The Cadiz Mastermind Fund: Why we don't like MTN, Sasol and SAB Miller

Paul Hutchinson, Head of Cadiz Collective Investments writes that Cadiz fund mangers firmly believe that share prices do not always reflect fundamental value over the shorter term as a result of the irrational behaviour of investors, market sentiment or neglect.

A study of behavioural finance shows that investors act irrationally, largely due to fear and greed - fear of losing money and greed for a higher return on their investment. This irrational behaviour often translates into excessive optimism or pessimism at the top and the bottom of the market cycle respectively. This creates an opportunity for an astute investor to profit.

With company valuations, poor circumstances often become overly discounted, while a recent fortunate history can result in (irrational) exuberance, which CAHAM interpret as a mispricing of risk. CAHAM view their role as being to correctly price this risk, and look to take advantage of this market inefficiency by a dispassionate, contrarian, independent approach to investment decision making. CAHAM buys good shares, not necessarily good companies.

The Cadiz Mastermind Fund

This investment philosophy is clearly demonstrated by the Cadiz Mastermind Fund, which invests in value opportunities in the South African equity market and aims to provide investors with a high level of dividend income over the short term and maximum capital growth over the medium to long term. It seeks out companies that trade significantly below their intrinsic market value ('deep value' opportunities).

The fund therefore offers a low PE, low price-to-book, high dividend yield investment opportunity. It is a focused, high octane fund, which mostly uses high conviction ideas. As a result it currently holds 36 shares. 24 shares account for almost 90% of the holdings, with the remaining shares consisting of a tail of deeply discounted, higher risk small cap stocks.

Share selection rationale for some of the material holdings in the Cadiz Mastermind Fund

Firstrand
(FSR) Firstrand, encompassing market leader brands such as RMB, Momentum, Wesbank and FNB, has had a good few months of performance against the rest of the Financial and Industrial Index. We believe that the market is beginning to realise that the share decline of last year versus the other banks and the broader index was overdone and that Firstrand (despite its hiccups of 2007) deserves a fairer rating against the rest of the marketplace, and especially against the other banks.

BHP Billiton (BIL)
Billiton has more than held its own in the current market turbulence. Trailing ratings are close to their all-time lows, a level which normally presages a bottom in the commodity cycle. While there remains a great deal of uncertainty as to the extent of the global downturn, a holding in the world's largest diversified mining company can still be justified given its positioning on the commodity cost curves and resultant superior margins. Its product and geographical diversification, as well as management excellence lends further support.

Investec PLC (INP)
Investec is an international specialised banking group that is based in 3 geographic areas; South Africa, the United Kingdom and Australia. Of these, the United Kingdom business has been most affected during the current credit crisis, with property prices falling and merger and acquisition work almost drying up. According to their September statement to the marketplace, they believe that operating profits will be in line with the prior year - which we believe is an exceptional performance, especially when compared to their international peer group. While the company has traded in line with the rest of the Financial and Industrial Index, we continue to believe that the company is being materially mis-priced by the market. After assigning a fair value on both the Asset Management and Private Banking (both annuity income) businesses, the resultant valuation of the group is currently trading on around 2 x earnings.

Kumba Iron Ore (KIO)
Kumba is South Africa's largest producer and exporter of iron ore. Annual production runs at some 37mtpa and, through an ambitious programme of expansion projects over the next few years, this is expected to reach some 60mtpa by the year 2015. A strong feature of the product that the company produces is that it has a lump-to-fines ratio of 65:35, which is highly sought after by its clients. The company is financially strong with a conservatively structured balance sheet and an operating margin of over 50%. In addition, it has a high payout ratio, contributing further to its investment appeal.

Richemont (RCH)
The value that was unlocked in October has been quite remarkable, particularly for a highly liquid ALSI40 share. We calculate that Richemont outperformed the market by 30%. Despite this re-rating of the luxury business, we believe there are still strong merits to hold this stock. As a South African shareholder investing behind exchange control you can acquire this diversified business with mostly hard currency earnings at just a 10% premium to our market's price earnings ratio.

Business Connection (BCX)
Business Connection's new board announced their very favourable restructuring plans and business targets. We believe that the business is well positioned and the long term contract nature of their services will prove more defensive in any downturn. The company still has a significant amount of cash (post the special dividend paid in September) and is an attractive hold with the prospects of margins recovering to around 8%.

Reunert (RLO)
Reunert offers a diversified portfolio of industrial businesses in South Africa, which service electrical, military, corporate and consumer customers. We still view Reunert as undervalued relative to other stocks with exposure to anticipated infrastructure spend. With Eskom's, Neotel's, MTN's and Vodacom's capital expenditure plans, Reunert is in a perfect position to capitalise on this growth. The stock offers attractive valuations in terms of all four key indicators (PE, DY, PB and normalised PE's).

Steinhoff (SHF)
Steinhoff has underperformed materially since mid-2006, despite earnings growth having held pace with the broad industrial market. Earnings are priced at a 46% discount to that of the industrial market, more than one standard deviation lower than its long-term mean; Steinhoff's dividend yield is in line with the industrial market and its price:book ratio is trading at a 55% discount and almost two standard deviations below mean. It is a stable, well managed industrial company trading well below its long-term ratings. It also offers geographic diversity with exposure to the UK, Western and Eastern Europe, Asia and South Africa. Approximately 70% of Steinhoff's earnings are derived from Europe, which also provides an excellent currency hedge.

Brait (BAT)
Brait is a small-cap financial services company focused on the management of third party funds in the private equity and absolute space. The company also has substantial balance sheet assets, including co-investments, in these funds. The company can be roughly valued by seeing it as these two distinct building blocks;

The first building block is the asset management business, where fees are earned on the private equity investments and absolute return portfolios that Brait manages on behalf of its investors. Brait is currently managing invested third party assets of R6.4 billion. We value this business, assuming a 20% return on investments (ROI), at R1.1 billion. (Brait has historically achieved 30%, however, we believe that exceptional returns will be more difficult in the tighter credit environment.)

The second building block is the fair value of the assets held on the balance sheet. Our current estimate of the realisable value of these assets, taking into account current market conditions, is R1.4 billion.

Brait's current market capitalisation is R1.6 billion. Using our above calculations of the two building blocks, we get a combined fair value of R2.5 billion. This implies a 56% upside from the current share price. In addition, the company has announced a dividend policy based on 12.5% of net asset value (NAV). At the current NAV, this suggests a dividend of 180cps or a yield of 11.6%.

Rationale for some of the shares not held in the Cadiz Mastermind Fund

MTN (MTN)
MTN operates in 21 countries throughout Africa and the Middle East. The main countries within the portfolio are South Africa and Nigeria, which generate over 65% of group profits. While MTN has a strong growth profile with average penetration levels of around 20% in most of the countries in which they operate, we believe that material risks associated with operating in these countries, such as political, currency and economic risks are not adequately priced by the market. We believe this need to diversify earnings from Africa is substantiated by MTN's desire to make acquisitions in India for example.

Sasol (SOL)
Sasol has outperformed the market substantially since the beginning of 2007 driven largely by the exceptionally strong oil price. Government's abandoning of the proposed super profit tax and the R/$ weakness were contributing factors driving Sasol's strong rerating over the period. As such Sasol is currently trading at a 40% premium to the P/BV of the All Share versus a long-term relative rating of close to parity. Put differently, Sasol is trading at more than one standard deviation away from its long-term mean rating. On this metric Sasol is expensive.

SABMiller (SAB)
SABMiller is a company that all South African's can be very proud of. A great company, however, does not necessarily translate into an attractive investment opportunity. It is all about the price that you are willing to pay. Shareholders in SABMiller currently have to wait 60% longer for future earnings to translate into the current share price. As a South

African investor you may be attracted to the diversity in earnings that has been created over the last six years of offshore acquisitions and expansion, but you need to be cognisant that 90% of these earnings are emerging market based. Key currencies like the Rand, Columbian Peso, Polish Zloty, etc. have fallen dramatically and this will translate into poor US Dollar earnings and therefore the stock shouldn't be seen as an emerging market hedge.

In conclusion
We continue to believe that the portfolio characteristics of a value manager's fund at the current time in our market's valuation cycle are extremely compelling. In absolute terms the Cadiz Mastermind Fund is cheap on a price: earnings of 6.4x, a price:book of 1.1x and a dividend yield of 6.3%.