Here’s the wonderful thing about the equity markets: much like in a box of Bakers Choice Assorted Biscuits, there’s something for everyone. Well, unless you’re diabetic or gluten intolerant, in which case you’ll be stuck in money market and fixed income investments. But for the rest, you’ll find something that suits your tastes.
Those “tastes” tend to be based on the same underlying concept: risk tolerance. Companies on the market range from highly dependable white Toyotas through to exotic Italian machines that will set your pulse racing — and not always for the right reasons. Just like the cars, these stocks offer completely different ownership experiences and rewards relative to the risks.
Just last week we had perfect examples of both on the same day. Covering the full risk spectrum of “investable” companies (in other words, not highly speculative or bottom-of-the-barrel names on the JSE), updates came in from Clicks and Sasol.
The numbers from Clicks are just about flawless. The group shows a return on equity (ROE) of 49.2%, a number so large that you have to double-check that it isn’t a typo. For context, the cost of equity in South Africa for a company such as Clicks would be about 13%. This is based on the South African 10-year government bond yield, plus a market risk premium that is appropriate for a company with Clicks’s risk profile (roughly 400 basis points over the bond yield would do it). Clicks is earning nearly four times its required hurdle rate on equity. To add to the excellent financial story, the group is still growing strongly, with both the diluted headline earnings per share and the dividend growing by just more than 14%.
Based on this, you would assume that shareholders are swimming in money from the returns being generated by Clicks. This is where the risk tolerance point comes in. You see, much like that white Toyota that holds its value so well in the used market, Clicks trades at a premium because the market already knows that the business is great. Assumed greatness equates to a high valuation multiple, in this case a p:e of just less than 30. This doesn’t leave much room for outperformance unless the market is willing to stick around at this valuation multiple and allow the share price to track the underlying earnings growth.
The Clicks share price is flat over 12 months and has returned 47% over five years, a compound annual growth rate of 8%. Once you add on dividends, Clicks sneaks into the double digits in terms of returns. The demanding valuation means that Clicks hasn’t given shareholders an appealing enough premium over the fixed income alternatives, despite the underlying company generating such a great return on the book value of its equity.
Much like that white Toyota that holds its value so well in the used market, Clicks trades at a premium because the market already knows that the business is great
It’s worth clarifying this point further. When you pay a premium valuation, you aren’t paying the book value of equity when you buy the shares. You are buying at a multiple of book value — in this case, an extraordinary multiple of more than 12 times NAV. The effective ROE is therefore much lower for shareholders than for the company itself.
Companies with premium valuations tend to appeal to investors with low risk tolerance who are looking for decent long-term returns without a high likelihood of loss. There’s nothing wrong with that, of course. It’s just very different from the rollercoaster ride you’ll experience at names like Sasol.
Sasol needs no introduction in terms of risk. The company created a generation of new retail investors during the pandemic. As by a rough wave in Durban in December, those newbies were then thrown around and deposited on the sand without their costumes, left to wonder what on earth happened. The share price is up just 4% over 12 months and remains miles off the peaks in 2022.
But in the past week, it’s up 16%, thanks to some moderate improvement to the underlying metrics. Unlike Clicks, the company still faces considerable external risk factors (especially the oil price) and the challenge of crumbling South African infrastructure. Unlike Clicks, it can reward punters with huge one-day moves that are higher than Clicks can produce in a year.
Sasol isn’t the white Toyota in the garage. It’s the classic convertible that gives you great joy a few Sundays a year when the sun is shining, while taking up headspace and causing stress the rest of the time. But as anyone who has owned such a thing will know, the diversification of having both cars is probably the sensible approach. Likewise, a mix of dependable stocks and risky names is a typical approach to portfolio management.
