongside this, Omnia is reviewing the business model, portfolio and strategy to succeed in the long-term.

 

Telecommunications Equipment

 

Outperformer: Alaris Holdings

Alaris Holdings is is a leading global radio frequency technology holding group listed on the JSE AltX since 2008. Alaris designs, develops, manufactures and sells specialised broadband antennas and other radio frequency products. Alaris seems to have effectively used its core competencies to expand into adjacent products and geographies. Alaris' key strength is the IP it has developed in the radio frequency technology engineering field. From this base, Alaris has expanded this into adjacent products like microwave and entered the international market on the back of a challenging South African operating environment.

Underperformer: Ellies

Ellies was founded in 1979 selling only TV aerials. Over the next 20 years Ellies increased its footprint across South Africa and expanded into adjacent categories such as satellite TV. After listing on the JSE in 2007, Ellies started diversifying its range entering the power infrastructure segment (through the acquisition of Megatron), commercial lighting, renewable energy, water treatment, property and telecommunications and entertainment. Weakening demand, loss of key contracts and the increasing debt burden all impacted negatively on the company leading to asset sales, a rights issue and business restructure to keep the company a going concern. Following a leadership overhaul in 2019, the new management team acknowledged that lack of strategic attention on the product range over the preceding years has led to market share losses in its core product lines. The new team is currently attempting to execute a turnaround strategy through operational efficiencies, cost management, profitable growth and improved compliance, risk management and governance. While Ellies was likely ahead of the curve in its decision to expand from and redefine its original TV aerial and satellite core, its approach may have taken it too far and along too many directions away from its core.

 

Construction Materials

 

Outperformer: Afrimat

Afrimat is an open-pit mining company supplying a broad range of materials ranging from aggregates, concrete products (bricks, blocks and pavers) to ready-mix as well as industrial minerals and iron ore. Afrimat was founded in 2006 from a group of well-established companies. Its initial drive was on building a strong foundation through a narrowed focus on building materials mostly in the coastal provinces. From this base it expanded geographically in South Africa before starting a focus on growing unique products (industrial minerals) through a series of mine acquisitions between 2011 and 2016. These acquisitions were against a specific strategy ('Growth through diversification') to diversify into the industrial minerals market in which the company believed it could apply its core open-pit mining competency. In 2016 Afrimat took an additional adjacency step through the acquisition of an iron-ore mine to enter the bulk commodity market. Afrimat stated an interest to extend further into bulk commodities by entering the coal market before abandoning a potential deal. Afrimat appears to have executed its diversification strategy successfully since initiation in 2010 through consistent application of its core competencies to deliver consistent growth and a well-maintained balance sheet. As Afrimat continues to seek acquisitions against its strategy it will be tested in its ability to continue leveraging its core capabilities without expanding too far or too aggressively.

Underperformer: Construction Infrastructure Group 

CIG is a diversified pan-African engineering infrastructure company operating in the power, consolidated building materials, oil & gas and rail sectors. CIG listed on the JSE AltX as 'Buildworks' which only comprised the consolidated building materials division (bricks, rooftiles and aggregates). The 2008 acquisition of Conco, a supplier of turnkey solutions to the electricity supply industry, formed part of a strategy to identify and assess value enhancing acquisition opportunities in the construction and infrastructure related industries and gain access to parastatal and public infrastructure development spend. Following the acquisition, the principle focus of CIG shifted to the power and electricity sector although the construction material business continued to operate. CIG continued its acquisition strategy entering the (Angolan) oil & gas waste-management industry in 2012, the rail industry in 2015 and electricity and smart meters in 2016. Through the process CIG built presence across Africa and Saudi Arabia. Following a period of strong growth, the company came under pressure as large multi-year projects in the power subsidiary (Conco) started underperforming and growth slowed or declined in the rail and building material divisions. CIG's net debt position rose too high and they were forced to renegotiate with funders and placed under debt standstill. CIG has reconfigured its leadership team, recently completed a recapitalisation deal with Fairfax Africa and has stated a desire to transition away from engineering, procurement and construction contracts into a sustainable platform supplying power needs across Africa.

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Sources

  1. Wasserman, H – 'Steinhoff, Tongaat, Omnia… Here’s the dead giveaway that you should have avoided these companies, says an asset manager' – 2019 – Business Insider SA – https://www.businessinsider.co.za/armitage-on-tongaat-2019-6
  2. Zook, C; Allen, J  – 'Profit From The Core' – 2001 –  Harvard Business School Press
  3. Zook, C; Allen, J – 'The Great Repeatable Business Model' – 2011 – Harvard Business Review

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