‘Call it what you will, incentives are what get people to work harder.’ - Nikita Kruschev
Discovery is a stock which has featured as a holding in the Nedgroup Investments Managed Fund for much of the past six years, and for most of this time it was one of the top holdings in the fund. The stock has delivered very good absolute and relative returns over this time period, beating the market by a wide margin.
Chart 1 below shows Discovery’s total return relative to that of the FTSE/JSE All Share index for the time that it was held in the fund.
So what prompted our decision to invest in Discovery when we did, and to sell out of the stock when we did? Explaining our thought processes in the case of Discovery will hopefully shed some useful light on how we allocate capital at RECM.
Discovery has managed to build meaningful and sustainable competitive advantages
Discovery consists mainly of two businesses: a medical scheme administration business (Discovery Health) and a life insurance business (Discovery Life). The Group has developed a number of new businesses over the years, with varying degrees of success. All of the Group’s businesses operate on the same core concept – giving people incentives to live and behave more responsibly by rewarding such behaviour with tangible benefits. At RECM, we are firm believers in the power of incentives to drive human behaviour, and Discovery’s recognition of this has always resonated strongly with us.
By harnessing the power of appropriate incentives, Discovery managed to build two very strong competitive advantages for itself in an industry which is highly competitive and commoditised. On the one hand, the scale Discovery built in the medical scheme administration business has given it such bargaining power in the South African healthcare industry that it is able to negotiate better tariffs from all players in the industry for members of its medical scheme. This allows Discovery to charge competitive premiums whilst maintaining suitable solvency levels and earning good returns for Discovery shareholders.
On the other hand, the Vitality programme has become the leading rewards program in South Africa. Having established this position, Vitality now benefits from meaningful network effects: the more members Vitality has, the more attractive it becomes as a partner for service providers. And Vitality becomes more attractive for members the more service providers the scheme has agreements with. This creates the classic network effect where the entire system works better for all participants the more participants it has.
Discovery has translated these competitive advantages into superior financial performance
These two formidable competitive advantages have allowed Discovery to earn financial returns well ahead of its peers. Chart 2 shows the average return on embedded value* Discovery has earned since 2002 compared to its primary local competitors.
Because Discovery’s business mix has historically been different to that of its peers, with less direct exposure to the fluctuations of financial markets, its reported return on embedded value has historically also been much more stable than that of its competitors.
Discovery’s share presented an attractive buying opportunity because of the market’s misplaced focus
When we first started to allocate capital to Discovery in October 2007, the share had fallen out of favour with investors due to the failure of the company’s early forays into the US market. This distracted the market from the very attractive fundamentals of the core South African businesses.
At about the same time, Firstrand unbundled its substantial shareholding in Discovery. This type of event often creates undue pressure on the share price of the unbundled business, because investors who owned the parent company’s shares typically did not own the shares for the interest in the unbundled business. The unbundled shares usually form a fairly small part of the shareholders of the parent company’s portfolio, and may even be of a company in an entirely different industry than the parent company. Hence there is often a great deal of selling of such shares taking place without much thought being given to the underlying value of the shares being sold. This can create very attractive buying opportunities for investors. In this case, Discovery’s management also recognised the opportunity, and used almost R400m of their own money to buy shares in the unbundling process. We viewed this as a positive confirmation of the attractiveness of the shares.
The Discovery share price declined meaningfully after our initial purchases, which we used as an opportunity to increase our clients’ exposure to the business. And during our clients’ ownership cycle, there were also times when the share price suffered some notable setbacks, for instance upon the announcement of government’s intention to roll out National Health Insurance. Our assessment in most of these cases was that the market’s perception of the potential impact on Discovery was overblown, and that the business would continue to go from strength to strength. This has indeed turned out to be the case.
At current prices, Discovery’s shares no longer offer attractive value
So given the strength of the underlying business, why does the Nedgroup Managed Fund no longer own any Discovery shares? The simple answer is that the market’s view of the business appears to have swung from sceptical and concerned in earlier years, to overly optimistic and positive about the long term prospects of the company. This has driven the share price to levels beyond our estimate of the fair value of the business, and hence our decision to sell out of Discovery. Looking at how the market has priced Discovery relative to its per share embedded value over time makes the case quite clearly, as Chart 3 below shows.
In conclusion, Discovery is a wonderful business that has been an equally good investment for the Nedgroup Managed Fund. But in recent months, the share price has reached levels that no longer justified the stock being held in the fund. We have every reason to believe that the stocks that are currently top holdings in the fund will deliver equally good outcomes for the fund in years to come.
* Embedded value is the present value of all the cash flows that an insurance company is expected to generate from its current book of business. Return on embedded value is the growth in embedded value for the year, taking into account any dividends paid, expressed as a percentage of the company’s embedded value at the beginning of the year. It is the most important measure of an insurance company’s profitability over time in our opinion.
Wilhelm Hertzog is the Investment Manager of the Nedgroup Investments Managed Fund