Barbarians at the gate: JSE mid-caps on the shopping list
It is becoming increasingly apparent that hidden value on the JSE is being recognised by private equity investors, industry players (particularly foreign companies) and even some locally listed companies.
We have seen a surge in activity as increasing numbers of South African companies are being delisted and taken private. This zeal and optimism contrasts with the prevailing negative sentiment we are still observing on the JSE: many smaller, domestic-oriented companies trade below their fundamental value and pessimism and disinterest continue to prevail.
We are not surprised that offers are being made for our portfolio companies. At PSG Asset Management we have included SA mid-cap shares in our client portfolios for a while now, and we are not surprised that offers are being made for several of our portfolio holdings.
Imperial Logistics (shareholders have accepted an offer from global logistics company DP World), Distell (to be delisted by Heineken in partnership with Remgro), Pepsico’s 2019 purchase of Pioneer Foods, and recent offers for Royal Bafokeng Platinum and Long4Life are notable examples of takeover interest in companies our clients own.
These assets are being targeted for good reason
There are several reasons why these companies are tempting private buyers.
Firstly, we are at a very favourable point in the cycle for taking companies private. Sentiment and confidence in South African mid-cap counters are still low, and as a result prices and valuations are probably too pessimistic. The graph below shows the ratio of new listings to delistings on the JSE. A ratio of less than 1 indicates a net reduction in listings. The ratio is lower when confidence is weak, and prospective returns are often very good from these low points. Conversely, beware when there is exuberance in the market and net listings are strongly positive. Domestic equities put in a very poor subsequent run following the last cyclical peak in 2015. With elevated delisting and few IPOs to compensate, the ratio is currently very low. Interestingly, this apathy on our stock exchange stands in sharp contrast to the elevated exuberance evident in the flurry of initial public offering (IPO) activity, particularly in US markets.
Secondly, these buyers are seeking the same attributes that we target through our own investment process: companies with competitive advantages (moats), that are well managed and well capitalised. And the price needs to make sense (or offer a margin of safety).
Thirdly, private and industry buyers have a powerful competitive advantage of their own. They are plugged into the true economy, with all its very real challenges, and have the confidence to buy businesses to delist them, thus removing the feedback from high-frequency price data and its corresponding volatility. This allows them to be opportunistic and to take a truly long-term approach. They do not care about benchmarks or relative performance. They just want a good deal. These competitive advantages are powerful and our investment process seeks to replicate them to the extent that we can as public market investors.
A deliberate approach to maximising client value in deal situations
At PSG Asset Management, we are in the position of being large enough to take influential stakes in smaller companies, and to make them material positions in our portfolios, a luxury many large asset managers do not share. In many cases we may have material shareholdings in companies (a 10% threshold is not uncommon). This gives us influence and an important voice, but we are often not large enough on our own to force a singular outcome.
Fellow shareholders may have shorter time horizons or may not share our opinion of the long-term value of the companies we collectively own. Should one of our portfolio companies receive an offer we actively engage with our fellow owners and the market, making our case.
Furthermore, our engagement with the boards and executive teams of targeted companies is a critical part of our approach and forms an important part of our social and governance responsibilities.
Ultimately, however, the only two elements we can control are exercising our proxy votes in a way that puts our clients first, and buying good companies at good prices in the first place. We strive to do both well.
Focusing of the complete investment cycle
The current trend of companies delisting from the JSE is not over in our opinion and we expect more delistings in the future if prevailing pricing continues.
The risk of selling too early and at too low a price is something we worry about, and we strive to achieve a fair and an appropriate investment outcome when we sell. The smaller companies that we own on behalf of our clients are a valuable component of our current portfolios and the return profile they can generate is difficult to replicate in large asset management firms. We aim to continue to fully exploit this opportunity as best we can.
Justin Floor is a Fund Manager at PSG Asset Management.