PORTFOLIO AND INVESTMENT INSIGHTS
VOLUME 1: JULY 2007
INVESTMENT INSIGHTS
THE GREAT GROWTH ILLUSION
“Toto, I’ve got a feeling we’re not in Kansas anymore.”
L. Frank Baum - The Wonderful Wizard of Oz (1990)
In learning more about the business models of hotels, retailers and restaurants we find them to be particularly informative
case studies. The shares are often the source of leveraged investment returns, both positive and negative.
We think the first reason for this is that the operating profitability is highly leveraged to their respective economic cycles,
which also happen to be more or less the same - consumer discretionary expenditure. Setting up a hotel chain, retail
chain or franchise centralised distribution network requires a large upfront capital commitment with substantial annual
expenditure – leases, staff, centralised marketing & administration and stock. Most of these are not recoverable costs , for
example, lease agreements are legally binding until the expiry of the lease. If your store happens to become unprofitable
that is just tough luck, you still have to pay the outstanding lease.
Customers have many options and are not contractually bound to buy from them. Every day they technically start from
zero and just don’t know how many customers will choose to walk through the doors that day. In textbook theory it’s called
a high fixed cost base to doing business. In the real business world it means that you have very little control over the level
of profitability of your business – it largely depends on the ability and willingness of your customers to spend money at
your stores.
The second reason is more subtle and somewhat poetic. If the past is any guide (and it is!), investors appear to reward
such companies with very high valuation multiples when the going is good and very low multiples when it’s not. In RE·CM
terminology: The perfect hunting ground for both undervalued and overvalued investment ideas.
The brilliant MacGuffin in this instance comes from the ‘illusion’ of growth that is created by the fact that these companies
rely to a very large extent on store expansion and/or acquisitions to drive turnover growth. Make no mistake, it is real
growth we are talking about here, but once conditions change and they cannot expand the growth ends right there. This is
apparent in the example below that we are using to help illustrate some of these concepts.
South African listed cash retailer Mr Price is by all accounts a wonderful company with a very good long-term track
record of profitable growth. It achieved a 17-year average return on equity of 20% and compounded annual growth rate in
dividends over 15 years of 28%. It has not made a loss since listing and has never cut a dividend. In short, at face value this
is a terrific company, something to buy and put in the bottom drawer for your grandchildren.
The chart on the following page shows the share price of Mr Price since 1995.
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PORTFOLIO AND INVESTMENT INSIGHTS
VOLUME 1: JULY 2007
Chart 1: Mr Price long-term price (log scale)
95
96
97
98
99
00
01
02
03
04
05
06
07
Source: Thomson Datastream
A logarithmic scale enables the viewer to meaningfully assess the percentage changes that occurred in the past. Because
we concern ourselves firstly with downside risk and then with upside ‘risk’ the two areas marked with the circles in the
chart: 1996/7 and 2000/2001 are of particular interest to us. Investors at the time experienced significant price declines, in
both cases by more than 50%.
Let’s take a look under the hood of this Mustang.
Chart 2: Mr Price Operating profit per square metre vs. Percentage share price change
100%
3.5
80%
3.0
60%
40%
2.5
20%
2.0
0%
1.5
-20%
-40%
1.0
-60%
0.5
-80%
FY
1991
FY
FY
FY
1992 1993 1994
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Operating profit per sq metre (R'000)
Percentage share price YoY
Source: Company reports and RE·CM analyst
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PORTFOLIO AND INVESTMENT INSIGHTS
VOLUME 1: JULY 2007
It appears that investors became somewhat disillusioned with this business when operating profit per square meter of
trading space declined. This resulted in declining operating profits and earnings and happened in both the time periods
referred to earlier, again marked by the two circles. In both cases this disillusionment created good long-term buying
opportunities. As an aside, two really good buying opportunities in a good business over a period of 11 years is actually
not bad at all – if we proclaim to want to own stocks for the long haul then why shouldn’t we wait patiently for the really
good opportunities that Mr Market provides from time to time?
Now, let’s dig a little bit deeper. Consider the following:
Mr Price
14 year compound annual growth rate
Turnover
22.1%
Operating profit
23.2%
Earnings per share
24.4%
Shares in issue
3.1%
Trading space
18.7%
Revenue per square metre
2.9%
Operating profit per square metre
3.8%
Source: Company reports and RE·CM analyst
Taking the share dilution into account it is quite clear that, if not for the increase in trading space, shareholders would have
experienced almost no growth whatsoever in this business. And that is before adjusting for inflation.
In its latest update to shareholders the company announced it is planning on doubling trading space over the next seven
years. At first glance that appears like quite a strong statement and is also reinforced by a Business Day article of July
12th with the eye-catching headline: “Mr Price ramps up spending to take on bigger industry names. Chain’s rapid growth
impresses analysts”. However, thanks to the wonderful world of compounding the annual rate of growth implied by this
statement turns out to be around 10.4%.
(WAKE UP IN THE BACK!)
This is extraordinary. A company with long-term compounded growth rates above 20% is in effect telling its shareholders
to expect nothing more than 10% for the next seven years. Before inflation. If this is not a profit warning of sorts then we’ve
never seen one before!
To drive the point of all this to its final conclusion, let’s take a look at the long-term margins and the valuation Mr Market
has placed on this business relative to its long-term history.
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PORTFOLIO AND INVESTMENT INSIGHTS
VOLUME 1: JULY 2007
Chart 3: Mr Price long-term Operating Margin
12%
10%
8%
6%
4%
2%
0%
FY
1991
FY
FY
FY
1992 1993 1994
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Company reports and RE·CM analyst
Chart 4: Mr Price long-term Price to Book and Price to Sales multiples
6
1.5
5
1.2
4
0.9
3
0.6
2
0.3
1
0
0.0
FY
1991
FY
FY
FY
1992 1993 1994
Price / book
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
FY
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Price / sales
Source: Company reports and RE·CM analyst
So, in conclusion, investors today are paying very high multiples on well above average levels of earnings. In addition to
the growth argument outlined above we think this is an investment opportunity that offers the sort of odds that we are just
not comfortable with: If you’re right you make a bit of money and if you’re wrong you lose a lot.
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