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How Allan Gray values a stock

Allan Gray is a strong proponent of value investing, the mantra famously championed by Warren Buffet. Put simply, value investing is the concept of buying assets that are trading at less than their intrinsic worth and holding them for long-term appreciation purposes.

“It’s much like you would go about buying a house,” says Andrew Lapping, Chief Investment Officer at Allan Gray, who presented at the 2018 Allan Gray Investment Summit. “You work out what you think the asset is worth; ignore the noise in the market; and if you feel it is trading at less than what you believe to be fair value, then you buy.”

The trick to value investing, particularly when it comes to the “share valuation”, is the methodology used to determine the asset’s underlying value. This is where each asset manager has their own rigorous process and complex modelling technique to arrive at what they believe to be the true value of an asset.

Take Naspers, which has turned itself into an internet and technology behemoth with stakes in China’s Tencent and Russia’s Mail.ru. Naspers shares have surged 330% over the last five years, making it the biggest stock on the JSE by market capitalisation and giving it a hefty price-earnings ratio of 59.25. Nevertheless, Lapping still believes there is value to be found.

“People don’t ordinarily conceive of Naspers as a stock that a valuation-based asset manager should be looking at simply because it’s risen so much in recent years and is fairly expensive from a price-earnings point of view,” says Lapping. “However, you have to look at the merits of the stock today and not base your decision on what has already happened.”

In a nutshell, Lapping believes Naspers is trading at a discount to the sum of its parts.

“We’re not buying Naspers because it trades at a discount to Tencent but rather because it trades at a discount to its underlying asset value,” he says. “This gives you multiple levels of safety between its value on the JSE and the value of its underlying assets.”

To arrive at Naspers’s fair value, Lapping estimates the underlying fair value of Tencent at R3700 per NPN share (not the see-through Tencent market price of R4500) and adds in the R300  of cash per share that it has on its balance sheet (in large part due to recent stake sales in TenCent and Flipkart). He then adds R450 a share for its listed assets like Mail.Ru and MakeMyTrip, as well as the R300 a share for all its non-listed assets including DSTV.

If you add that all up (R3700 + R300 + R450 + R300) then you get R4750. Then add in a 20% discount that one applies to holding companies and you get R3800 a share.

“Management has done a very good job of asset allocation, while the market is pricing the share for management to destroy value,” says Lapping.

Glencore is another stock that Allan Gray regards as a solid investment proposition. In valuing Glencore, Lapping says that when one estimates the company’s through-the-cycle free cash flow on a per-share basis you arrive at a figure of 42 US cents, which when compared to its stock price of $4.10 suggests the company is trading at less than ten times free cash flow.

“That’s cheap, but there’s a very good reason for the discount,” he says. “They have a number of issues and related negative press but we believe the market is overly negative.”

Glencore has been mired in a series of off-colour deals, most notably in the Democratic Republic of Congo (DRC). Then there’s the fact that commodity prices have performed rather modestly in the last three years.

Lapping acknowledges that there are some issues with Glencore, but stresses the need to look “through the cycle” when valuing the company.

“You don’t get opportunities like this for free - there’s bound to be some hair,” he says. “We are aware of the risks.”

Lapping says the DRC is not “everything” for Glencore as it has plenty of good assets in other jurisdictions. He also believes management’s capital allocation decisions have been sound.

The final value pick for Allan Gray hails from the embattled mining sector – Impala platinum. Lapping notes that sentiment towards platinum group metal (PGM) stocks has been extremely negative in recent years. This has been borne out in Impala’s share price, which has dropped 95% since May 2008, taking its market capitalisation from R225bn back then to just R13.5bn at present. While it’s tempting to fault the platinum prices for this share price decline, Lapping eyes a different culprit.

“Rand metal prices, when adjusted for inflation, are in line with the 20-year average and well above the long-term average,” he says. “So the industry’s problem is definitely not exceptionally low metal prices. Production costs consistently increasing well above inflation is the underlying cause of the company’s poor performance.

“Given the very negative sentiment, not much has to go right for Impala to be a good investment as the company has some decent assets which are worth more than the share price. The risk is that Impala’s Rustenburg operations are worth a very large negative,” he explains.

“There are always risks in investing but the overwhelming risk that you want to guard against is permanent loss of capital, not volatility,” he says. “There’s always going to be volatility along the way.”

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