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The value of growth

First Avenue’s CIO asks why local quality stocks have under-performed relative to global quality, and why there may be a growing opportunity.

The value of growth

 

By Hlelo Giyose

 

Companies have a lot in common with communities, villages, towns, cities, and countries. For one, they grow. For another, the same natural laws that govern the growth of mammals determine the growth of cities, countries, and yes, companies. 

These natural laws govern the characteristics of growth by placing constraints on misalignments between size (mass) on the one hand and power, temperature, and organ functionality on the other. 

Town planners might not be aware, but the principles of town planning are based on these same biological qualities. Many businesspeople are not aware of the impact of this on their businesses either.

Even less cognisant of it are politicians and legislatures, and hence the high failure rate of policies and countries. South Africa, through statist tendencies, has violated the tenets of scaling in its communities, villages, towns, and cities, and now both investors and companies listed on the JSE are paying for it very, very dearly.  

Local v global

To us at First Avenue, the outcome is evident in the comparison between the fortunes of our global equity proposition and our South African equity propositions. Both invest in high quality companies whose internal organs better maximise metabolic capacity (production of energy and materials required to sustain and reproduce life) and minimise energy loss.  The result is a natural selection favours continued existence of high-quality companies relative to their competitors.  

However, the difference in performance between South African high-quality companies and their global brethren could not be starker.

Quartile performance of First Avenue solutions vs peers
  6 months 12 months 36 months
Select focused   strategy (local + global) First First First
General equity strategy (100% SA) Third Fourth Fourth
Focused equity strategy (100% SA) Third Fourth Fourth

Note: Rankings based on gross returns
Source: First Avenue, Morningstar

What quality companies are metabolising is economic growth. They do this by arbitraging factors of production for revenue, and ultimately, economic profits. 

Growth cannot happen without a continuous supply of resources to their cells to metabolise.  Organisms eat, metabolise, and distribute metabolic energy to their organs. This is the template for how all growth occurs – the equivalent of renewing corporate value in companies and ratcheting up economic development in countries. 

It is none other than the law of conservation of energy – whatever goes in must be accounted for in terms of how it is allocated between the various categories of what it acts upon and produces: maintenance or growth. 

The government is elected to act as a heart that pumps oxygen-rich blood (by distributing taxes and government debt) to cells (the various arms of national and municipal government), for the citizenry to transform into economic value.            

In South Africa, economic transmission mechanisms are, however, not following the biological functionality you find among living organisms in nature. There is capriciously inadequate raw material for companies in South Africa to arbitrage.

The only companies that are thriving are those that supply (export) raw materials (resources) to other countries better able to generate growth, or those who are listed in South Africa, but operate elsewhere.

Scaling

Nature has its own way of making sure that living organisms grow in such proportion that they are not unwieldly. Trees do not grow taller than their trunks can support. Humans, no matter how much weightlifting and body building they do, will never grow so big that their body cannot support their structure.

These scaling principles are all around you. Human creations simply mimic nature, or they fail over time.

In a business, net income and total assets scale at a given ratio with the number of employees. There is no point growing one variable if it goes out of proportion with the others. You could not pay more employees if new business did not come in fast enough to match the rate of job creation. Likewise, there is no point growing your business faster than your employees can process it.

The same applies for government support of an economy.

If infrastructure building, goods, the delivery of essential services, and so on are scaling sub-optimally, then population sizes of various cities are not worth their weight in economic opportunity.  Businesses that attempt to provide goods to that community or city find that the absence of complimentary services or facilities limits opportunity.

Natural selection

This is the problem facing South Africa. Yet, we still have a large proportion of our portfolio invested in SA Inc. stocks. So, is our portfolio a lost cause? 

We believe that natural selection now has a free rein in redesigning the economic landscape of the country, regardless of the government’s opposition. Do not bet against natural selection. It is the most powerful force in nature. 

Natural selection has already reduced South Africa’s weighting in global emerging market indices to a level that betrays national pride. Natural selection has also ensured that South Africa’s GDP in proportion to global GDP continues to fall. If you wanted to see how badly scaled the country is, the economy ranks as the 35th largest in the world, yet 89th on a per capita basis.

The country is a lot smaller, more inefficient, unproductive, and economically unreliable than its population would suggest. Natural selection will simply align investment, not to population size, but to GDP per capita.  This implies an addressable population of 10m. The rest are simply economically un-addressable.  

As government finances collapse, posing a risk to its elaborate social net, businesses providing food, clothing, education, healthcare, private security, and so on will cut their coats according to this cloth. 

We have already seen how natural selection begun rebalancing the retail sector. The demise of Edcon Group, a 90-year old clothing retailer, will drastically reduce supply in the industry. Alongside this, the retreat of international players will align supply and clothing inflation with the opportunity value.  Despite structurally receding GDP growth, the sector is now creating growth for itself.    

What is interesting to is that many parts of SA Inc. are now considered value stocks because they are pricing in zero if not negative growth despite their quality.  Value stocks of weak, no moat, companies will be dealt with harshly by natural selection. The great opportunity, however, is in the strong, moaty businesses priced for no growth. 

And this opportunity, we would say, is worth playing for.  

 

Hlelo Giyose is the CIO at First Avenue Investment Management. 

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