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*Find out why low-cost housing will decimate your portfolio…

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From Gary Booysen on the top floor...

Dear Reader,

Last week, Nathan, one of our readers, sent an interesting question to Money Morning and, while most writers wouldn’t touch it with a ten foot barge pole while dressed in a bright yellow Hazmad suit, I thought I’d give it a poke. Little did I know at the time, what I revealed was absolutely shocking!

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SA has a chronic shortage of affordable housing. Two companies listed on the JSE which provide this are Sea Kay and RBA. Why are they so depressed? - Nathan

The question’s simple enough. We have a chronic shortage of affordable housing in South Africa and yet Sea Kay, the largest listed company dealing with RDP housing, is chronically depressed. In fact, most of the low cost construction companies are tanking.

So, what’s going on?

The simplest answer is that share prices don’t always reflect underlying value of a company. The old Wall Street adage says, “The stock market can remain irrational far longer than you can remain solvent”. But Occam’s razor isn’t going to cut it this time.

Such an easy answer is something you might expect as a cop out from a busy broker not a professional analyst.

If this really was a mispricing we could expect the value of this investment returning to hover around the actual underlying value. But a quick look at Sea Kay’ s chart makes me very hesitant to call this a mispricing.

Sea Kay has collapsed 95.90% since its peak on the 7th of November 2007…

The share price has been dropping steadily since the end of 2007 and with Sea Kay trading only slightly above 12c, there was more to this puzzle than meets the eye.

Why the steady decimation of shareholder value?

Source: Sharefriend

Once you get into the nuts and bolts of Sea Kay’s business, a very disturbing picture starts to emerge. In fact, Sea Kay looks rotten to the core!

On the 26th of February 2010, The National Housing Finance Corporation (NHFC) filed applications for the liquidation of Sea Kay Holdings and Sea Kay Engineering (a wholey owned subsidiary). Sea Kay has now taken legal advice and seems reasonably confident that it’ll be able to fend off these legal problems.

You see, the NHFC loaned Sea Kay R128 million to finance low cost housing. The group has so far paid back R56 million including interest leaving the loan amount outstanding at R108 million.

So why isn’t it meeting its targets and paying its debts?

The problem is simple, its client isn’t paying its bills.

And 80% of Sea Kay’s work comes from government.

It’s no surprise government isn’t paying its bills. Jobless numbers are up and tax revenues are down.

Sea Kay’s Executive Director, Pieter van der Schyf, points out that if the 16 contracts concluded with the various housing departments were to be paid, then the company would have more than enough to cover the liability.

Sea Kay’s former executive director, Gerry Holtzhausen, describes it as a Catch 22 situation: The group didn’t want to antagonise government as it would need it as a future source of work, but at the same time it can’t just work for free.

He also pointed out that "many smaller construction companies have closed doors because of non-payment by government."

The whole thing stinks to high heaven.

Government can’t just keep putting in orders and then not pay the tab. The short-term result will be expulsion from the “safe” emerging market club as international investors withdraw their foreign investment. But the longer-term result is far more grim. And I’m not talking about the multiplier ripping through the country reducing revenues further as the tax base all but disappears. I’m talking about the destruction of solid business institutions that have played a massive role in the strength of our economic navigation of during political change. It seems a waste to throw that away now! But there’s no point in playing the blame game…

What should be happening?

Economists have known the power of the free market system for a long time. We know that social intervention skews resource allocation and results in deadweight loss. So it’s time for government to stay out of business!

Government simply can’t build houses for the mass, unemployed, economically-inactive population on the backs of the taxpayers. No matter how hard SARS whips us, there’s only so much the economically active population can bear before it simply gives up.

Low cost housing is not an investment opportunity!

It’s easy to be tempted by the promise of government spending to drive a recovery of construction stock but it’s also highly unlikely! Splashing taxpayers’ money around to build more houses is never going to drive a construction boom.

Less intervention from government will result in more economic wealth being generated. Less tax will mean more entrepreneurial activity and less regulation surrounding labour will result in more jobs.

And more jobs will result in more education, more houses and more wealth for everyone.

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Take a lesson from India…

There’s been a sick sort of joke between economists surrounding the provision of telecommunications and medical services in India for a while. India has always been a heavily “licensed” society where the free market wasn’t allowed to operate property. The Indian government had succumbed to false belief that it could intervene in the economic system for the good of all.

It used to hand out licenses left, right and centre in a system that tasted strongly of Soviet style central planning. Of course, healthcare was seen as a vital service and, as such, was heavily regulated. Telecommunications, on the other hand, was seen as a luxury and left mostly to its own devices.

The result was that in five short years India had one of the most advanced telecommunication industries on the planet while sporting some of the most horrendous health care this side of the Ganges.

Sea Kay is no different…

Government’s heart is in the right place. It’s trying to desperately uplift entire swathes of the population but in the attempt is getting very little done.

Sea Kay is hoping to benefit from a renewed infrastructure and government housing project now that the World Cup is over and they’ve stopped channeling funds into stadiums. But a recovery looks unlikely, there simply isn’t enough tax-payer money sloshing around to help these companies shoot the lights out.

It’s also tempting to think that the group could possibly make a come back.  It’s sold off the entire share capital of brick manufacturer Sidibeng as well as steel truss and frame manufacturer, Silver Falcon, in an attempt to pay down its debts and get back on track.

But Silver Falcon’s gone for a measly R7.34 million and Sea Kay’s telling shareholders this should help to alleviate some of its cash flow problems, I can’t see it turning around a business with such a small capital injection.

The group’s also just released a trading statement saying earnings are going to fall by between 17c and 18c per share so the trouble continues.
 

Final verdict: Should we be buying construction?

Absolutely not, even if you’re hoping to grab a slice of government’s infrastructure spend!

The sector looks in shoddy shape and share prices reflect this. If you’re keen on the construction sector, however, I’d go for something with good offshore exposure like Murray & Roberts (MUR) and definitely not something that relies too heavily on SA’s politicians.

Until next time…

Happy investing!

Sincerely,

Gary Booysen

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