Averaging down is not wise investment

Last Wednesday, local trading floors were abuzz with an excitement not seen since global markets took a dive in September 2008, following news that influential US investment banker Lehman Brothers had collapsed. Dealers chatted animatedly with each other and engaged eagerly with clients on the telephone.

Dealers chatted animatedly with each other and engaged eagerly with clients on the telephone.

In the minutes before trading commenced, African Bank released a statement reporting that losses for the financial year could exceed R7-billion, and that the unsecured lender would require at least R8.5bn in additional capital to stay afloat.

The low-end lender's troubles started in April 2013, when management surprised the market by warning that earnings would be 40% lower than the previous accounting period, wrong-footing analysts who were forecasting a 15% increase in profits. The bank's executives divulged that furniture subsidiary Ellerines was haemorrhaging cash, and tough conditions in the economy had forced a dramatic increase in the bank's provisions for bad debts. The announcement shocked the investment community, sending the share price into a freefall.

Before Wednesday's disclosure, the bank was already trading at about a quarter of its worth last year. A R5.5bn capital-raising exercise in December, underwritten by international investment house Goldman Sachs, drew support from a number of major institutions that remained optimistic the beleaguered lender would survive its difficulties and, in time, recover its former glory.

I'd held the shares for clients in the past, attracted by the bank's steady history of growing earnings and paying high dividends, but when management alarmed the market last year with a profit miss that was so far removed from analysts' expectations, it seemed a clear signal of looming danger. Realising heavy losses, I chose to abandon ship before it sank.

A number of issues bothered me. Foremost was the poor health of the South African economy. With mining and manufacturing - the bedrock of the nation's wealth - wavering under the burden of unreasonably high labour demands, energy shortages and increasing input costs, complicated by the rand's steep decline, it appeared obvious that the majority of the bank's customers would face mounting pressure to meet their obligations in the months ahead.

Strife at the Marikana mine last year followed by lengthy strike action by platinum and metal workers added to these stresses.

Yet, in defiance of logic and probability, and discernible evidence of growing investor strain, many of the best brains in our local investment community continued to back African Bank's turnaround, trusting their faith would eventually bear rewards. Coronation, the country's top-rated asset manager, accumulated a 22% stake in the lender, buttressed by the PIC, the nation's largest investment institution, which built a 12% share. They were not alone in their conviction.

There's an important rule these big investors ignored; they made the mistake of telling the market it was wrong. Despite management's advice to the contrary, the progressive decline in the share price provided ample evidence that the bank's business was facing increasing difficulties. Still, the institutions stuck to their decision to chase shares, disregarding clues they were on the wrong track. In defence they claim their exposure to African Bank was not material in relation to total funds under management, and client losses will be marginal. But if that was the case, what did they hope to gain for their customers?

Wednesday's blow was the death knell. The share price halved within seconds of the market's opening, plunging from around R7 to R3.50. Astoundingly, the mood on trading floors in the country was one of thrill and exhilaration. Normally cautious investors and traders, caught in the melodrama, took leave of their senses and, imagining the sell-off was overdone, piled into the stock in the hope of making a quick killing from a bounce that usually follows an excessive dive in a share price.

Their agony was short but brutal. George Soros always counsels that it is not whether you are right or wrong, but rather how much you make when you are right, and how much you lose when you are wrong.

Frustrated by the African Bank episode, I only had the strength to offer one last piece of advice : Averaging down has inflicted more suffering on investors than Genghis Khan did on Asia.