Paper profits not an infallible guide

As such, the equities market is expected to be busy as investors make decisions based on these financials. In efficient markets, share prices rally on good results with the opposite happening on depressed financials.

By contrast, performance of the bourse in March was subdued, with the mainstream index retreating 6,35%. Minings were also on the downside, plummeting 10,88%. Year to date, both indices are in the red by 6,19% and 15,58%, respectively.  The bad run is to a large extent attributable to the ongoing implementation of Indigenisation and Economic empowerment laws together with uncertainty on the political front with regards to when elections will be held. This has driven away potential investors — notably foreign ones.

The poor numbers coming onto the market have further depressed sentiment. There were a few notably impressive performances reported to date.

These included Innscor and its subsidiary National Foods and those from BAT. But the majority of the numbers filtering into the market are confirming fears that the growth the economy experienced since dollarisation might be slowing down. Profits reported were either stagnant when matched with 2010 levels or showed a decline.

 

The slowdown may be an indication of reduced product demand which could be a function of increased competition from foreign companies or a result of tightening liquidity.

 

This is not uncommon as history shows that countries coming out of hyperinflation and adopting a stable currency usually experience a strong rebound followed by a long period of flattened growth or even a sharp reversal. We could well be entering this phase of flat growth or steep decline.

This might be the case since the quality of earnings being reported by companies is actually deteriorating. The majority of the companies that reported owed the bulk of their profits to noncore operations. Zimre Property Investments (ZPI) and Pearl Properties, for instance, published their results for the period ended 31 December 2011.

 

The latter had earnings attributable to shareholders of US$18,6 million buttressed by fair value gains on investment properties of US$19,7 million. Likewise, ZPI profits for the year jumped 66% to US$7,5 million beefed up by fair value adjustments on investment properties of US$7,7 million. We are however, of the opinion that these fair value gains are not justified as property prices are depressed.

 

The tight liquidity in the environment has seen property prices falling. Hence it is hard to believe that the portfolio values for the two companies could grow by 26,3% and 21% over the year as claimed by Pearl and ZPI! If we exclude these fair value gains, earnings for Pearl grew by a slight 1,5%, to US$4,5 million, whilst ZPI recorded a decline of 11,35% to US$1,5 million. One reality that property companies are coming to realise, which management at Pearl has admitted, is that it is no longer possible to grow profits simply through hiking rentals.

 

Tenants are liquidity strapped and this has at times forced both owners and tenants to rationalise their space usage. The only long term viable solution is to increase lettable area or refurbish existing properties so as to attract better class tenants. ZPI once mentioned that development projects would be the way to go going forward since increasing rentals might prove difficult. However, the companies will have to source cheap long term funding for these purposes as average yields on property companies are lower than the cost of funding.

Recording super profits backed by fair value gains was not peculiar to these two companies alone. TA Holdings had a profit after tax of US$6,3 million of which US$5,6 million came from investment income. Fair value gain on investment property of US$4,2 million was the main component of their investment income.

 

The parent company for Fidelity, Zimre Holdings Limited, also posted a profit before tax of US$9,2 million anchored by fair value gains of US$7,9 million.  What companies will have to accept is the fact that profits not supported by positive cashflows are just paper profits which cannot be ploughed back into the business nor can they be paid out as dividends. Yes, they are supported by accounting principles but the honest reality is that these are not real profits!!

The past fortnight also saw banks publishing their results for the period ended 31 December 2011. At face value the results definitely show an improved position from 2010 levels. Market players nonetheless are of a different view. CBZH, for instance, had attributable earnings of US$30,2 million which translated to an EPS of US 4,83 cents.

 

The share price, when the results were published, stood at US5 cents giving a PE ratio of 1,04x. At these levels the counter appeared cheap and one would have anticipated a rally on the share price but this was not the case. FBCH likewise has not responded favourably to what seemed like a decent set of results.

 

The company had attributable earnings of US$9,7 million and EPS of US 2,11 cents. A PE ratio of 3,17x also seemed undemanding! What therefore could be the factors suppressing the share prices? One obvious reason is that market players do not believe that the results being published by the banks show their true profit positions.

 

It is quite widely assumed that banks are sitting on a huge pile of toxic loans that they are not adequately providing for. Whether this is true or is just a misconception – no one really knows for certain. It is up to the banks themselves to go the extra mile and convince investors of their numbers. In this regard more disclosure is required.

The paltry dividends that are being paid also suggests that the earnings’ quality have been compromised. This is because companies will not have the necessary cashflows to pay the dividend or their actual cash profits do not allow them to pay higher dividends. CBZH for instance had a higher dividend cover of 17x, while that of Zimre Holdings Limited stood at 23x.

If the results that have been published so far are an indication of things to come, then 2012 is going to be a painful year for equity investments and for prospects of the economy as a whole. Nonetheless, as George Soros once said, fortune favours the brave if you get it right. The outlook for the current year might seem gloomy but we believe that there are pockets of opportunities on the local bourse which if picked correctly might make someone rich.

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