Value investing – a negative art

Caylin Conradie
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‘If there is difficulty or doubt the security should be declined.’ Benjamin Graham 

Risk management is essential to mitigate the consequences of being wrong about an investment.

If there is one important lesson that time in the market will teach you, it’s that being wrong is part of the process. There is always an element of unpredictability when you invest in anything, so a certain percentage of these decisions will be wrong. A good investment process focuses on how serious the consequences may be if you turn out to be wrong – how wrong it could go and how much it would matter. At Denker Capital, managing risk is core to our investment approach.

Taking risk is an inevitable ingredient of investing and of life, but the rewards must be worth the risks.

You shouldn’t take a risk you don’t have to, or for which you won’t be adequately rewarded. Over the past 12 months, we have seen a significant number of companies succumb to the reality that higher risk is not necessarily rewarded with higher returns. The collapse of shares like Aspen Pharmacare, Tongaat Hulett, Blue Label, EOH, Rebosis, Group Five, Ascendis, ELB Engineering Services and Aveng are proof that, while there are many possible outcomes when initially assessing an investment opportunity, only one will eventually transpire.

We didn’t invest in many of the shares that recently collapsed, because the investment case was just too complex.

Every investment has something wrong with it – a cheap company may have a risky balance sheet, generate poor returns or have a weak management team. A great company with excellent growth prospects may be overpriced. Our job is to ensure that whatever is or could be wrong with a company isn’t a game changer. Thinking hard about the risks is key to avoid investing in seemingly cheap stocks where the number of potential outcomes is large, and where their impact may be significant.

Tongaat Hulett had a wide range of outcomes and the potential effect of these was just too great.

For many years the company generated very low returns on its South African sugar business. It relied on its profitable starch business and ongoing property sales to fund ever-diminishing returns from the local sugar business. The company also depended on dividends from its Zimbabwean operations to fund its ever-increasing debt position. A change in any of these factors would significantly affect the potential value of the assets, and a scenario where several bad outcomes occur concurrently would be disastrous. This is exactly what happened. The South African sugar operations made losses, property sales dried up, and the company could no longer access its cash in Zimbabwe. In this example, when we assessed the company as a potential investment, the number of potential outcomes was simply too numerous, and the potential impact was just too significant.

Aspen Pharmacare’s change in business strategy was too risky for us.

With Aspen Pharmacare, we also followed the company for many years and continue to have a high regard for its management. However, the industry changed rapidly. This forced the company to make a dramatic shift in strategy away from commoditised generics to specialist therapeutic classes of drugs like thrombosis and anesthetic drugs. This involved spending R70 billion over the past few years to reposition the company. Such a dramatic shift in business strategy comes with significant risk and the outcome to date has left Aspen Pharmacare generating a meagre return of 7% on capital, with a mountain of debt (R62 billion versus a market cap of R44 billon). While we had owned the business in the past, the risks were just too high and we sold our shares at R240. (The share price at the time of writing is R98.)

We continue to learn and do our best to avoid ‘stupid’ decisions.

As Charlie Munger said, ‘It’s remarkable how much long-term advantage people have gotten by trying to be consistently not stupid, instead of trying to be intelligent’. By thinking negatively and asking what could go wrong helps reduce the impact of bad decisions and improves the overall returns of a portfolio.

We enhance our process proactively and continuously with fresh insights and lessons.

Although we don’t currently own any of the abovementioned companies whose shares have collapsed, we have made our fair share of errors, which is why our process is designed to ensure that we learn from these valuable lessons and bring these insights back into our process so that we can improve and get better.

Denker Capital’s due diligence process for assessing companies focuses on three key elements:

  1. We focus on understanding the economics of the business. We assess whether the business can generate sustainable returns on capital, its growth opportunities, its ability to generate cash, and its capital structure.
  2. We place significant emphasis on the management team who are responsible for capital allocation decisions.
  3. We make sure that we aren’t overpaying for the value we are receiving.

Ricco Friedrich


The information in this communication or document belongs to Denker Capital (Pty) Ltd (Denker Capital). This information should only be evaluated for its intended purpose and may not be reproduced, distributed or published without our written consent. While we have undertaken to provide information that is true and not misleading in any way, all information provided by Denker Capital is not guaranteed and is for illustrative purposes only. The information does not take the circumstances of a particular person or entity into account and is not advice in relation to an investment or transaction. Because there are risks involved in buying or selling financial products, please do not rely on any information without appropriate advice from an independent financial adviser. We will not be held responsible for any loss or damages suffered by any person or entity as a result of them relying on, or not acting on, any of the information provided. Please note that past performances are not necessarily an accurate determination of future performances.
SCI stands for Sanlam Collective Investments (RF) (Pty), a registered and approved Manager in Collective Investment Schemes in Securities.





About the author

  • Caylin Conradie

    Caylin is responsible for the marketing and communication functions of the business. Her career started at Allan Gray in 2008, where she gained client service experience. In 2009 she joined Ora Fund Managers (now Trustee Board Investments) where she was responsible for distribution support as well as the marketing and communication functions relating to the company’s tax-efficient funds and equity investment solutions. She joined the team in 2017.