Woolworths case study into VFM’s bottom-up investment process.

Author: Safs Narker (CIO & Head: Equities)

Beware overpaying for the hype.

Like every other fund manager, Vunani often gets queries about our investment philosophy and processes around stock selection.

The diverse range of views among analysts about the market direction and specific stocks, can admittedly be confusing and at times worrisome for investors. Analysts can be influenced by herd mentality, prevailing market sentiment and even FOMO (fear of missing out). Often the hardest decision for analyst/investment managers is to take a position contrary to the populist view when market participants are all howling with exuberance.

Our approach is steeped in bottom-up fundamental stock analysis.

Our approach is steeped in bottom-up fundamental stock analysis to clearly and succinctly determine the key drivers to a company’s earnings in the medium to long term. Whilst macro-economic factors paint the backdrop to any companies operating environment, often these factors are quickly priced or even over-priced in the company’s valuation.

Deciphering the fundamental drivers of earnings and varying outcome scenarios are critical to determine whether exuberance or despair has clouded a company’s current valuation metrics.

Our investing process challenges market convention and perceptions when shares are either “the talk of the town” or completely out of favour. The team’s combined experience over multiple decades has provided some deep insights and understanding of domestic markets and various companies. We have long forsaken the idea that we can forecast future earnings any better than what consensus (broker community) has done and distributed in public forums. What we do believe we have is the ability to test and critically dissect the earnings drivers to ascertain how optimistic or pessimistic the assumptions are and if valuations provide an opportunity to generate reasonable returns in the medium term.

What we know from academic studies and from our own market data is that earnings growth drives company valuations over the long term (>10 years) but in the short to medium term company ratings (PE’s) can be the biggest generator or detractor of returns. One need look no further than 2019 S&P returns of >30% was driven largely by PE re-rating of companies within the index. So what does this mean? Effectively market participants are expecting future earnings streams to be growing strongly to justify the PE rating, if these don’t materialize, expect a rather negative overall return.

Our research shows that avoiding drawdowns is significantly important for a fund’s performance,..

Our research shows that avoiding drawdowns is significantly more important for a fund’s performance, than paying excessive high valuations and hoping that earnings will deliver stellar returns to justify your initial purchase. Any disappointment will be harshly repriced to the detriment of our clients’ net-worth.

Woolworths, Sasol and Naspers are three popular stocks that we seemingly took contrarian views on. Amid the noise, the hype and consensus views, we kept our heads down and tested various scenarios under which the projected earnings/valuations could be justified. At the point of reducing our holdings, all these counters seemed top picks amongst the investment community due the wonderful growth stories. Paying for future growth with ever increasing PE multiples is surely a recipe for disappointment at some point.

Sasol and Woolworths (in particular) are great examples of stocks that we reduced exposure to when market participants were overly enthused by management projections of new ventures. Bear in mind that management of any company are effectively walking advertising for the business. They have vested interest in share schemes and bonus structures to ensure that company is highly rated so it is in their best interest to paint a positive outlook. Our jobs as investment professionals is to apply professional judgement and skepticism to management assertions.

In Woolies’ case, we reduced our exposure in late 2015 after they acquired David Jones in Australia which required a rather large capital outlay. At that stage, management were filled with the visions of ever increasing margins and the elusive diversification benefits. Whilst some of the assumptions appeared reasonable, market participants got overly excited with the narrative and priced David Jones on a sustainable PE multiple of 30x. Whilst a reasonable business, the margins and managements optimistic outlook needed to be dramatically exceeded to justify these valuations. We reduced our exposure and eventually exited Woolies completely.

We missed the last 10-20% of the rally but we saved our client portfolios the drawdown from R120 to R44 (current), in excess of 60%. What became apparent in subsequent years (post 2015) was the reality that managements best intentions could not deliver against expectations and the underlying Australian competitive retail environment. Furthermore, Woolies operated a balance sheet will virtually no debt prior to David Jones however the debt burden from a badly executed deal resulted in the business having to cut its dividends.

At current levels, you may feel that “it has to be valuable” consider it traded at R120 a few years back. Consider the earnings profile is now much lower so at current valuation, buyers will still be paying around 14x spot earnings for a business with a low dividend and high levels of balance sheet gearing.

Ultimately what drives returns of any company are:


Woolies case study provides a clear example of paying to a higher a multiple and suffering the negative effects when earnings disappoint. To compound matters further, the debt burden of the company ultimately meant shareholders had to sacrifice dividend flow to appease debt holders.

Sasol is another company that has followed this path in recent reporting seasons. A once promising Lake Charles Chemicals Project (LCCP), slated to convert Sasol into a global chemicals business (demanding a higher rating no less!) has been a perpetual thorn in its side. The project has had numerous cost overruns and return on capital employed has reduced consistently to subpar returns. Whilst management execution has resulted in CEO’s being dismissed, what is left in their combined wake is a balance sheet highly geared with US Dollar debt and a business need to service debt and liquidate assets.

The earnings have disappointed and the dividend has vanished. Against the backdrop of global oil peers paying dividend yields of 4-5%, the key question to be answered in the next few reporting cycles is what is Sasol actually worth. We believe the underlying fundamental risk remain elevated and will remain observers at this stage as we believe valuations have not yet fully adjusted to Sasol’s new reality.