Friday, November 1, 2002

Newsletter Issue 1, November 2002

Who is this newsletter for?

This investment newsletter is for investors who have some or all of the following attributes:

Ø Have more than R50,000 invested directly in the JSE Securities Exchange, or aspire to do so
Ø Tired of poor advice given by some stockbrokers or financial advisors
Ø May not have the time or skills to do the necessary investment research and analysis
Ø Willing to invest long-term, adopting a buy-and-hold strategy
Ø Willing to follow a simple yet logical formula for investment success

If you are a speculator or trader, then this investment newsletter may still be useful, but the value of it would be diminished.

Who are we?

Daberistic Solutions cc is a company that provides quality, useful investment advice and related services to private and institutional investors. Our investment advice is focused on meeting the investors’ needs of creating long-term sustainable wealth.

Our advice is based on a simple, yet tried and tested approach developed and used by some of the most successful investors of all time, including Philip Fisher and Warren Buffet. This approach entails:

Ø Invest in businesses and not shares. In other words, think and invest like a businessman.
Ø Expand and intensify our “circle of competence”: only invest in businesses that we understand.
Ø Analyse the potential investments by looking at its business, management and financials. In doing so, also obtain information on the companies from the financial press and people that are associated with the company (e.g. customers, suppliers, staff).
Ø Determine whether a company is worthy of investing, and the fair price to pay for its shares.
Ø Only buy when the shares of a company are at or below their fair price.
Ø Own a portfolio of businesses, and not a portfolio of shares

What we promise to do

Ø We will recommend equity investments that have great potential of providing a compound annual total return of 20% or more over the long term. The total return consists of both dividends and capital gains.
Ø We will provide you with quality, logical and useful investment advice.
Ø We will only recommend investments that are within our circle of competence, i.e. businesses that we understand well.
Ø Endeavour to respond to your queries within 72 hours.
Ø Improve our services by listening to you, our valued client.

What we promise not to do

Ø Give investment advice based on short-term views.
Ø Recommend investments that are outside our circle of competence

What you can expect from each monthly newsletter

Ø At least one company that we recommend investing
Ø From time to time, companies that we have analysed and considered not worth investing
Ø Annual reviews of our recommended companies
Ø Periodical, honest assessments of the successes and failures of our investment advice and services.
Ø An article on equity investment
Ø Occasionally, other personal finance matters
Ø Plus some surprise features!

Stock recommendations

Ceramic Industries is a company that is worth investing.

First, some facts about this company:

Full name: Ceramic Industries Limited
Nature of business: Manufacture of ceramic tiles and sanitaryware
Classification: Construction & Building Materials – Building and construction materials
Founded: 1987
Listed on JSE: 1992
Market capitalisation: R1.4 billion as at October 2002
Motto: Our tradition is ceramics, innovation our future
Vision: To be the preferred global supplier of ceramic tiles and sanitaryware by 2010

Why do we recommend this company?

ü The company’s directors and their associates together hold more than 60% of the shares. They manage the company as owners and not mere employees. Their track record in growing the economic value of the company attests this.
ü Unlike many companies which raise debts to finance acquisitions and expansions, this company uses its own cash resources to expand its operations, and it has done so successfully.
ü It is frank about the successes as well as failures in its operations. Specifically, it communicates openly about its failure with its NCI plant and problems with the joint venture in Italy.
ü It has favourable long-term prospects: Locally, the per capita consumption of tiles is 0.75 m2 compared to per capita consumption in excess of 1.5 m2 in other developing countries like Brazil and Indonesia. This illustrates good growth potential in the local tile industry. Globally, in line with its vision to be the preferred global supplier, it has established a joint venture in Italy, and has plans in Australia and Brazil.
ü It is focused on reducing costs and enhancing technology, which in turn improves its operating profit margin. As a result, the operating profit margin has increased from 13.6% in 1996 to 26.3% in 2002.
ü Its return on shareholders’ equity is a high 36.6% in 2002, and it’s likely to be maintained at this level.
ü Strong cashflows generated by its operations

Based on our valuation, the fair value of this company is R1,711 million, or R93.70 per share. If you can buy Ceramic Industries’ shares at or below this price, you should be able to achieve a total return of 20% per annum over a period of three to five years. The total return consists of both dividend income and capital gains.

The current market value of Ceramic Industries is about R1,400 million, or R77 per share. This is an 18% discount to our fair value. Buying at the current price represents good value for money.

How much should you invest in Ceramic Industries?

If you have a relatively small portfolio (R50,000 to R100,000), you may want to invest R15,000 to R20,000 in Ceramic Industries. If you have a bigger portfolio, you may want to invest between 10% and 15% of your portfolio in Ceramic Industries.

Recent news

4 October 2002: Ceramic to expand production

Ceramic has expanded its production in an attempt to keep up with increased demand for tiles in South Africa. The company has invested about R128m to build and import technology for its Pegasus factory, which will manufacture pressed floor tiles. Pegasus plant manager, Peter Delange, said that the factory wants to be the foremost low cost producer of ceramic tiles in South Africa. For the year to Jul 2002, Ceramic's sales rose 32.6% to R554.7m.

12 September 2002: Ceramic granted R30m tax incentive

Ceramic has been granted a tax incentive of R30m by the department of trade and industry's strategic industrial projects programme for the group's Pegasus factory. The plant produces pressed floor tiles. Nick Booth, the CE, said tax incentives were offered because of jobs generated by the factory. It had created about 1 800 downstream jobs, 64 direct, and 120 upstream jobs. The first Pegasus kiln was scheduled for commission in Nov 2002 and the second for early 2003.

11 September 2002: Ceramic results for 12 months ended 31 Jul 02

Revenue increased 32.6% to R553.6m (R417.49m), operating profit was up 44.7% to R145.6m (R100.6m), and attributable earnings was 30.4% higher at R114.14m (R87.51m). EPS was 30.4% higher at 625cps (479cps), and HEPS was up 29.8% to 621.9cps (479cps). The group increased market share during the period, enhancing its role as South Africa's leading ceramic tile manufacturer. Betta Sanitaryware achieved excellent growth and also entrenched its position as the leader in the manufacture of vitreous china sanitaryware. The group has decided not to increase selling prices at the beginning of the 2003 financial year. This is in accordance with its marketing strategy to limit price increases to levels lower than inflation.

Increased production was readily absorbed by growth in local demand for the group's product. Local supply met only 65% of the total demand, but management is confident that the South African ceramic tile and sanitaryware markets afford significant growth potential. Current southern African consumption, excluding South Africa, is estimated at 20m square metres per annum. The sustainable growth potential of the southern African market will remain a key focal area for supply from increasing production capacity. Satisfying sales growth has been experienced in sub-Saharan Africa and particularly in Zambia, Malawi and Tanzania. For the period under review, exports grew by 28% and contributed 13% of turnover. Export growth was constrained by increased local consumption. Ceramic will continue with expansion strategies, both locally and abroad. The company remains ungeared, with all capital projects financed through cash reserves.

11 November 2001, Sunday Times

Down to earthenware

Top 100 Companies

Publicity-shy manufacturer of toilets and tiles thrives as rivals fold by concentrating on the basics of a job well done, writes Gill Moodie.

Ceramic Industries, South Africa's biggest manufacturer of ceramic tiles and sanitaryware (toilets, basins and the like), shies away from the limelight: it does not even have a public relations officer.
It quietly goes about its business - growing consistently, and producing sound results and value for its shareholders.

Ceramic occupies the number-two slot in this year's Top 100, with compound growth of 57.16% a year for the five years to the end of September.

"We believe that the improvement in the share should be because of the performance of the company, not because we've done a big marketing drive," says Ceramic CEO Nick Booth. "We're a company that believes we've got a job to get done, and we get it done. We [the management team] thoroughly enjoy what we do, and that's why we do it."

A major part of Ceramic's success is its ability to improve productivity. There is constant reassessment of operations at its five factories. Increasing margins by driving down costs - rather than increasing prices - means that Ceramic has grown as inefficient rivals have gone out of business.

Profit sharing for employees (there is a monthly income statement for all to see) helps, as does the fact that Ceramic has no gearing.

It has also secured a wide range of merchants - from the Italtile-CTM group to hardware and plumbing chains.

Tiles make up the greatest part of Ceramic's business, for which the main market is "the average South African improving their house", says Booth.

To a large extent, this shields the company from economic slowdown. When downturns come, says Booth, many people turn to paying off their bonds and improving their homes as their best investment.

The increasing desirability of imported terracotta floor tiles at the fashionable upper end of the market has also helped to create an aspiration for tiles at lower income levels - which is where Ceramic comes in.

Nowadays, laying floor tiles in the average room is cheaper than laying a carpet.

Despite this, SA has a much smaller appetite for tiles than other emerging economies such as Brazil. That is mainly because there are few distribution points in the country, says Booth. But that is starting to change, with hardware and tile merchants expanding into less urbanised and rural areas.

The sanitaryware side of the business supplies the construction industry and the DIY market. There is growth potential there, too, though not guaranteed, in government investment in housing.

Finding new ways to stay efficient is becoming more pressing because of the entrance of low-cost producers, particularly from Brazil, into SA. Brazilian producers are taking advantage of cheap shipping costs to SA - about half of that to the US.

The battle plan to deal with the threat is Ceramic's "new baby": the R90-million Pegasus factory in Vereeniging, scheduled to open next October.

Another big project for the coming year is a joint venture in the home of the terracotta tile, Italy, with that country's only listed tile manufacturer.

Ceramics is committing R40-million to the venture, part of its ambition to be globally competitive. "If you want to play in the first division, you've got to play with the best in the world," Booth says, "and to do this you've got to learn the local rules."

Unit trusts versus direct equity investment

You may well have heard of unit trusts or even already invested in unit trusts. You may ask, “why investing directly on the JSE? Isn’t that risky?” I thought it would be useful to compare unit trusts and direct equity investment in the table below:

Unit trusts
Direct equity investment
People pool money together to invest in certain types of assets, such as equities, property and interest-bearing assets.
You have your own private portfolio
Money managed by a professional fund manager
You manage your own money
A safe and convenient way to save and invest
Need to acquire skills and spend time to do research; potentially very risky if you don’t know what you’re doing
Regulated by the Financial Services Board, which acts as a watchdog over your investments, giving you the peace of mind
Listed companies are governed by the Companies Act and JSE listing requirements
You can invest small amounts per month
You should have at least R50,000 to make direct equity investment worthwhile
Diversification: Your risk of a loss is reduced as the fund manager buys a large number of shares across a wide spectrum of companies, industries and countries.
You are unlikely to hold shares in a large number of companies due to the limited size of your portfolio

From the comparison above, it seems that unit trusts have many advantages over direct equity investment. However, they have at least four distinct disadvantages for the investors this investment newsletter is targeting:

1. Higher costs: For someone with a decent investment portfolio, unit trusts incur higher costs than direct equity investment. General equity unit trusts have an upfront fee of 5% to 6% and annual management fee of 1.14% to 1.71% of the value of the investments. This compares with direct equity investment’s costs of between 0.8% to 1.6% when buying or selling shares, and ongoing administration fee of 0% to 0.5% per annum for a R100,000 portfolio.

2. Diversification: With unit trusts, the problem is not insufficient diversification, but rather often inadequate diversification or over-diversification. Inadequate diversification arises when a fund manager buys shares in a large number of companies, but most of these companies concentrate in a few industry sectors. Over-diversification means a fund manager has shares in too many companies. He is unlikely to keep track of all the companies in which he holds shares. This often results in average returns for investors.

3. Loss of investment control: With unit trusts, the fund managers manage money on your behalf. As long as they keep to the mandate given to them, they decide which stock and how much to invest. You have no say at all. It is a possible scenario that, despite you invest in five different general equity unit trusts, you do not have sufficient exposure to a company that, in the years to come, has the potential to give you truly remarkable returns.

4. Short-term focus: Unit trust investment performances are measured and analysed quarterly or monthly, and fund managers are judged according how well they have performed against their peers. They are under tremendous pressure to perform month after month, quarter after quarter. This tends to make them focus on the short-term returns rather than long-term returns. Also, they tend to constantly look over their shoulders to see what their peers are doing. They may try to imitate their peers’ investment portfolios so as to reduce the risk of massive under-performance. This kind of behaviour is unlikely to result in the best long-term returns, and is certainly not in the best interests of investors.

Another disadvantage of investing in unit trusts is that, one may argue, one is taken away the opportunity to learn about the stock market and investing in the stock market. However, admittedly, not everyone wants to learn about the stock market.

We are not trying to project unit trusts in a bad light. They do have many merits, and for many people, it’s the only affordable way to get exposure to the stock market. Through past experience and some research, we have also identified fund managers and asset management companies that have excellent track records and are likely to create greater wealth for their clients in the future. (If there is interest, we will devote some space to this in a future newsletter.) However, truly excellent fund managers are rare.

So, unit trusts or direct equity investment? It’s your choice. You can use one to complement the other. If you want to invest directly on the JSE, you can rest assured that we have done all the hard work for you, so that you can invest in the recommended company, knowing that the chance of a permanent loss of your capital is minimised.

Quotable quote

This is my favourite investment quotation, and this is what we strive to do:

Investing is most intelligent when it is most businesslike.
- Benjamin Graham, The Intelligent Investor

We really would like to hear from you any praises, constructive criticisms and suggestions you may have regarding this newsletter. For example, do you find this newsletter useful? Is there anything unclear that requires explanations? What else would you like to see in this newsletter? Help us to help make this YOUR investment newsletter. Please write to:

If you have any investment related queries, you are welcome to send them to the same email address.