28: Dave Woollam
Shareholder activist, former CFO of BoE Bank and African Bank
‘Debt without assets is just putting you deeper into a poverty hole.’
5 August 2019
CIARAN RYAN: This is CFO talks and today we’re talking to Dave Woollam, he is the former CFO at BoE Bank, which then merged with Nedbank, and he was then appointed CFO at African Bank. He left African Bank in 2010, that was before it ran aground on the rocks of massive bad debt problems. In fact, it was this strategic direction taken by the bank that prompted Dave to leave African Bank in 2010. He has since become a very vocal shareholder activist and I’d like to get into some of the consumer credit aspects and shareholder activism activities that Dave has been doing in recent years. But first of all, welcome Dave.
DAVE WOOLLAM: Thank you, Ciaran.
CIARAN RYAN: You’ve written in the past that the role of the chief financial officer is partly to record history and partly to predict the future, in order to predict the future, one needs to record history accurately but, most importantly, one needs to record relevant information. Can you expand on that view and what exactly you mean by relevant information?
DAVE WOOLLAM: It’s a broad issue that I spend quite a lot of time thinking about. I think it comes back to, in a sense, the very standardised form of financial reporting, which is dictated by IFRS. Without getting into any deep critical analysis of IFRS, we can maybe dive into that a bit later, I think one of the problems that has evolved is that IFRS has become very complicated, a lot of new standards that require a lot of judgement and it’s also very standardised, it’s a one-size-fits-all solution, whether you are a bank, whether you are a retailer, whether you are a mining company. There are nuances but the financials are often prepared in a very standardised format and I think that can lead to either a very superficial view of the business or not necessarily a particularly relevant view of the business. We do see many listed companies attempt to flesh out the numbers and put more relevance into the numbers, for example, key performance ratios or indicators but I think one of the things that we have an issue with is a lot of these are designed to show the company in the best light or a better light than necessarily is the case and that’s why I think we’ve had some of these financial surprises in the last year or two because financial reporting has been geared towards presenting a very rosy picture or a picture that the company wants to present. So when I say that as accountants we are partly historians, we need to record the transactions of the business accurately and relevantly so that we can identify what the key levers of performance are, what are the correlations between different levers and if you pull lever A. what does it do to lever B. Think of it like flying an aeroplane, you’ve got multiple levers or multiple controls and each one of them can’t operate in isolation, they need to operate in harmony and an experienced pilot will be able to manage all those multi-levers in a very harmonious way, in a very smooth way. I think the CFO of the future is someone who can really understand those levers, understand the true essence of the business and understand what volatility in earnings can come from different levers that are being pulled or different levers that are having pressure exerted on them and then be able to react to those with compensating adjustments, and being able to predict the future in accurate ways so that the business is ready for what may come, whether it’s exogenous forces or whether it’s changes in the environment or just cyclical changes. That ability to react, fly through the storm and not lose control of the controls or the levers is, I think, one of the most critical aspects of affective financial management.
The explosion of unsecured lending
CIARAN RYAN: I want to come back to that in a minute but I’d just like to jump quickly to the consumer credit market and this is an area that you have quite a lot of expertise in, and it is becoming a bit of a problem in South Africa with the rise of unsecured lending. Bad loans were a big problem at African Bank, there have been questions posed by Viceroy about Capitec’s exposure to the unsecure lending market. I was looking at the figures yesterday from the National Credit Regulator and the unsecured loan book in South Africa now stands at R200 billion and that was growing at I think it was 16% last year. Is this a problem and why has this unsecured lending thing become such an issue in recent times and is this something that is likely to explode in the future?
DAVE WOOLLAM: Ciaran, it certainly has exploded in the last decade, since the introduction of the National Credit Act in 2006 the rules of the game changed dramatically, prior to 2006 there was a very segmented credit market, a bifurcated credit market, where the more traditional affluent market with access to assets such as houses and cars and other security, were able to get credit very easily from the banking system and the vast majority of people, ordinary people in South Africa whose only asset is their income, the ability to earn a salary or earn income, were largely either isolated or had access to very small parcels of credit because it was regulated by the Usury Act. I think there were very real concerns about that being almost a racial definition because of the historic legacy of apartheid in our country. So the vast majority of people in our country, ordinary South Africans, mostly black South Africans, really didn’t get access to credit and credit is an important enabler, it allows people to do things they ordinarily couldn’t do if they’re just living month-to-month on a salary. We’ve seen throughout history and throughout the world that responsible access to credit is a very powerful contributor to economic transformation allowing people to jump across the poverty gap up into a better life. But, like all good things, too much of a good thing can be very bad or very dangerous. With the introduction of the NCA, the amount of credit that could be granted to people, albeit regulated by some rules around reckless lending and other things, in my opinion it just got way, way too big. People were able to access hundreds of thousands of rands of unsecured loans, payable over seven, eight years in some cases and in many cases those loans were not productive loans, they weren’t being used to acquire assets, they were just consumptive loans. When one uses a loan to build your house, it’s a very powerful thing, you can give your children more security, you can provide a safe place for your children to learn and grow. But when you use it on consumption, you are really just bringing forward the consumption of your future salary and that can be very dangerous. I just think in South Africa there was not a sufficient debate or constraint by the lenders to understand what that would do. I think we saw during the period from 2009 to 2014 an explosion in credit with a very strong sales push, a very financially illiterate or ignorant market who didn’t really understand the consequences of what they were entering into, other than the immediate gratification of what that loan could do. Whilst it’s not all bad and I don’t want to paint any lender as all bad, I think that the average South African in any context of measurement around the world, the average working class South African, just has too much debt and not enough assets to show for it and that I think is the critical part of the debate that is lost is that debt without assets is just putting you deeper into a poverty hole, a poverty trap.
CIARAN RYAN: Is this going to result in trouble for the banks that are particularly engaged in unsecured lending in some point in the future?
DAVE WOOLLAM: I think the big banks and I would include Capitec now as a big bank, I think they have earned their rightful place amongst the big five or big six if you include Investec but they don’t really play in this market at all. I think by and large the large banks, the large retail banks that offer not only loans but also transactional accounts and other access to financial products have played a lot more responsibly than we have seen from some of the more specialist lenders or some of the retail lenders because they have more sophisticated credit systems. I think they also realised the negative reputational risk of getting caught up in a failure like African Bank was, is just not worth it. So I think there has been a lot more constraint amongst the big banks. There has been a slight structural reason why the big banks’ unsecured lending has grown so much in that the way capital rules work and the way regulation works, a lot of banks that used to give people access to higher secured loans like 100% mortgage or even a more than 100% mortgage are now only offering less secure credit and then offering a top up or unsecured loan as a separate contract. So we’re seeing almost a switching in the big banks. Whereas the more specialist lenders are still really just doing straight unsecured loans, can you afford the loan, yes, we think you can, here’s the money and don’t forget to pay us back.
Debt gearing a significant contributor to failed companies
CIARAN RYAN: Can we just jump back to the role of the chief financial officer, in one of your articles you talk about the unique performance drivers in each business and you did touch on this in the very beginning that IFRS is like one-size-fits-all. Now, if you’re merely recording the financial transactions in the standard IFRS format, it’s unlikely to allow these key performance levers to emerge and be fully understood. In this article that you wrote you mentioned the lending division of a bank, there are four primary levers at play. One of them, the first one you mentioned is capital versus debt funding, what are some of the issues CFOs should be paying attention to when they’re taking on additional debt?
DAVE WOOLLAM: I think it’s a very relevant point that you raise because I think we have seen, in the last year or two, debt gearing being a significant contributor to the failure of some of the companies that have hit troubled times. Whether it was Steinhoff, which was obviously a spectacular explosion with other consequences, but even other companies like Tongaat, Omnia more recently, Aspen, there have been no questions around impropriety, there’s just too much debt, they bought too many assets with debt. So debt is a very relevant topic right now and gearing. If one looks at it in its simplest form, for any business it needs a mix of funding or capital and capital can come in two forms, it can come in equity, which is expensive but very stable, has no repayment terms, has no drawback, or debt, which is a lot cheaper but has significant covenants and repayment terms. Ideally one wants to achieve an optimal weighted average cost of capital. So if you think about it, one of the analogies I use is if you are making concrete, the cement is like the equity, it’s the ingredient that makes concrete hard. Sand is like the debt funding, it adds bulk, if you have too much sand your concrete mix is going to be vulnerable to cracking or not holding. If you have too much cement it’s just going to be very expensive, you’re going to have a very expensive foundation or a very expensive piece of concrete. So one has to try and find that balance, engineers are very good at understanding what that balance should be between strength and cost, and accountants need to think like engineers when funding any business, whether it’s a bank, which is highly specialised capital management or even a small business, the critical raw material to any business is capital and the objective of any business is to earn a return on that invested capital. That’s the most fundamental basic thing that a company needs to do. If you don’t get the right mix of capital, the chances are that you are either going to be uncompetitive because you have, for example, too much equity and you’re ungeared or you have too much debt and you’re vulnerable to a shock or a volatility event, which could blow you out of the water. So every company should have a treasury-type function, it doesn’t have to be a full-time role but management, the CFO, should be thinking about what’s the optimal funding structure for this business. What happens sometimes is that we see companies leveraging up, using more debt because it makes the shareholder returns look good. That can often, especially in good times, there’s a quote by Warren Buffett that says the rising tide floats all boats, and there’s another quote of his that says it’s only when the tide goes out that you see who has been swimming naked. In good times you see companies gearing up, taking on a lot of debt, buying assets or making investments with debt and when a bad turn in the economic cycle comes they’re just not prepared and they end up with significant risk of insolvency or a liquidity event like we’ve seen at Tongaat recently. If one looks back at 2008 that was the hard essence of it and we’re seeing it now, it’s a little bit off the topic but in America the percentage of listed companies that have geared up their balance sheets to buy back shares in the market is at an all-time historic high and the amount of listed companies in America with triple-B rated bonds, one notch above investment grade, represents 50% of the total bond market. That’s just an avalanche waiting to be triggered, it just is not sustainable. The moment the US goes into recession, those bonds are going to start to default and they’re going to trigger an avalanche, in my opinion. So we get these really strange excesses on each end of the cycle and that’s why I say one needs to look at history, one needs to backtest that history from a risk management point of view and then find the balance, and don’t push yourself too hard either way because it looks attractive for short-term returns because realise that a terminal event could be just around the corner.
The contribution of finance to the SA economy
CIARAN RYAN: Just on that subject, I recently wrote an article for Moneyweb about the contribution of finance to the South African economy and whether, in fact, this is an overstated contribution because it is the biggest contributor at 23% of GDP. But a lot of that finance, the measurement of finance in the South African economy, is based on the recycling of already existing assets. So it’s the buying of shares, it’s pension funds investing in already listed stocks, it is the banking sector financing assets that are already created, so there’s not a lot of money going into the development of new factories. That’s essentially what the article was saying. Just to continue on what you were saying, one of the ways, of course, that you can measure whether your capital is efficiently structured, is economic value added because a lot of the CFOs would consider equity to be free capital. As you say, there’s no repayment terms attached to that, there’s no particular obligations attached to equity but if you use an economic value added model all of a sudden you are having to look at it as if there’s a cost to it. What is the attraction of using that as a method of measuring capital efficiency?
DAVE WOOLLAM: I think from a shareholder perspective it’s very attractive but for some companies it’s very unattractive because they simply don’t make a return that exceeds their cost of equity. To explain what that means, any investment requires a certain return based on its risk. So a risk-free bond in South Africa might yield 7% and, therefore, any investment that has higher than risk-free, in the case of government bonds, needs a premium attached to it. So you might get a corporate debt at 9% and big blue chips with a weighted average cost of equity of 11%, 12%. But ultimately one can calculate using the capital asset pricing model and it’s obviously subjective, what the cost of equity, which is the required return from shareholders for their investment into a particular company, should be. Then one measures the return on equity, which is the profit made by the company divided by the average shareholder equity. There are a couple of noises in there as to whether there’s goodwill in or out and I prefer to use return on net tangible equity but the essence of it is does the company generate a return above its cost of equity. If it doesn’t, it’s destroying value, shareholders should ultimately close the business down and invest in another business that’s going to generate the appropriate return. But we see these companies that for years and years and years generate sub or single digit return on equities and there’s no cost of equity calculation that ever gets to a single digit in South Africa. Companies tend to focus more on things like margin, profit growth but you can grow your profits and reduce your return on equity quite easily and in that instance you are actually going backwards, in my opinion. So I think EVA is something that hasn’t really been used because it often exposes the poor companies but I am a really big believer in it and I think measuring return on invested capital, return on equity or economic value add, whichever version of that is the absolute starting point before I look at any real deep investment analysis in a company.
CIARAN RYAN: Going back to one of the articles that you’ve written here, you highlight a few other issues and I think you were talking specifically about the banking sector here, issues that are relevant to business sustainability such as bad debt rate, cost efficiency and pricing. Now, what’s interesting is you were saying pricing is rather like underwriting when you’re talking about the banking sector. Can you just expand on one or two of those concepts, why pricing is so critical and keeping an eye on the bad debt rate?
DAVE WOOLLAM: I think banks are a fairly unique financial model because, one, they use gearing much more extensively than traditional businesses. Banks are mostly about gearing, they hold a piece of equity, let’s use a 1:9 ratio, a 10% equity mix and a 90% debt mix because that debt is in the form of customer deposits but [Unclear 19:50] term loans from customers and they then recycle that money into loans to customers in the form of mortgages or unsecured loans for car loans. The objective, of course, is to generate a sufficient return from those assets to pay your depositors and hopefully pay your shareholders an appropriate dividend. When one is lending, you’ve got this very delicate, like flying the aeroplane process, where you are trying to balance the amount of risk you take with the cost efficiency of the business and they work in opposite directions. So if you grow your loan book very fast, you get very good cost efficiency because every rand of operating costs is now spread over a larger pool of loans. So it’s very attractive for some lending businesses to grow their way into cost efficiency but the consequence of that could be that 18 months down the line you start to get bigger bad debts. If your cost/asset ratio goes from 8% to 6% but your bad debt rate goes from 10% to 15%, clearly you are going backwards because for every unit of cost efficiency you’ve gained, you’ve given back two units or two-and-a-half units of bad debt. So there’s this very delicate balance in banking and inevitably all banks go through cyclical, what they call through the cycle changes, you go from a very buoyant economic environment, where it’s easy to grow your book and bad debts are low, to getting to an environment where there are economic headwinds like we’re seeing now and your bad debts are rising and you need to shrink your book but now your costs become a big factor. So there are these very delicate elements, plus the ratio of equity and debt is also driven by risk because of the banking rules and also just because of simple economics, you might gear up a mortgage book quite highly because the residual risk is really low but you would use much more equity in an unsecured lending book, maybe 30% would be appropriate, and only two parts debt, one part equity. To measure all this, when I was in the banking world we developed…the DuPont-type model to go from price, which is the price you charge for the loans, has to pay for your bad debts, which is like the insurance part of claims versus premiums, it has to pay for your costs and it has to pay for your funders and ultimately generate a return for your shareholders. There are very delicate interplays between those, and the really good banks are the ones that can tweak those levers ever so gently without rocking the boat but can keep everything in harmony. I think in South Africa the big four banks, to be honest, I think everyone in South Africa gets a bad rap at the moment, the environment is very, very difficult and I think the banks have done an extraordinary job in light of the environment that they are operating in by keeping profits fairly stable.
CIARAN RYAN: We’re running out of time here, Dave, but I just want to touch very quickly on this point, and it’s forecasting from a chief financial officer’s point of view. Of course this is the job of the chief financial officer, he’s not only a historian, he’s also looking into the future, we’re talking here about proper forecasting and there are different ways of forecasting, what can you say about that and how companies are getting it wrong some of the time?
DAVE WOOLLAM: I think one of the ways that it does fail or go wrong is that the budgeting process is done almost in isolation of strategy or the strategic evolution of a business. I don’t think that’s overwhelmingly the case but there are degrees of separation that the board debates strategy, comes up with a new idea on marketing or product development and then finance produces the budget, and whether there’s a good and rigorous backtesting of the two and a circular process that one informs the other. Strategy should inform the numbers; numbers should validate the strategy. If it doesn’t, then you’ve got to go back and tweak the strategy until you get something that works and is realistic. A lot of companies have wonderful strategies that you can put up on the wall in the form of posters and stuff but whether they work in the real world financially is often not adequately tested. Then I think one needs to take a longer-term view, one year is just not enough, you need to take a three to five-year view and that isn’t budgeting, I don’t really like three to five-year budgets but I think one needs to forecast the key levers or those key performance indicators and then test them for different scenarios, test them for a known economic recession scenario or test them for a change in regulation scenario. By taking a longer-term view you can really get a good feel for whether your business is resilient, again, as Warren Buffett talks about, has a moat because when times get tough you want to know how good your moat is that’s going to protect you through those tough times and get you out the other side strong and resilient.
CIARAN RYAN: Final question, if you had a good book to recommend, whether it’s business or fiction, what would it be?
DAVE WOOLLAM: One of the best books I have ever read is the biography about Warren Buffett, you’ve probably already gathered that I am a bit of a fan of Warren Buffett. But The Snowball: Warren Buffett and the Business of Life by Alice Schroeder is an old book, it’s been around a long time, I think that was an extraordinary book because it just gave really good insight. I’m not a big reader of business strategy books, to be honest, I know there’s a place for them, but I prefer to read autobiographies or biographies straight from the horse’s mouth of people who have won or have shown a winning tendency. There are some other books that I have read more recently and one book that I would really recommend is a book called Conscious Capitalism by John Mackey and Rajendra Sisodia. I actually think this is probably, for me, one of the greatest challenges that the business world is going to face in the next decade, is how do we embrace the power of capitalism with the innovation, the incredible economic opportunities that come from capitalism but without the hard and sharp edges that capitalism has shown itself to be, which is to sometimes leave other people behind, increase inequality, possibly exploit situations for their own benefit without a net benefit to the economy or society. I think that’s going to be an area of great interest and something I read a lot about.
CIARAN RYAN: Great suggestions, thanks very much for that Dave, we’re going to have to leave it there. Really appreciate you talking to us, I found that fascinating and let’s get you back on in future when there’s something more to talk about, particularly with all the stuff that’s happening in the corporate market in South Africa, there is a lot happening and there is a lot to talk about.
DAVE WOOLLAM: Thank you, Ciaran, it’s been a pleasure.
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