Presentation on theme: "Dr Michael Power, Investec Asset Management"— Presentation transcript:
1Dr Michael Power, Investec Asset Management Why is the Cost of Capital so high in South Africa? What is SA Inc. doing about it?Dr Michael Power, Investec Asset Management
2What is SA Inc’s Cost of Capital? SA Inc: for an ungeared company, 15% (Risk free rate of 9.5% + Equity Risk Premium of 5.5%)Compared to:UK Inc: for an ungeared company, 8% (RFR of 4% + ERP of 4%)US Inc: for an ungeared company, 7.7% (RFR of 3.7% + ERP of 4%)In other words, a South African company needs value added returns that are almost twice as high as British or American company to be profitable.Why did Anglo American, Billiton, South African Breweries,Old Mutual and Didata move their head listings to London?So they could become more profitable
3The Proof of the Pudding Press Report covering Anglo American’s first earnings release following their move to London:“Ogilvie Thompson said the group was pleased with its London listing, which had lowered its cost of capital…”23 March 2000
4The Cost of Capital Defined It is the blend of a corporation’s capital base, debt and equity, defined as the WEIGHTED AVERAGE COST OF CAPITAL or WACCWACC = equity % of capital base (risk free rate + (beta x equity risk premium)) + debt % of capital base ((risk free rate + lending margin) x (1 - tax rate))The modern multinational will spread itself between the world’s pools of capital so as to create the lowest risk adjusted blend of capital it can
5Why is the WACC so important? It sets the proper hurdle rate to determine true ‘profit’A company whose auditors say it is ‘profitable’ and whose ‘profits’ are taxed by the Government may not be truly profitable!Returns to capital less Cost of Capital = Economic Value Added if positive, Economic Value Destroyed if negative“It is critical that all operationsearn returns in excessof the cost of capital”Roberto Goizueta,Former CEO
6My focus here is on ‘more expensive’ equity not ‘less expensive’ debt Why debt is usually cheaper than equity?Because of tax; the debt part of WACC is calculated as follows:→ ((risk free rate + lending margin) x (1 - tax rate))But if a company’s gearing rises too high, the interest rate will almost certainly rise above the cost of equity as lenders’ concerns rise with gearing levels and they demand penal lending rates…Cost of DebtInterestRateCost of Equity‘Normally’ geared‘Abnormally’ gearedGearing Levels
7The Key Variables in a Cost of Capital Common to both debt and equityRisk free rate – RFRDebtGearingTax RateEquityEquity Risk Premium – ERPIndividual Stock beta – a measure of the stock’s volatility vs. its home marketThe focus here is on the RFR and ERP
8Risk Free Rate and Equity Risk Premium What affects the RFR?Defined: A theoretical interest rate that would be returned on an investment which was completely free of risk. The 3-month Treasury Bill is a close approximation, since it is virtually risk-free.►Country risk, including FX risk, political risk, investor appetite for sovereign riskWhat affects the ERP?Defined: The extra return that the overall stock market or a particular stock must provide over the rate on Treasury Bills to compensate for market risk.► Market history and outlook, market character
9Mea Culpa. Have South Africa’s institutions ‘underinvested’ in Bonds? One reason why South Africa has such a high cost of capital is that it has such a high risk free rateThis RFR is high partly because institutions have underinvested in Government paperArguably a hang over from the era of prescribed assetsPossibly due to a misplaced belief in the primacy of equitiesAlso due to fear of being the first mover in the wrong year: Would investing institutions rather be wrong together than one look silly for doing the right thing in the one year when equities did outperform bonds?An aside: Has the South African Government ended up paying farmore on its debt than it ‘should’ have over the past 15 years?
10Real Men prefer the equity highwire over cash… South African Equities vs Cash since 1989Returns (Pre-tax, August 1989 = 100)All ShareCashSource: JPMorgan2003: Cash: +12.8%, Equities: +16.1%
11…but Gentlemen still prefer bonds! All BondAll ShareCashSouth African Bonds vs Equities vs Cash since 1989Returns (Pre-tax, August 1989 = 100)2003: Cash: +12.8%, Equities: +16.1%, Bonds: +18.1%
12In 3 out of 5 ‘bad’ years, bond returns beat inflation Bonds in the five ‘bad’ years when equities ‘won’: Not so bad, except in 1994YearBondsEquitiesCPIBonds less CPI198923%55%15.3%7.7%199114%31%16.2%-2.2%199340%54%9.5%30.5%1994-18%9.9%-27.9%199933%61%2.2%30.8%In 3 out of 5 ‘bad’ years, bond returns beat inflation
13Bonds vs. Equities vs. Inflation since 1989 YearInflationEquitiesBonds+261%+697%+1009%Compound Average6.6%13.8%16.7%Real growth through investing in securitiesis easy to achieve in South Africa.But ‘easiest’ to achieve by not taking equity risk!
14All this begs the two questions… Does South Africa have a structural negative equity risk premium?Since 1994, equities have outperformed bonds in only Indeed, even cash has outperformed equities in this period: +14.1% p.a. vs % p.a. to end of February 2004What on earth is a negative equity risk premium? Does such a measure as an “equity risk discount” exist?
15South Africa’s Unbalanced See-Saw UnderweightBondsOverweightEquitiesBond yield ‘too high’;Cost of capital – 15%+ –built on ‘too high’ arisk free rateBy overinvesting in equities, South Africa’s investors ironically make it more difficult to outperform in equities.This is because a ‘too’ high a cost of capital makes it more difficult for corporations to add real value to their capital.
16JPMorgan’s look at SA Inc’s true profitability Currency to the rescueIs SA Inc on its way to becoming unprofitable again?
17What are companies doing about SA’s high cost of captial? What have the big boys done?Making the Great Trek to London
18Conventional Wisdom uprooted Cost of Capital is determined by the locale of the assetsMoving your place of listing has no effect on your cost of capital“By moving its head listing to London, Anglo had no effect on its cost of capital”Wrong! Cost of Capital is a price, a price for a ‘share’ of a package of risk, a share in a companyThat price – as are all prices – is determined by the interaction of the supply of risk (provided by the company) and the demand for risk (made by investors)Moving to London virtually halved Anglo American’s cost of capital from about 17% to about 9%An investment returning value added equivalent to a 14% return on capital turned from being unprofitable to profitable merely by Anglo moving to London.
19The Two Sides of the Price of Risk: Corporate Supply and Institutional Demand The CompanyInstitutionsThe Price ofDebt CapitalThe Appetitefor DebtRiskThe Supply ofDebt CapitalThe WeightedAverage Costof CapitalThe Capital MarketThe Appetitefor EquityRiskThe Price ofEquity CapitalThe Supply ofEquity CapitalRisk demandRisk supply
20The Role the Company plays: The seller of cash flows, the buyer of capital A company owns those cash flows arising from its investments over future time periodsA company finances its activities by blending debt with equity to create a capital base. The capital charge made against that base – calculated by using the WACC rate – is the hurdle rate for profitable capital employment.That hurdle rate is usually applied to prospective projects as a discount rate to determine their likely financial viability.Critically, this hurdle rate is the price of capital determined where:the supply of risk i.e. those investment activities undertaken by the companymeets:the demand for risk i.e. what investors in debt and equity capital are willing to pay to buy access to those cashflows
21Stage 1: Anglo with a head listing in Jo’burg PriceofEquitySupply of Equity Riskchanneledthrough the companyZDemand for Equity Risk fromSouth African InvestorsYQuantity of EquityAt fair value, SA investors would buy Y amount of risk at Price Z
22Stage 2: Anglo moves head-listing to London Appetite settled from SA at BExtra appetitefrom London at BPriceOfEquityBDemand for Equity Riskfrom British InvestorsZADemand for Equity Riskfrom South African InvestorsSupply of Equity Riskchanneled through the companyDYCQuantity of EquityBritish investors have a higher tolerance of risk – so they pay B where SA investorswould only pay Z and demand even more risk – C rather than Y – at that higher price B.At Price B, SA investors would demand only quantity D and so they sellY-D in scrip, which flows from SA to the UK. In addition, the UK demands C-Y extra scrip!If only seeking Y capital in London, Anglo would only pay Z not B, a lower cost of capital
23Stage 3: Anglo’s move complete PriceOfEquityCombined Demand for Equity Riskfrom British and South African InvestorsBDemand for Equity Riskfrom British InvestorsOne-off capital gain for SAZADemand for Equity Riskfrom South African InvestorsSupply of Equity Riskchanneled through the companyDYCQuantity of EquitySome existing South African investors with a greater willingness topay more for risk would not have sold their Anglo shares in the London move.
24Segregated pools of capital mean separate demand curves Q: What if Anglo had issued no new scrip upon moving to London? (It did, as did Billiton, Old Mutual, SAB & Didata!) A: The price ‘should’ have risen very sharply!Appetite settled from SA registerSegregated pools of capital meanseparate demand curvesMPriceofEquityZDemand for Risk fromBritish InvestorsSupply of Risk channeledthrough the companyDemand for Risk fromSouth African InvestorsNQuantity of EquityYBecause of the kinked supply curve at Y/Z, the price would have risen from Z to M,to be met by the transfer of scrip Y-N from the SA register to the London register.
25Why would London have a higher risk tolerance? Suggested Answer: Segregated pools of capital – each with their own particularsupply of risk opportunities as well as appetites for those risk opportunities – havetheir own specific tolerances for risk.What would increase that risk tolerance?On the supply side, BREADTH: The wider the variety of supplied risk opportunities– i.e. the broader the range of investible risk options open to investors – the greaterthe capacity for diversification and so the higher the tolerance involved in an individualrisk opportunity (either in terms of price or quantity or even both)On the demand side, DEPTH: The bigger the level of demand for risk – i.e. thegreater the aggregate amount of capital available for investment – the deeper theappetite for riskLSEJSEBroaderDeeperLondon has a broader, deeperappetite for risk than Jo’burg
26“But if the assets don’t move, how can simply moving the head listing increase the valuation?” True, there is no change to the quantum of supply of risk in the form of future cash flows from the assetsWhat changes is the nature of demand for those cash flowsIf the new place of listing has a higher tolerance of risk and so a lower cost of capital, the discount rate by which the cashflows are discounted is reduced. This means the valuation rises.JSELSEDiscount rate 15%Discount rate 9%Anglo American’scashflowsAnglo is more valuable to the LSE than it is to the JSE
27The Two Tier Market at the JSE: Domestic vs. “Foreign” March/April 2003: World Markets came down more than SA didand currency strength exacerbated convergence; blew out again in May
28What are the consequences of this insight? Although it would mean contradicting South African-derived valuation metrics, an asset is priced in the market where the marginal purchase/sale of its shares takes placeCompanies rooted in deeper, broader capital pools can afford to pay up to buy assets listed in shallower, narrower capital pools: so Anglo can afford to pay more for Amplats, Anglogold & Kumba than we canWhere local assets are bid for by foreigners, South African institutions might be able to hold out for a higher exit price than we would accept were the acquiror localThat we now have a two-tier market: the dual-listeds march to the metric of an offshore (mainly London-based) drummer whereas the SA-only listeds march to our own rhythm.
29How much is our market affected by this issue? Non-SA Head-listings:Index weight close to 40%Anglo AmericanRichemontBHPBillitonSABMillerOld MutualLiberty InternationalInvestec UKDidataCompanies with offshore controllingshareholders: about 4%AnglogoldAmplatsKumbaABIIscorWestern AreasCompanies with large offshoreregisters: about 6%GoldfieldsHarmonyImplatsSAPPINearly 50% of our benchmark is affected by this consideration, including every Resource company with a benchmark weight over 0.2% except SASOL, and almost 1/3 of the Industrial and the Financials weights. Of the Top 40 FTSE/JSEAfrica Index, the above list constitutes about 2/3.
30Why Anglo can pay more for Amplats than most South Africans can Anglo American is slowly but surely buying out the minorities in Amplats– it now owns over 72% of the company – at prices which the SouthAfrican investment community consider to be too high.Q: Who is “Right”?A: Both sides!Q: Why?A: Because Anglo has a lower cost of capital than we do, say 9%vs. our 15%. With Amplats’ current valuation currently discounting a 12%cost of capital, the share is expensive to us as the opportunitycost of capital we must employ is 15%. But to Anglo American, Amplatsis showing value as the opportunity cost of capital Anglo must employ isonly 9%. Anglo American can ‘grandfather’ its base cost of capital onto itscontrolled assets wherever they are located.
31How did SAB ‘buy’ a 7.5% cost of capital? By buying Miller! Though SAB did not realise the full implications at the time of the acquisition,buying Miller had the net effect of reducing their cost of capital by 2% from9.5% to 7.5%. This was achieved through two methods:The Ballast Argument: The average risk profile of SABM’s cashflows was reduced withinclusion of US-based, US-Dollar earning (i.e. beta-reducing) Miller, thereby reducing the discountrate used by SABM’s investors, particularly US-dollar based investors.The Tolerance Argument: Via Miller, SABM accessed an investor base with a highertolerance of risk:on the equity side, this comes from now having at least 37% of their investor basein the US (23.5% of that being Altria); SABM has an ADR facility;on the debt side this comes from borrowing cheaply in US dollar corporate bond markets:their August 2003 $2bn bond issue (admittedly of varying maturities but all of at least 5 year)was $600m at 4.25% and $1.1bn at 5.5% (an average cost of 5.06%), both secured againstMiller whereas SABM Plc – the head company! – was only able to borrowed its $300m at 6.625%.The US loan cost 157 bps less than the UK loan!
32The Cazenove Case Study Auctioning a business worldwide “We were selling a business and approached a number of potential suitors to invite bids for the business. The suitors were from all over the world, including Western Europe, Scandinavia, the UK, Southern Europe, Central America and South Africa. All parties were given identical information and asked to submit indicative bids. What was interesting, and it may have been coincidence, was that the value of the bids correlated exactly with relevant countries’ costs of capital – i.e. The country with the lowest cost of capital bid highest, and vice versa. Needless to say, the South African bidder lost out.”Julian Wentzel of CazenoveQ.E.D The price was determined by the bidder’s home cost of capital.The location of the assets was not all-determining in the price.►Could SAB have afforded Miller from South Africa?
33The Errunza-Miller Study December 2000 “Market Segmentation and the Cost of Capital in International Equity Markets.” Findings: Capital market theory suggests that the removal of barriers to capital flows reduces companies' cost of capital and investors' realized returns. The authors studied the issuance of 126 American Depositary Receipts as a form of company-specific capital market liberalization. They find a significant reduction – an average of 42% – in the cost of capital for companies that issue ADRs for the first time.Journal of Financial and Quantitative Analysis vol. 35, no. 4, 577–600
34It works for South Africans too! MTN in Nigeria In the case of valuing MTN’s Nigerian assets, MTN is leveraging its lower SA cost of capital when charging out its capital to MTN Nigeria.In South Africa MTN’s cost of capital is currently 16%In Nigeria, a stand-alone investment would typically have a cost of capital of at least 25%MTN is currently adding a 4% country risk on to its Nigerian operations (which now account for 42% of EBITDA and 68% of its pre-Head office cost profits)The 20% MTN Nigeria cost of capital is at a 5% discount to the ‘normal’ rate that would be charged. Why? Because of the appetite for risk available in SA’s deeper, broader capital markets
35ConclusionsSouth Africa’s cost of equity capital is high because its RFR is highEverything must be done to reduce that rate.The SARB: Are real interest rates excessively high?Banks: Are lending margins too high?Institutions: Have asset allocation decisions over-favoured equities?Otherwise: Companies have little option but to move their head listings to e.g. LondonThe alternative to a lower hurdle rate is a higher level of return How could this be achieved relatively ‘painlessly’ for South Africans? Through a more competitive exchange rate!