By Pieter Koornhof
Capitec has been an incredible South African success story in improving access to affordable banking services, and in delivering value for its investors.
If you had invested R1 000 in the all share index (ALSI) on the day Capitec listed and reinvested all your dividends since, your investment would be worth R11 457 today – a very respectable return that exceeded inflation by more than R8 000.
A similar investment of R1 000 in Naspers would have grown to an impressive R287 378. However, as shown in Table 1, R1 000 investment in Capitec would be worth a staggering R2.3 million today.
Lessons from Capitec’s success
There are important lessons to be learnt from analysing the key drivers of Capitec’s growth.
Find a gap in the market
Capitec’s founders intentionally targeted the banking industry due to its high barriers to entry and large market size. Banking has onerous regulatory, technological and capital requirements, which reduce the likelihood of new competitors entering the market and competing away profitability. The banking profit pool in South Africa is also very large at more than R90 billion a year, and millions of individuals and businesses use banking services every day. This afforded Capitec ample runway for growth.
Follow a client-centric approach
At the heart of the business was (and still is) its strong client-centric and innovative culture. This includes high-quality client service and fees that are simple, transparent and affordable. It has also been innovative in finding ways to better serve clients, including keeping branches open on weekends, running a 24-hour call centre, and paying interest at high rates on savings accounts.
Maintain focus and discipline
Despite the growing range of products, Capitec’s management team has been disciplined and discerning in pursuing new areas of growth. They eschewed big acquisitions and following fads, like growing into Africa, which often proved to be the undoing of other South African companies. Instead, they stuck to their circle of competence, namely retail financial services, and kept their product range small. This reduces operational complexity and costs, while simplifying the client experience.
Adopt an agile structure that reduces complexity and allows for iterative improvement
Capitec’s management team deliberately focused on retail lending and banking as these entail millions of similar transactions. Because of this characteristic, Capitec could automate and optimise its processes and systems for handling such transactions and, as their volumes grew, it became extremely cost-efficient at processing them.
In addition, Capitec’s management refrained from going into secured lending and investment banking. Even though these are highly profitable segments for the other banks, they are not a good fit for Capitec’s business model.
This business model built on large volumes of small and relatively short-duration transactions allowed it to follow an iterative approach to incrementally improve its products and processes, and made it nimble. It could quickly change course by adjusting its credit pricing and risk appetite based on feedback. Contrast this with building a new mine, where you have to make the decision to invest billions of rands upfront, and it takes a decade before it becomes clear whether the call was right or not.
Think outside the box
Capitec adopted a revolutionary strategy by opening branches with no back offices, and instead performed these functions centrally. This allowed it to have smaller branches and thereby save on rental costs, while also avoiding the usual duplication of costs from employing (highly paid) back-office staff at each branch.
Capitec’s management teams have over the years proven adept at managing IT in a cost-effective yet progressive manner as clients migrated from branches to mobile, online and app-based banking. Key to this was Capitec’s prioritisation of keeping the client experience very simple and intuitive. Management recognised early on that IT was not just a necessary cost of doing business, but could be a potent competitive advantage.
Luck plays a role
The business was founded when South Africa’s economy was growing strongly and social grants were expanding. These provided tailwinds for the high initial growth and returns that laid the foundation for Capitec’s later success. It would be more difficult to get off to such a good start in today’s anaemic economy.
When should you pay up for growth?
Capitec’s story, and similar ones from other fast-growing companies, can make investing in such businesses seem like a sound investment strategy, but achieving high returns is easier said than done.
Part of the difficulty is that when a company has a couple of years of rapid growth, the market often values the share as if such growth will continue for decades. While companies can sometimes achieve this feat – Capitec is an important example of one that did so – it does not typically turn out that way.
History is littered with fast-growing companies that overreached in pursuit of growth and subsequently blew up, or delivered poor shareholder returns when they failed to live up to the market’s lofty expectations of them.
When, if ever, is it prudent to pay a high multiple for a fast-growing company? At Allan Gray, we are not “value” or “growth” investors. Instead, we follow a valuation-based investment approach, which means that we invest in companies that trade at a discount to our assessment of their intrinsic value, regardless of whether they are categorised as “value” or “growth”.
When analysing a fast-growing company that trades on a high multiple, we consider the following:
⦁ Buying a fast-growing company on a high multiple means that the company must continue to grow its earnings at a high rate for it to be a good investment over the long term.
⦁ The higher the multiple one pays, the smaller the margin of safety for avoiding permanent loss of capital if the company’s performance falls short of expectations. In a similar vein, the higher the multiple one pays, the faster and longer the company has to grow at a high rate in order to justify its starting valuation.
⦁ Paying a high multiple does not necessarily mean a company is expensive, just as paying a low multiple does not necessarily mean a company is cheap. The key consideration is how the intrinsic value of the company (which incorporates its fundamental quality and growth prospects) compares to its share price. As Benjamin Graham taught: “Price is what you pay; value is what you get.”
⦁ As one looks further into the future, the uncertainty increases exponentially as the range of possible outcomes broadens. A myriad of events can affect the company: Macroeconomic conditions may deteriorate, regulations could change to its detriment, an excellent CEO could leave, its strategy may be replicated by competitors and lose its potency, technological disruption could render it less competitive or obsolete, it can run out of growth opportunities as its market share increases, etc. While competent management teams may adapt to such changes in circumstances, it remains hard to predict beforehand how this will play out.
All these considerations make it difficult to determine whether a company can sustain a very high growth rate for a long period of time. In light of this, it is only on rare occasions that we would assess it prudent to pay a high multiple for a fast-growing company. As such, we currently have limited positions in a small number of high-growth companies, including Capitec, Transaction Capital and PSG Konsult.
Pieter Koornhof is an investment analyst at Allan Gray.
BUSINESS REPORT