Treasure hunting

THE VALUE OF proprietary, deep-dive research.

Hunting for treasure (or undervalued shares) often takes you to unusual locations. Lyn’s Bar VIP was no exception. Gazing around me, I realised that ‘bar’ was perhaps too strong a word, ‘VIP’ definitely so. Upturned empty crates masqueraded as chairs around a mismatched collection of tables. The few patrons present lolled stretched out across the battle-weary bar, staring quietly into half-empty quarts of beer. It was only 10 a.m. but business had already begun. Or perhaps it had continued from the Tuesday night before. Posters, colours long faded, advertising a plethora of beers, musicians and now ancient sports stars, adorned the otherwise tired, grey walls. A fridge stood in a corner, light flickering. In walked Lyn, the lady I have been waiting 30 minutes to see. Finally, the work could begin.

A key part of our long-term, valuation-driven investment process is our proprietary research. It is this thorough, rigorous and in-depth work that helps us arrive at our estimate of a stock’s fair value. And it was this research process that took me to Lyn’s bar in Yopougon, a sprawling, mostly low-income suburb of one million people in Abidjan, Cote d’Ivoire.

Cote d’Ivoire on the West African coast is a country of 25 million people that has enjoyed an economic boom following a civil war that ended in 2011. The IMF expects the country to see average GDP growth of 6.8% per annum to 2023 – the 11th highest in the world. The beer market has long been controlled by Solibra, a subsidiary of the global Castel group. Markets with large, growing populations and strong GDP growth controlled by a monopoly brewer are typically very attractive ones for investors. Our interest was first piqued last year when our screening tools revealed that Solibra was trading on valuation multiples well below its global frontier brewing peers. It was time for the treasure hunt to begin.

We quickly did some further work and realised that information on the company was scarce. The four-page annual report was all in French, there was one sell-side analyst covering the stock and the website had limited information. While this was an example of a particularly limited company profile, scarcity of information is not unusual in many of the global frontier markets where we invest. Often the lack of information creates both a sense of frustration and an opportunity. It was highly likely that any market or company research we did would not be widely appreciated or reflected in share prices. Inefficient markets create opportunities for the active investor.

At the time, Solibra’s share price had sold off by about 30% over the past year. The investment opportunity was beginning to look very interesting. A monopoly brewer in an attractive market where there appeared to be mispricing due to market inefficiency warranted a closer look. It was time to do some detailed work on the company.

The following weeks saw us talk to a number of experts in African beer markets, begin building a valuation model and do as much Cape Town-based research as we could. It quickly became apparent that the reason for the share price moves was that Heineken was about to enter the market with a brewery in Abidjan. This did not immediately scare us off. We had seen competition enter monopoly beer markets before, often with limited success. Typically the barriers to entry in the beer industry are high and a well-run, aggressive incumbent can usually keep the new entrant at bay. We surmised that Heineken would likely gain a small market share, say 10% or 15%, a level at which it would struggle to make an adequate return on investment. Solibra would see a year of disruption, maybe take a small step back in profitability and then it would be business as usual again. With the share down 30%, the market was clearly pricing in a much direr outcome, which was surely an overreaction. The only way to be sure, though, would be to visit the market and do some on-the-ground research.

Flights were booked, bags packed, meetings arranged and schedules planned. The three days passed quickly; a whirlwind of sights, sounds and experiences. While no one from Solibra was willing to meet with us, the interviews we conducted with ex-employees, competitors, distributors and retailers (like Lyn’s Bar VIP) proved invaluable. The message from Yopougon, from Cocody, from Marcory and the other neighbourhoods we visited was the same. The situation in Cote d’Ivoire was far worse for Solibra than we had initially thought. Heineken’s entry was likely to have a much bigger impact on the beer market. While the Solibra share price had already fallen 30%, earnings were likely to come under significant pressure. Adjusting for our new outlook, Solibra no longer looked cheap; in fact, it looked expensive. Following the trip we decided not to invest in the company as the valuation was not compelling enough. That was August 2017. The share has fallen 50% since then.

While we will be the first to admit that we by no means get the investment call right all the time, this was one example of many where our detailed research process enabled us to avoid losing the capital entrusted to us by our clients. Also, it is not always about flying halfway across the world to do the work, as the next two examples show.

We met with a Greek jewellery retailer called Folli Follie in Cape Town last year. We were excited ahead of this meeting, since the company looked very cheap and the business prospects attractive. However, after the meeting and several discussions with industry experts, we decided not to invest in the company. While there was a lot to like, we were not able to sufficiently ease our concerns around the retailer’s poor cash generation or understand the mismatch between the reported revenue growth and industry experts’ more bearish outlook on Folli Follie’s brands. 

Our decision not to invest proved to be the right one when a short seller’s report came out in May this year questioning the company’s results, with numerous accusations made, including that store numbers were in fact much lower than reported. Since then, the share price has fallen more than 70% and trading in the share has been suspended. The company is strongly refuting the various allegations in the report, and investigations and audits are ongoing. We truly hope that the company will be able to demonstrate that the financial statements were not maliciously misstated. Only time will tell. 

Finally, a last example worth mentioning is Pak Elektron, a manufacturer of appliances and electrical equipment in Pakistan. At first glance this company also looked interesting. The company traded on a single-digit price earnings multiple, and as a beneficiary of Pakistan’s investments in the power sector, the business was growing strongly. However, when we compared the profitability of the company to similar businesses around the world, we saw that this business was significantly more profitable. While many people might see high profit margins as a good thing, we view it as a big risk when we cannot fully explain why a business should be so much more profitable. We did a deeper dive into the financials and conducted interviews with management and other sector participants but could not get the requisite comfort. We decided not to invest.

In February 2018, the World Bank announced that Pak Elektron had been debarred from participating in World Bank-financed projects for a period of 33 months due to collusive practices during bidding processes. The share price is currently down 50% since we first looked at the business in 2016. Although our research did not specifically identify collusive practices, we are heartened by the fact that the red flags we identified, similar to the concerns we identified in the case of Folli Follie, ensured that we avoided a large loss of capital.

The trip to Lyn’s Bar VIP did not ultimately result in a new share in the portfolio. But unlike treasure hunting, it is both what you choose to buy and what you choose not to buy that matters for the portfolio investor. Spending hours researching a company only to conclude not to invest can sometimes be a bit disappointing. Ultimately though, safeguarding our clients’ capital remains front of mind. In all markets, but especially those like global frontier markets where information is scarce, our proprietary, deep-dive research-driven investment process adds significant value.