Money with a dash of Funny: August 2014

Wednesday 6 August 2014

No great shakes

"Somewhere around 5.5 on the scale is equivalent (for the inner physicist in you) to 11 Terajoules of energy. Tera is one trillion! The Japanese earthquake in 2011 which measured 9 on the Richter scale and had a devastating impact (with the subsequent tsunami) measured 2 Exajoules, or 2 quintillion joules. Quintillion has 18 zeros, trillion has 12. 1,000,000,000,000,000,000 (Exa) vs 1,000,000,000,000 (Tera)."

To market, to market to buy a fat pig. Whoa, it is not often that we get to talk about a seismic event here in South Africa, yesterday was an exception with a tremor felt across these parts, the origin according to the USGS website was 6km east of Orkney. Yes, there is a detailed map and location, 10km deep apparently and magnitude 5.3 on the Richter scale.

According to the Wikipedia entry on the Richter scale, these moderate events occur worldwide around 1000 to 1500 times a year, so three to four a day globally. The most serious, the 8.0 to 8.9 occur once a year, 9 and above every one to five decades. Major earthquakes, the ones in magnitude 7.0 to 7.9 on the Richter scale occur 10 to 20 times a year and have a devastating impact.

Somewhere around 5.5 on the scale is equivalent (for the inner physicist in you) to 11 Terajoules of energy. Tera is one trillion! The Japanese earthquake in 2011 which measured 9 on the Richter scale and had a devastating impact (with the subsequent tsunami) measured 2 Exajoules, or 2 quintillion joules. Quintillion has 18 zeros, trillion has 12. 1,000,000,000,000,000,000 (Exa) vs 1,000,000,000,000 (Tera). You don't need to be exceptionally challenged with numbers to be bamboozled by the size of those two numbers, the perspective is all that I wanted to show you, I hope I nailed it. My late physics teacher would be proud of me with that calculation, provided I nailed it!

Earthquakes and tremors aside, the local market ended marginally higher settling off the best levels of the day however. US markets recorded a sell off in the middle of the session, the S&P 500 down around one percent by the end of the session, that has led to the lower open here on this side. The Russians are ready to impose sanctions of their own on the Europeans, including no fly zones. We can see how that will all work out.

Fox dropped their bid for Time Warner, after hours Fox was up 6.8 percent, Time Warner was down a whopping 10.55 percent. Well done to the board of Time Warner for refusing to engage with the Fox guys, really, well done. Staying with media for a second, I saw that Gannet had decided to split their business in two, the newspaper companies (which includes USA Today) will be separate from the rest of the business.

Newspapers in their physical format are on borrowed time, the people who advertise are telling you that. This year mobile advertising overtook newspaper advertising revenues in the UK, I would have thought it would have happened earlier. Predictions to 2017 suggest that total advertising revenues in print publications (newspapers and magazines) will be in the mid teens in the UK, I am sure that all developed markets will be the same. We continue to avoid all of these businesses as investments.

Alrighty, we finally get a chance to write up about the Zimmer results, which were released over ten days ago. As our holding time frames are for as long as possible, as long as nothing structurally changes, the timing of the reports is not necessarily mission critical. The mission is to stay long and strong!

For those of you not familiar with Zimmer, as per their website the company "designs, develops, manufactures and markets orthopaedic reconstructive, spinal and trauma devices, dental implants, and related surgical products." It sounds a little like the six million dollar man (Steve Austin) or the bionic woman, if you know what I am talking about there then you are more mature than the rest of society, some respect please!!

The company has been around since 1927, is headquartered in Warsaw Indiana, not Warsaw Poland. Their products undoubtably are for people with excess funds to spend on their health requirements, and you can definitely see that in their geographic sales segments. North America and Europe account for around 83 percent of sales, at least as per the graphic below, which is taken from their 2013 annual report that you can of course download at Recent News Releases and Information segment on their website. 44 percent of the 17 percent of sales is Japan, so over 90 percent of their sales are in developed countries, cementing the notion that this company's customers are mostly rich people.

Below the geographical breakdown, in the segment titled sales by product type (graphic above) you can see that knees and hips are undoubtably their biggest sellers. Why would that be the case? As we live longer in developed societies and by we I mean the royal we (all humans), our bodies need to keep pace with the wears and tears of life. A new lease on life for folks with new knees and new hips enables them to live more comfortably without the associated lack of mobility or pain.

I suppose that you need to understand a little anatomy in order to understand their products! Aside from knees and hips, there are dental products (implants), trauma products which stabilise broken or damaged bones, specialised spinal division (it looks incredible) with surgical equipment that helps all their businesses, blood and waste management, bone cement (yes really) and wound site management.

In North America, their biggest market by sales, the market is very competitive with DePuy Synthes (owned by JNJ, a Vestact recommended stock), Stryker (another Vestact recommended stock), Biomet and UK business Smith & Nephew (being courted by the aforementioned Stryker and even Medtronic is suggested to be in the mix). In Europe the market is more fragmented with smaller operators, companies like Waldemar and KG and Mathys, as well as the earlier mentioned US and UK companies. It is a tough market that is proceeding in terms of technological advances at a breakneck speed.

The company is however losing market share, or at least that is the perception. The stock is not expensive at 16 times forward, growth rates have been reigned in with management guiding lower to 6 to 6.1 Dollars worth of earnings (ten cents lower than previous guidance). Year to date the stock is up just over five and a half percent, the year high is around 8 Dollars from where the stock currently trades (98.36 Dollars last evening). The yield is a paltry 0.9 percent, most of the companies mentioned earlier have average yields, JNJ is the exception as they have two other huge businesses attached to their products and devices one.

At these levels the company is not a sell, but I would not be buying any either. I think that the thesis remains intact, there will be more elective and necessary surgery as the population ages in their core markets. There will also be more middle to upper middle income people in the coming decades using their products, I am very bullish on the prospects for the sector. Stryker would be my preferred buy, if you own JNJ their division as a standalone is currently the biggest in the world, the collective devices and diagnostics business. As most folks have the stock at a much lower level, it is a hold at these levels.

Byron's beats: Curro 2014 interim results

Yesterday we received 6 month results for the period ending 30 June 2014 from Curro, the biggest for profit private school education provider in South Africa. The presentation has lots of very informative tables so bear with all the figures being thrown at you. First lets look at the progress made as far as schools and learners are concerned.

As you can see the ramp up of students has been aggressive in a small space of time. If that concerns you take a look at the pie chart below showing how much more room there is to grow. Curro are still a very small fish in a very large pond.

Ok lets delve into the numbers. Revenues increased 54% from R315 million to R487 million. EBITDA increased by 89% to R96 million which equated to headline earnings of R27 million. This equated to earnings per share of 9 cents with no dividend declared. As you can imagine predictability of earnings going forward is very difficult. Trading at R26.30 the multiple is huge but don't forget that this company has only recently become profitable. Talking about profitability this table was very interesting. It shows the kind of margins Curro receive at certain capacity levels. Incredibly at anything above 25% Curro are in the green pretty handsomely.

The future looks bright for Curro but as you can see the market already knows that. The share is priced for heavy growth. I wouldn't let that deter you though. There are still so many positives to take from this model. One of the those is the relationship they have with 57.5% shareholder PSG. I read in a Moneyweb article yesterday that the experts from PSG are actually the ones who are out their looking for expansion opportunities while CEO Dr Chris van der Merwe runs the day to day operations of the current business. That sounds like a fantastic relationship to me.

As you may remember they did a rights issue a few months back where they managed to raise R589 million. This wasn't their first capital raising through the market and won't be their last in my opinion. In 2014 they plan on investing R1.5 billion alone, that is nearly 20% of their market cap. By 2020 they plan on owning 80 schools (32 right now) but I honestly believe they will match this target before then. I like the theme, I like the management structure and I think the stock is a good investment. Not for the fainted hearted though, the ride is going to be interesting.

Home again, home again, jiggety-jog. Yowsers, ABIL have reported another awful set of numbers, the CEO has resigned, it all looks completely awful and feels not too dissimilar to a Metorex type situation, rights issues, on their knees and feeling the heat. More on that tomorrow.

Sasha Naryshkine, Byron Lotter and Michael Treherne

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Tuesday 5 August 2014

S&P trumps Dow Jones, over and over

"In 40 years, if you had stuck your money into the S&P 500 tracker it would have returned 2297 percent, the Dow 30 has under performed, with a return of "only" 2031 percent. It confirmed my bias to the S&P 500, the collective market decides, rather than a bunch of chaps, as to what is the best method."

To market, to market to buy a fat pig. Financials roared ahead in the local markets, there was a recovery across the seas and far away with the US markets up comfortably on the session. It has been a strange old tale of the divergence of the Dow Jones Industrial Average, Year-to-date performance on the blue chip 30 index is a negative 0.04 percent. What? That is right, the blue chip index, the top 30 industrial stocks picked by the folks that founded the index (and they still choose what is in and out), size and scale has nothing to do with it.

The broader market, the S&P 500 is a market capitalisation index, the bigger in size, the more chance of being near the top of the table of the index. So far, that index, the S&P 500 is up 4.9 percent year to date. As far as I remember this is one of the biggest divergences that I have seen. In 40 years, if you had stuck your money into the S&P 500 tracker it would have returned 2297 percent, the Dow 30 has under performed, with a return of "only" 2031 percent. It confirmed my bias to the S&P 500, the collective market decides, rather than a bunch of chaps, as to what is the best method. Do not ever battle with the collective, you will lose. Not always, because human nature rewards the outliers that are disruptors and changers, normally always for the better.

The top ten constituents of the S&P 500 represent 17.5 percent of the total market cap of the S&P 500 (which has 501 constituents). They are names that you know well, in order of market cap, Apple, Exxon Mobil, Microsoft, JNJ, GE, Chevron, Wells fargo, Berkshire Hathaway B, JP Morgan Chase and lastly Procter & Gamble.

What is quite interesting is the way that the index has changed over the years, there is more a healthcare and technology feel to corporate America (as per the divisionalising or segmentation of business activities to indices) now, trumping energy, industrials and even consumer discretionary. Financials still are massive, that goes without question. Check it out, download last month's fact sheet on the S&P 500, and then check this pie chart:

Technology. I found a piece by Bespoke Investments titled S&P 500 Historical Sector Weightings which although it is old, it serves perfectly well for the purposes of this conversation. Technology as a percentage of the S&P 500, as per the table in the article was a whopping 29.2 percent of the index in 1999. Wow. From 6.3 percent in 1990. Now? As per the pie chart above from S&P it is only 19.4 percent. It is the biggest constituent.

The recent moves in healthcare are telling, it is becoming more and more important. It now represents 13.5 percent weighting in the S&P 500. When the going is tough for the market, it rises, obviously we know that healthcare spend is emotive, somehow citizens are hardwired to this idea that someone else must always pay, where the money comes from, that part is seemingly irrelevant in the conversation. Nothing is for free, ever. Perhaps air, as in The Lorax tale however, someone is working on that. I guess you could argue that government levy taxes on emissions, so air is not free.

Just for interest sakes if you did not click on the bespoke piece, here is the table that shows the ebbs and flows of the makeup of the S&P 500 over the 20 odd year period, starting in 1990 and going forwards to 2012, you can see the makeup currently with the pie chart above, at the start of the conversation.

The other major move over 25 years is how telecoms weighting in the S&P 500 has significantly reduced from 9.1 percent in 1993 to a mere 2.5 percent now. Obviously technology has had everything to do with that, what counts as normal communication in 2014 is vastly different from 1993. Industrials and materials have become less important as the US has moved towards the information age. Energy has made a massive comeback by value in the S&P 500 with fracking in the US being so important.

The key to investing over the next two decades is to try and predict whether or not healthcare is going to continue to be dominant and whether or not you should allocate more of your own value to what is a fast growing sector. We believe that this is the case. We like technology, not all of it, be more specific about the companies and not generalise about a sector that is better than the other. You can like sectors (thumbs up), in the end you own companies that are masters of their destiny and you hope outperform their peers.

Michael's musings: Up, Down and Flat

Caterpillar recently had their second quarter results which were largely in line with analyst estimates. The one statement used by Caterpillar which is a quick summary of the results is "Higher profits on lower sales". Sales compared to the same period last year are down 3% and profits are up 8% from $1.45 a share to $1.57 a share.

Saying profits are up though is a bit deceptive because operating profits are down 5%. The gain in EPS is due to there being 30 million less shares to share the profits among and also favourable income through currency hedging (which they made a loss on last time). Having said that as a shareholder the shares that you own have benefited from the share buybacks, which the company has indicated they will spend a further $2.5 billion on further buybacks.

Caterpillar has 3 main divisions which brought in $14.62 billion in revenue. The biggest and most important division is their construction industries division which contributed $5.4 billion to the revenue number, up 11% with a huge increase in operating profit of 83%. The increased profits are from increased sales prices and lower manufacturing costs, both positives. Below is an image of the division's breakdown, with a very positive 20% growth in sales in North America. The construction industry would be a leading indicator of future growth in North America, so a positive sign for other stocks.

The next sector that had a very big impact on the company is their resource division whose revenue dropped 29% from $3.3 billion to $2.2 billion, with the more worrying drop of 75% in its operating profit. Part of the big drop in the operating profits was due to them not having a once off income from a settlement last year. The below image of how the division did in the different parts of the globe, paints an ugly picture.

The last division is their Energy and Transportation division which had a decline in revenues of 2% to $5.175 billion but had an increase in operating profits of 6%. Both these figures are relatively flat and the profit number which is arguably the more important figure moved in the right direction.

Giving their outlook for the rest of the year Caterpillar see developing markets to continue to grow but "developing economies will remain challenged". The bigger concern and it has been seen in the current quarters figures is their forecast for mining, "we expect mining companies will continue to be cautious about resuming equipment investments, and we expect mining capital expenditures in 2014 to be below 2013". Going forward the company lowered their median sales forecast figure by $1 billion but increased their median EPS forecast figure from $5.55 to $5.75 per share.

The results are very volatile, with one division having a large increase in profits and the other a large decrease. Going forward I don't think that there will be fireworks from the stock and will probably be under pressure until the mining industry opens their wallets for capital spends. As Byron said in the last piece on CAT, we approach with caution.

Home again, home again, jiggety-jog. Mr. Market is having a better time of it this morning, compared to last week which was not the best week for equities. We are around half a percent better. The headlines that I read is that somehow the earlier than anticipated rate hike means that the market is on for x or y or z. What the Fed does matters little for your portfolio. What companies do is more important and I presume that when deciding what businesses do and where, this factors in interest rates, it is not the only decision. Rates are what they are, if your investment philosophy or thesis is to agonise over what to do next as a result of the Fed, then I think you are doing it all wrong.

Sasha Naryshkine, Byron Lotter and Michael Treherne

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Monday 4 August 2014

Steinhoff is bigger than THE Hoff

"Steinhoff released the results of the rights issue in which they raised a whopping 18.2 billion Rand. To give you an idea of how much 18 billion Rand is, that is roughly the market capitalisation of Grindrod. Absolutely astounding that the company could raise that much money, there was clearly the appetite there from the local market at 16.58862 rights per 100 shares, at 52 Rand a share."

To market, to market to buy a fat pig. Friday was so long ago. It was before Khotso Mokoena won a gold medal for the triple jump, world class stuff in the driving rain. I got a touch of sun on Saturday, my word it was warm. Just a reminder, it is summer in Glasgow and winter here in Jozi. It certainly did not feel like it watching the screens and seeing folks in short sleeve shirts here on the weekend!! We cannot and will not complain about the weather.

I am sure that market commentators had loads to complain about last week, we went through the lot on Friday. I always say that the irony is that when you are adding to a portfolio over time, you should be hoping that the prices stay low for as long as possible. Why? Surely that does not make sense. Same company doing better year in and year out at a cheaper price almost always equals a bargain. Whilst it is true that we have seen multiple (or Price to Earnings) expansion, stocks are hardly unreasonable.

I read a research report that shows many internet companies with lofty valuations are set for pretty quick PE unwinds, in other words because revenues and profits are going to grow so quickly in the coming years, in fact the next three, a 50 multiple suddenly turns into a 20. Granted that is at the price today, the price in the future, your guess is as good as mine. If earnings grow and you do not see multiple expansion, stocks go up a little. Of course as an investor you would prefer measured returns rather than volatile returns, the latter would unnerve you to some extent and ironically see you less likely to invest further.

I always thought that there are several words one can use in a headline to attract attention, the word scary always attracts attention. Over a decade of writing these newsletters has seen me grapple with the headline, that is never easy. So when I see this piece: A Scary Valuation Indicator, I am naturally sceptical. It turns out however as a casual observer that this is hardly "scary" and that we are just seeing equity markets adjust from a time that nobody was scared of anything, that turned into a time when everyone was fearful of everything, to a more normalised environment. To be scared is one thing, to be scared witless and numb, well that is another.

Not scary were the non farm payrolls numbers on Friday, the best combined six month streak for years and years means that the US economy is still on track to recover to somewhere near full employment, to read the full report: Employment Situation Summary. Read what you want to into that, the report was more or a less a Goldilocks porridge number, not too hot and definitely not too cold.

Markets slipped in New York, more on geopolitical events rather than earnings, which on balance have been better than anticipated. Whilst the jobs situation is important to establish a trend, everyone forgets the number from six months ago and yet places more importance on this number than any other. Keep calm and carry on!

When owning companies, you are not owning a share price. You are owning the future profitability of that business and paying a price today for that. The collective try and figure out whether or not the price is right, right now. Tesla is a great example of that. What a business! They are trying to revolutionise the way we think about private transport and the combustions engine. However, the business does not make meaningful profits, if any. They are only going to sell 35 thousand vehicles this year, of the Model S that is. The expectations are for a run rate of 100 thousand vehicles next year.

Whilst Tesla are selling all these motor vehicles and growing revenues quickly, they are spending loads of money ramping up production, breaking ground for the gigafactory (an agreement has been signed with Panasonic on battery development and manufacture) and in general attracting lots of attention, the company still makes a loss. So how do you value it? Obviously you are making lots of assumptions on Tesla's ability to meet a growing demand, affordability relative to the combustion engine and running costs, equally conversion to battery operated vehicles by consumers, which is a mindset hurdle.

Once there are more people with electric motor vehicles there will be more people that want a similar vehicle. The only negative that I can see locally with electric vehicles is that the power produced locally is by burning coal. So whilst you might feel like you are doing the environment a favour, you are not really. One more moderate negative, because the car is so quiet, pedestrians will have to be more aware visually i.e. not as dependent on sound for telling where vehicles are. We are on the cusp of some sort of change I think, with regards to consumer mindsets in richer countries. I think Tesla will disrupt hugely and do superbly well, if you buy it you must know that it is going to be a long way out however.

Steinhoff released the results of the rights issue in which they raised a whopping 18.2 billion Rand. To give you an idea of how much 18 billion Rand is, that is roughly the market capitalisation of Grindrod. Absolutely astounding that the company could raise that much money, there was clearly the appetite there from the local market at 16.58862 rights per 100 shares, at 52 Rand a share. There was enough of a discount, the thought of being diluted in what looks like a good investment was too much for the local investment community to pass over.

The number of shares in issue post the capital raising is now 2 459 880 692. At 53.38 Rand a share you can quite easily see that the market cap is sizeable, bigger than Sanlam, just smaller than Aspen and in 16th place on the ranking tables now. Wow. At the bottom of the market in mid 2009 the market capitalisation of Steinhoff was 17.152 billion Rand. The number of shares in issue was around half of what it is now, 1.28 billion back then, generating half the earnings on a per share basis. Revenues have more than doubled in that time, as have earnings.

What is key is that the makeup of the business has completely changed, this is now a European and United Kingdom business with South African assets held through two different entities, a stake in KAP and almost all of JD Group (around 86.2 percent). If the listing in Frankfurt eventually goes ahead, the company will then be in a position to obtain a higher rating relative to their European peers. Inside of the Dax 30, the blue chip index in Frankfurt Germany there are few comparisons to the business that Steinhoff do.

In the consumer space there is Gerry Webber and Adidas, Puma who make clothing, there are automobile and parts manufacturers in the broader consumer space including ElringKlinger, Continental and BMW, Cewe is in digital printing, there seems to be no other furniture manufacturers and retails. Henkel are close, they make glue, shampoo, detergents and the like, Beiersdorf makes and sells skin care products. And all these businesses trade on much higher earnings multiples than Steinhoff, which has traditionally been quite low relative to the rest of the market here locally.

The only point I am trying to make is that Steinhoff are quite possibly going to take some time to be rerated by a different subset of investors, should they be listed in Frankfurt soon, the point about re-rating with PE expansion is that the Rand price would reflect accordingly, although the leader/follower (Frankfurt/Joburg) would take some time to work out.

In my mind all that Steinhoff have to do now is meet the markets expectations when they report numbers for the full year to end June sometime in early September. Remember that earnings will be calculated on the smaller number of shares in issue from the end of June, a trading statement should be anticipated towards the end of the current month. I suspect that market conditions all being equal, most folks should be positively surprised.

Meanwhile, the aforementioned Grindrod and their market capitalisation of 18 billion Rand was under some pressure Friday, although today it (it being the share price) is bouncing off the worst levels. Best I do a copy paste on why earnings expectations and reasons why HEPS are expected to be lower:

Shareholders are advised that Grindrod expects its ... headline earnings per share (HEPS) to decrease by between 30% and 35% (2013: 76,2 cents per share). The decrease in HEPS is due to the continued depressed shipping markets, the impact of the industrial action in South Africa and closure of the commodity trading business.

The thinking was that shipping was supposed to be "stable" now, clearly not yet. Industrial action, that is supposed to be a once off, the labour and business landscape looks spotty at best in South Africa. Interim numbers are expected to be released on the 21st of August, that is in three Thursday's time.

Home again, home again, jiggety-jog. Markets have moved higher here, somewhat, up nearly four tenths of a percent. Retail stocks are stronger on the day, getting a lift here, not enough to lift the whole market to new heights however. Stay tuned as always!

Sasha Naryshkine, Byron Lotter and Michael Treherne

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Friday 1 August 2014

L'Oreal continues to be well worth it

"30% of sales is spent on advertising and promotion expenses! I am sure a fair sum of that goes to people like Scarlett Johansson and Blake Lively. Gross profit margins of 71% also shows you that these products are cheap to make but expensive to tell you how well they work."

To market, to market to buy a fat pig. Yesterday was a tough old day to be long the equities market. It was far easier to be long the VIX. VIX is volatility on the S&P 500, that was up a whopping 27.16 percent on the day. You could have bought that instrument a month ago around and be up 60 percent. Equally it can go nowhere and down 30 percent on a single day too. My instincts (I have no market secret sauce, nor do I have spider sense) tell me that it is too hard to try and call markets in the very short term. Like Tiger Woods and Rory McIlroy, there are champions at the top of their respective fields of expertise.

Going to a course, paying 500 Dollars (or Rand equivalent) in order to strike it lucky is not too dissimilar to getting an hour lessons from the club pro and expecting to swing like the Big Easy is possibly the correct analogy. With all due respect to the club pro and the person delivering the seminar on trading (pointing to fancy graphs and trends), becoming a specialist after a lesson or two, your chances are almost zero. I see people walking into training seminars being taught by people who themselves supposedly have the key, how does that all stack up? There is no quick way to trade and make money, even the best of the best spend years and years doing it.

The best way to make money is to buy quality and stay the course for as long as you can, reinvest the dividends, ignore the noisy. It is however much harder to tell people to do that, the allure of a quick buck and the warm fuzzy feeling one gets when you make a solid quick 20 percent is addictive. The people that do have home runs fail to tell you about the strikeouts. Investing is like test cricket, trading is like T20 or baseball, if I could use that analogy.

So what upset Mr. Market and caused the bottom to fall out a little, well 2 percent is a lot for many people, here goes a short list:

1) Ukraine and Russia, heightened sanctions and the repercussions, the "situation" has hardly improved.

2) Gaza, whilst there is a ceasefire, the "situation" is still tense.

3) Central banks and their next moves, the ECB is in a tight spot, the US economic outlook has improved and therefore interest rate hikes are being talked about.

4) Argentina default, did they or didn't they, technically yes, but as you can see from this FT article it is still very fluid: Hopes remain of deal on Argentine debt

5) Perhaps the strangest reason of all, the one that I saw the Business Insider trumpeted: Traders Are Blaming Thursday's Big Sell-Off On 1 Stat. Inflation. The dreaded inflation.

So what do you do as an ordinary person? You have no control over macro economic events and even less over geopolitical events. In fact you have in the bigger picture, no control over these events. What you do have control over is the companies you own, what they are up to, what consumer patterns to follow, which geographies to invest in (sometimes through the very companies you own), you get my point. It is more important to worry about that, rather than the Rand, or the price of X or Y or Z. File the noise in the ignore category.

Sometimes it is the sectors that you avoid that is equally as important as the sectors that you invest in. Yesterday I missed the opportunity to say which industry would you rather be invested in (this is one of Paul's favourites) cell phones or cigarettes? Quite clearly the statistics have shown that cell phones are actually more addictive than cigarettes, there are various sets of research that show that people check their smartphones over 100 times a day on average. Clearly that is more addictive than cigarettes and remembering that you can check your mobile almost anywhere, it is becoming harder to light up wherever you want.

Where am I going with this? Another industry that we are not too in amid on is the paper industry and more especially the fine coated paper industry. That would make a business like Sappi as an investment, not the best around. To illustrate a little further let me use some of the numbers that they (Sappi) released yesterday. From their 3rd Quarter 2014 Financial Results Presentation. First, the numbers (by way of a screen grab) and the one that stand out for me are the monstrous debt and subsequent interest bill, as well as marginal profitability. Earnings themselves have been patchy.

Here however is another two sets of graphics that tells me this company is not a buy, firstly the products that Sappi sell

61 percent of their sales are coated paper. And then below 66 percent of their products are sold in the USA and Europe.

I do not mean to beat up on a business, especially on the 102nd birthday anniversary of Milton Friedman. All I am saying is that whilst Sappi adjust towards cellulose (to compete against cotton in the textiles industry) their core product, paper for reading material in their core markets is going to continually look weak.

Last I checked schools and industry were moving towards paperless societies and storing documents in the cloud was far easier than storing them physically in a file. Last evening paging through a large Atlas (that is now a display piece) I was telling my eldest how much easier it is than when my dad used to tell me to go look it up in the dictionary or the encyclopaedia set. I checked on OLX, you can buy a complete set of Popular Mechanics encyclopaedia set for 500 Rand, or roughly one month worth of internet.

There are industries that are growth industries because more people are bound to use their products in the coming years and there are industries that are seeing lower sales and have razor thin margins as a result of too much capacity. Sappi falls into the latter and as a result is a sell. Coupled with a NAV of 222 US cents and creaking debt of 2.286 billion Dollars, or 24.52 billion rand. This is relative to a share price of 40.69 or 379 US cents and a market cap of 22 billion Rand. Too much debt, not getting smaller (they might give themselves breathing space by refinancing), it is going to be too hard. Avoid.

Byron's beats: L'Oreal H2 2014

Yesterday evening we received first half results from L'Oreal. Overall like for like sales grew by 3.8% but due to currency fluctuations sales reported in Euros were down 1.7%. They have been hit by a double edged sword with the Euro strengthening amongst developed market currencies but at the same time many developing market currencies have weakened. For a company reporting in Euros this is of course not a good situation and explains why the share price has been flat for the better part of a year.

To kill many birds with one stone lets take a look at a table which lays out sales by operational division and Geography.

Here you can see all the currency effects, especially in the U.S and emerging markets. Wow this company is well diversified geographically. There is still huge growth potential in these regions though, especially in Asia and Africa.

Divisionally L'Oreal Luxe grew very nicely. That includes their top end makeup and perfume brands. Think Richemont and LVMH, the top end brands are very defensive and are soaring in this current environment. Active cosmetics which includes expensive suncreams and anti blemish products also did really well but is one of the smaller divisions. Professional products which includes products used at hairdressers and salons had a tough period thanks to slow growth in the U.S. Maybe it was the bad weather? I'd expect this division to pick up as that economy soars. Consumer products were solid but not exceptional as we have seen from competitors such as Johnson & Johnson and P&G.

What absolutely fascinated me about this business was the margins and where money is allocated within the business. See the table below. 30% of sales is spent on advertising and promotion expenses! I am sure a fair sum of that goes to people like Scarlett Johansson and Blake Lively. Gross profit margins of 71% also shows you that these products are cheap to make but expensive to tell you how well they work.

Earnings for the year are expected to come in at 5.49 Euro which is enhanced by the big share buy back they have done with Nestle. We covered the details of that transaction in February in a piece titled Nestle make their intentions clear. The stock trades at 126 Euro or 23 times this years earnings which sounds about right for a business of this size growing like for like sales at such a fast pace. Any Euro currency weakness would also boost the share.

We continue to be attracted to the theme that L'Oreal are at forefront of, aspirations of new consumers. In fact Sasha tweeted a fascinating article the other day titled The "Next 15" will drive 80% of emerging market growth by 2025. Here is an extract. "McKinsey suggests that through mass urbanization there will be 60 megacities, double that of today, accounting for a quarter of global GDP. To target these areas of growth, luxury brands must adjust strategies to include cities that may not yet be on their radar to ensure that they have a presence as new markets begin to flourish."

I guess that is what 30% of sales in marketing will be geared towards, targeting that new market. We are still very happy to be adding to this stock, especially considering the current share price weakness.

Michael's musings: The everything store does not have profit

Last week it was Amazon.com's turn to in the earnings season to release their results. I am busy reading the book about Jeff Bezos and Amazon, so the team here decided to leave the report for me now that I am back from the Cape.

First things first, Amazon made a loss of $126 million for the second quarter of this year. A disappointing number but not a huge surprise because of all the money they are ploughing into technology, new distribution centres and other items designed to improve the customer experience. The guidance for the next quarter is even worse, as they are forecasting a loss of between $410 - $810 million, with $410 million of the loss coming from stock options and the writing down intangible assets. Personally I think that it is going to be a couple of years before we see a meaningful profit number from Amazon. I think that Jeff is going to increase his R&D and Capex spends as revenues grow.

The revenue number is by no means small or growing slowly, up 23% to $19.34 billion for the quarter. As one analyst said, it is quite a feat to make a loss on revenues around $20 billion. Next quarter revenues are expected to grow by 26% to between $19.7 billion to $21.5 billion! Breaking the revenue down into regions North America is $12 billion and the rest of the world is only $7.3 billion. To give you a comparison figure Walmart in their last quarter had revenues of $115 billion! When it comes to online sales though Walmart only had $10 billion for the last financial year, which is around half the figure that Amazon had for this quarter.

The large revenue number generates a large operating cash flow of $5.33 billion up around $800 million from the same time last year. This is the number that I think matters in Amazon's case because the bulk of the cash flow was put back into building a bigger Amazon with $4.288 billion going to property, equipment and web + software development. If and this is a big IF, Amazon do not spend this cash on building the company, the PE ratio would sit around the 27 mark. Which considering that they are growing revenues in the mid 20's, that looks cheap!

Given that profit is currently not very high (or negative) on the goals list for the management at Amazon what does their debt look like to fund the lose making company? It is not very high, sitting at the $4 billion mark, which is very small considering the operating cash flow number.

What is at the top of the Amazon goal list though, the customer! This is what will and does differentiate them from other online retailers. Being customer focused has made Amazon a very easy site to use and created a very loyal customer base. All the investment in infrastructure and R&D is to improve the customer experience by making the choice available bigger, easier to access, cheaper and quick to be delivered. More customers means better prices from suppliers for Amazon, meaning cheaper products leading to more customers.

Going forward online retail is only going to grow and Amazon will be the company leading the way. This is a stock that I would be buying for the long run, a buy and forget story, because I think it could be a bumpy ride, with small swings between profit and loss for the foreseeable future. Once the reinvestment of cash stops or slows down, I would expect to see Amazon towering above the competition and having a meaningful earnings number to justify the lofty valuation.

Home again, home again, jiggety-jog. Markets were down there, down here and everywhere. A big drop overnight on Wall Street, the biggest number today is undoubtably the non-farm payrolls number. In the meantime, happy birthday Milton Friedman. My favourite most pithy piece from the great man:

The world runs on individuals pursuing their separate interests. The great achievements of civilization have not come from government bureaus. Einstein didn't construct his theory under order from a bureaucrat. Henry Ford didn't revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty you're talking about, the only cases in recorded history, are where they have had capitalism and largely free trade.

If you want to know where the masses are worse off, worst off, it's exactly in the kinds of societies that depart from that. So that the record of history is absolutely crystal clear, that there is no alternative way so far discovered of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by the free-enterprise system.

Sasha Naryshkine, Byron Lotter and Michael Treherne

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