Corospondent - April 2020
Global Emerging Markets - April 2020
THE CORONATION GLOBAL Emerging Markets Strategy returned -23.1% during the first quarter of 2020 (Q1-20), slightly ahead of the -23.6% return of the benchmark MSCI Emerging Markets Total Return Index. The one-year return of the Strategy is -12.8%, which is 4.9% ahead of the benchmark. Over more meaningful longer-term periods, the Strategy has also outperformed by 2.5% p.a. over three years, 1.3% p.a. over five years, 3.0% p.a. over 10 years, and by 4.1% p.a. since inception almost 12 years ago.
We are pleased with the longer-term outperformance generated by the Strategy, especially if one considers that the return of the asset class over 10 years (less than 1% p.a. total return) will have been very disappointing for the average investor in emerging markets. The importance of gene-rating alpha is therefore even more pronounced, as only with significant alpha over the last 10 years will one have generated a positive real return after fees.
The world has changed very quickly since our last commentary in early January. In the intervening three months, a previously unheard-of virus that originated in China has shut down the second-largest economy in the world and spread at a furious rate throughout the globe, prompting sweeping shutdowns. The world seems to be on track for the biggest quarterly decline in GDP since the Great Depression and many countries will face tough months, if not years, ahead.
Our colleagues on the South African team have written extensively about our views regarding Covid-19 and how it will impact the world, so for the purposes of this commentary we will limit discussion to its impact on key emerging markets and the steps that some of them have taken, before moving on to the Strategy and its positioning.
Emerging markets are at different stages of preparedness for the impact of the virus. At the one end of the spectrum we have China, which brought its economy to a virtual standstill by keeping the country on enforced lockdown from the time of Chinese New Year in January until the end of the quarter. Having taken this pain upfront, something that is unlikely to be replicable in countries with more collaborative forms of government, China looks to be rebounding fairly quickly.
Other Asian countries, such as Korea and Taiwan, having learnt from episodes historically (SARS/ MERS/Swine flu) have also managed to limit the spread of the virus by taking early, concrete action, and so far look like they may come through this less affected than China.
India and South Africa instituted lockdowns of roughly three weeks each (both of which have subsequently been extended) in the hope of limiting the initial spread among their populations and taking the economic pain upfront. It is hard to know how effective these lockdowns will be, given the dense living conditions of a large proportion of each country’s population (particularly India), but these steps were probably necessary to slow the spread of the virus in order to prepare their healthcare systems for a potential deluge of cases.
At the other end of the spectrum (within emerging markets) are Brazil and Mexico, which have started taking measures very late (at a national level) and are likely to experience more negative outcomes on their healthcare systems as a result. Russia and Turkey would probably fall into this category too, although, in the case of Russia, the ability of the state to enforce a full lockdown is significant. Turkey has tried the middle-of-the-road approach of keeping workers active but forcing the elderly and children into isolation.
While all of the above information is useful as a backdrop, it is of relevance in this discussion only in the context of how it impacts the Strategy, its holdings and potential investments. Although markets have fallen by almost a quarter so far in 2020, this average disguises the fact that many stocks have fallen by far more, or far less, including those held in the Strategy. The actions taken in the Strategy therefore reflect our belief on how material the impact of the Covid-19 disruption will be on the long-term fair value of the companies held in the Strategy.
As a general principle, we have not added to all positions in the Strategy that have fallen disproportionately, but have generally been selective in adding only to those that we believe will recover quickly operationally; have the balance sheet to withstand a prolonged severe disruption; and where there hasn’t been a material change to our long-term fair value as a result of this crisis.
The standout performer in the Strategy in the period was JD.com, the Chinese ecommerce retailer. JD was up 15% in the period and contribu-ted close to 0.8% of alpha. The share has doubled since the post-IPO lows it reached in late 2018. The share did well due to great results for 2019 and a better-than-average outlook in China during the height of the country’s lockdown. In 2019, revenues grew 25% and the company earned a profit after sustained losses since listing. Their outlook for Q1-20 (to end-March) guided to 10% revenue growth, even though the country probably saw double-digit declines in GDP during this period – the peak of the Covid-19 crisis in China. One would expect the appeal of ecommerce to be enhanced in a world of social distancing, but over and above this, several innovative steps taken by management have underpinned this strong performance.
A good example is continued deliveries using their self-owned logistics network, even in the most affected province in China (Hubei), using drones for delivery where possible. The moat around the business continues to grow and because of the higher conviction we have, coupled with the large relative outperformance of JD compared to the Strategy as a whole, the position size has actually increased to 3.3% at quarter-end.
Other notable contributors were Wuliangye Yibin (Chinese baijiu spirits manufacturer), which declined 15% but contributed 34 basis points (bps) of alpha, as well as Philip Morris International, down 13% for a 33bps contribution to alpha.
Ping An Insurance Group and Yum China collectively contributed another 50bps of alpha, the latter recovering quite quickly operationally and recently announcing that up to 85% of its stores in China are now open. The Strategy does not own Petrobras, and the big share-price decline (both the Brazilian market and the oil price decline contributed to this) added 40bps to relative performance.
The biggest detractor for the Strategy was the underweight in Tencent, which it does not own directly. This cost 1.1% of relative performance, and even though the Strategy does own Naspers and Prosus, whose valuations are ultimately derived from Tencent, this was insufficient to offset not owning Tencent directly.
Naspers and Prosus collectively contributed 78bps to relative performance and comprise 7.7% of the Strategy. We own them in preference to a direct shareholding in Tencent due to the substantial discount at which they trade to Tencent, as this provides an additional margin of safety; Prosus trades at a discount of around 35% to its underlying net asset value (mostly Tencent) and Naspers at an additional 25% discount to the value of its stake in Prosus.
Management of both entities are actively pursuing strategies to reduce this discount in order to unlock value for shareholders. The very high look-through exposure to Tencent in the Strategy reflects our conviction in the strength of Tencent’s business.
Among stocks owned, Airbus ended up detracting the most from performance, taking 85bps off relative performance. Airbus was a top 10 position (2.8%) at the beginning of the year and after holding up well early in the year, we started to reduce the holding significantly as the environment for world travel deteriorated. This aggressive reduction in the position size preceded a 60% collapse in the share price to as low as €49 at some stage, leaving the position at 1.6% at quarter-end.
Airbus is a good example of the extreme market reactions that have taken place. In the short term, the airline industry – Airbus’s customer base – is facing financial ruin, as airline travel has collapsed to a fraction of normal levels for this time of year. Airlines are cyclical, highly leveraged and thinly capitalised businesses (which is why we have rarely owned any in the Strategy historically) and will need to be recapitalised en masse in order for air travel to return to some semblance of normal. The impact on Airbus in the short term will therefore be quite negative, as airlines delay receipt of orders for new planes they manufactured in the last few years and, in some cases, cancel them entirely. In the medium term, however, this crisis will pass, and air travel will recover, in our view. The short-term financial impact will be manageable – airlines make regular payments during the build stage of a plane and pay penalties for cancelled or massively delayed orders. They also outsource a large chunk of production to suppliers, so the pain of delayed orders is not solely theirs to deal with.
Overall, about 75% of costs are variable in nature, so the cash burn during this downturn can be managed and Airbus starts off in a signifi-cant net cash position of €12.5 billion (as at December 2019, the most recent results reported). This is 28% of current market cap and equivalent to two times last year’s (adjusted) operating profit. We estimate that, due to their positive credit rating, they have straightforward access to an additional €12 billion of funding, if required, so even in a dire scenario where their working capital moves highly negative with no corresponding set-offs from clients and suppliers, they have ample liquidity to see them through a very depressed 2020 and 2021. There is also €3.3 billion of annual research and develop-ment expenses that could be scaled back if required.
The duopoly nature of the industry means that customers only really have two choices of supplier, and however tough things may be for Airbus, they pale in comparison to its only competitor, Boeing, which is highly leveraged and still dealing with the aftermath of the grounding of the 737 Max last year.
Although it is not without risk, we are very positive on Airbus long term and continue to hold it in the Strategy. By our estimates, even with a 50% decline in total deliveries over the 2020-2022 period, by 2022, Airbus will already be genera-ting €4 billion in free cash flow, compared to a current market cap of €45 billion at the time of writing – close to a 10% free cash flow yield two years out. The company guided to a more benign outcome, with a projected reduction in output of one third starting from this second quarter of 2020.
The Indian financial companies HDFC (mortgages) and HDFC Bank (full-service banking) declined by 36% and 39% respectively, costing close to 1% of combined relative performance. In our view, these declines are excessive; the short-term impact of India’s shutdown does not reduce the fair value of these businesses by anywhere near this quantum. It is reasonable to expect bad debts to spike in India; however, we believe the risk is more pronounced in the corporate sector than the consumer sector, as consumers are likely to receive significant support from the government to help them through this crisis.
Because of our concerns about corporate exposure, we sold the small 50bps position held in Axis Bank in order to concentrate our Indian financial exposure in the higher-quality names. In the case of HDFC (4.2% of Strategy), the mortgage book is fully secured by residential property (mostly primary residences), with very conservative loan-to-value ratios at loan inception. HDFC Bank (2.6% of Strategy) has more consumer exposure than any of its peers, with almost half in semi-urban and rural India, where the disruption from the lockdown is likely to be less severe than in urban areas, in our view. Their balance sheet strength, consistent track record of navigating through previous crises (of which there have been many in India) and excellent management team lead us to believe they will gain market share in this environment. The main competitors are either poorly run state-owned banks or private sector banks with company-specific issues to deal with. Most recent data on loan growth from the Reserve Bank suggest HDFC Bank is growing their loan book at 2.5 times the rate of the market as a whole.
There has been a high level of activity in terms of new buys and sales to zero in the Strategy during the quarter. Notable new buys in the quarter were the South African trio of Shoprite, Spar (both food retail) and Pepkor (entry-level clothing retail). Collectively, these are only 1.9% of the Strategy, but represent the first material domestic South African exposure in the Strategy in a few years. The trio is among the best businesses in the country, being predominantly cash retailers catering to the mass market. In a tough economic environment, they will benefit from downtrading by consumers and will weather the storm better than their peers, in our view.
All three have declined significantly by 30% to 50% over the last year, in addition to the 25% decline in the rand since the start of 2020. Relative to peers in emerging markets, they are now quite attractive, with valuations ranging from 12 to 14 times forward earnings and with 4% to 5% dividend yields. We acknowledge the well-publicised risks in South Africa today (the poor fiscal situation and the investment environment overall), but these are great businesses in their own right, and we manage the risk by limiting the overall exposure to sub-2% of the Strategy.
Another notable new buy is Indian tobacco business ITC, an affiliate of British American Tobacco and whose purchase was primarily funded by switching British American Tobacco exposure into ITC. The share price of ITC has halved since 2017 and is below the level of five years ago. This highly cash-generative business has declined from 30 times earnings a few years ago to 13 times today.
One can separately value ITC’s non-tobacco businesses, which they started years ago in an attempt to diversify away from tobacco and which are marginally profitable, and strip this out of the overall valuation. On this basis it is even more attractive at eight times core (tobacco) earnings.
ITC has an almost 85% share of the formal tobacco market in India, making it a quasi-monopoly. The high level of illicit tobacco sales in India means that the burden of providing excise taxes to the government falls disproportionately on ITC, and in recent years, the government has not been shy to hike taxes on cigarettes, which is why the share price has continued to decline. Despite this government treatment, ITC continues to grow earnings at low double-digits and is likely to do better than this over time as the non-tobacco businesses improve profitability or are sold to realise value for shareholders.
With almost 20% of its market cap in cash and a 5% forward dividend yield, ITC is very attractive. Longer term, if the Indian government ever becomes serious about cracking down on the illicit market and informally produced thin sticks (known as ‘bidis’), then ITC has substantial room to grow volumes as the formal market takes share within the country. We have covered it for years but never owned it, as it has always traded at 25 to 30 times earnings, and the continued share price decline provided us with an opportunity to buy this asset for the first time with a large margin of safety.
Elsewhere in India, we also bought a small (0.8%) position in Infosys, a global IT outsourcing services provider, to supplement our existing exposure to the industry via Tata Consultancy Services (1.1% of Strategy). Infosys declined by as much as 45% from mid-February and we built the position up gradually during the quarter. In the shorter term there will be significant headwinds to the industry as companies cut investment to cope with the downturn, but in the long term, the shift to outsourcing IT services in order to reduce permanent headcount will probably be helped by this crisis. Infosys trades on 14 times forward earnings (excluding its net cash position) with a 4% dividend yield.
Rounding up the list of new buys was Brazilian payments provider Stone Co. Stone has grown its market share in the payments space to 8% today, from 2% in 2016, by concentrating on small and medium-sized business that have historically been poorly served by the banks and merchant acquirers. With rising card penetration and increased innovation in the financial services space, it is our view that Stone will continue to take market share in a growing market and could reach 15% market share within a few years. Its highly scaleable business model means that margins will improve significantly, with greater transaction volumes, and it will convert a high proportion of earnings into free cash. The share price has halved since the beginning of February, broadly in line with the decline in the Brazilian market, despite the relatively superior earnings growth prospects for the firm.
After six years in the Strategy, we sold Cogna (previously known as Kroton) in mid-February. We had been reducing gradually as it appreciated; however, the announcement by management of an equity raise to fund potential acquisitions in the education space in Brazil was, in our view, very negative. We had stressed in previous discussions with management our opinion that the share was very cheap and that an equity raise would be value destructive. Given that management has been stressing an improvement in cash generation and that their debt level is manageable, we viewed this change in tactic as a warning sign. We therefore sold out once this equity raise was announced as the share price went up initially.
We also sold the small remaining positions in Taiwan Semiconductor Company and Samsung Electronics, as they held up quite well in the sell-off and were an attractive funding source for some of the buys above. The final sale was that of 51 Jobs, the Chinese white-collar recruitment and business process outsourcing provider, which reached close to fair value in January.
Members of the team travelled to India, Brazil and Mexico during the quarter to meet current and potential portfolio holdings, before all travel was curtailed in light of global developments. We wish all our clients safety and good health in the weeks and months ahead.