Corospondent - January 2019
2018 Quarter in review - January 2019
CORONATION GLOBAL HOUSEVIEW STRATEGY
It was a disappointing year, with markets experiencing broad-based asset declines. During the fourth quarter of 2018 (Q418), global markets sold off sharply. The MSCI All Country World Index (ACWI) declined by 12.8%, while the US market was down 14% as trade wars and slowing global growth plagued market sentiment. In the UK, Prime Minister Theresa May survived a vote of no confidence, but the chances of a no-deal Brexit rose and the FTSE 100 Index declined 11.7%. Emerging markets (-14.6%) underperformed the developed world (-8.7%) over the year but did relatively better in Q4 2018. Emerging market risk aversion saw portfolio outflows and notable currency depreciation for the year in South Africa (-14%), Russia (-17%) and Turkey (-28%), relative to a strong US dollar. It has been many years since we have been able to buy high-quality businesses at the undemanding ratings currently available in many emerging markets.
The Bloomberg Barclays Global Aggregate Bond Index was up 1.2% for the quarter, but down 1.2% for the year in US dollars. We remain cautious on global bonds, given the very low yields at which they trade, coupled with an environment of normalising interest rates and the risk of rising inflation. In South Africa, the All Bond Index returned 2.7% for the quarter, bringing annual performance to 7.7%, which compares favourably to other domestic asset classes.
Over the year, investor sentiment in South Africa deteriorated as Ramaphoria evaporated and structural concerns reasserted themselves, as the dire state of many state-owned enterprises (SOEs) was further revealed. Most sit with inflated wage bills from overstaffing and years of above-inflation pay increases. The job cuts required to rein in costs are a tough call for a divided governing party facing an election in the next few months. Following the election, we are hopeful that a stronger mandate for the incumbent will enable more decisive reform. Eskom remains a significant problem, with its strained balance sheet and years of poor maintenance resulting in the reoccurrence of load shedding in an economy already struggling to grow. A proposal to transfer R100 billion of the parastatal’s debt to the government balance sheet would erode national debt-to-GDP by a further 2%.
Positively, there has been progress on governance, with SOE boards being reconstituted and underperforming management teams being replaced. In addition, third-quarter GDP figures indicated a return to growth, although a further hurdle came in the form of the South African Reserve Bank’s (SARB) surprise repo rate increase of 25 basis points in November. This action was premised on a depreciating rand, persistent electricity price increases and a high oil price. Food inflation also looks set to rise in 2019, with maize prices spiking in response to a poor rainy season in key planting areas.
The FTSE/JSE Capped SWIX All Share Index ended 2018 down 10.9% (down 3.8% in Q418) as the euphoria of the first quarter subsided, resulting in both weak equity markets and a marked deterioration in the currency. The rand was one of the weakest currencies globally. Worldwide, markets were also weak as fears of trade wars, rising US inflation and the reversal of years of quantitative easing plagued market sentiment. Full-year index returns were dominated by the resource sector (up 16%), which was driven by globally diversified miners such as Anglo American (+32%) and BHP Billiton (+28). Given weak global markets, domestic sentiment erosion and several stock-specific issues in offshore shares listed domestically, both financials (-9%) and industrials (-18%) declined over the full year. All sectors declined in Q418, with financials, resources and industrials down 2%, 5% and 6%, respectively.
We have the fortunate dilemma of seeing attractive value in both the offshore shares and domestic shares listed on the JSE, given the increased upside to our estimates of fair values after a year of marked declines.
The portfolio’s core building blocks remain in place, with significant positions in offshore stocks, including Naspers, British American Tobacco and MTN. All of these companies have faced various challenges over the past year. In addition, we have used price weakness to build positions in other global businesses, including Quilter and Anheuser-Busch InBev.
Earlier during the year, MTN was hit by claims from the Central Bank of Nigeria and the Nigerian Attorney General for capital repatriation of $8 billion and $2 billion in back taxes. The share reacted violently to the news, with sharp declines, and priced in a severe outcome, with seemingly no value placed on the Nigerian operations. The actions of the Nigerian bodies attracted international attention as the investment climate was broadly undermined. We added to the position at this time. The issue of repatriation has subsequently been resolved for a notional amount of $52 million. Despite resolution, shaken investor confidence means MTN continues to trade well below our opinion of fair value, as we view investors as placing an excessive discount on African operations.
British American Tobacco, a major holding in the portfolio, ended the quarter at -27.4% and the year at -43.4%. The company significantly increased its exposure to the US market with its 2017 acquisition of Reynolds American, but since then, US tobacco companies have been plagued by a barrage of negative regulatory developments. The US Food and Drug Administration seeks to clamp down on tobacco levels in conventional cigarettes and reduce flavoured tobacco, particularly menthol, where British American Tobacco is the market leader. In addition, the market is facing structural change as reduced-harm offerings, such as vaping, could result in an accelerated volume decline in combustible cigarettes.
New entrants (particularly Juul in the US market) have managed to establish good distribution channels and gain market share through a well-designed product with youth appeal. The share has been punished in response to these factors and the high levels of gearing from the Reynolds acquisition. Trading on 7.6 times its forward earnings and with a dividend yield of 9%, we believe the share offers exceptional value. British American Tobacco’s healthy free cash flow conversion and the likelihood that any regulatory change will take a few years to implement will support balance sheet de-gearing. Given the ongoing negative news flow (regulatory developments, the rise of e-cigarettes and the like), there seems to be little price support, despite the valuation underpin. Ultimately, we believe fundamentals will assert themselves.
Naspers remains a large holding in the portfolio, given the compelling opportunity set latent in this business. We remain cognisant of the inherent risk in Tencent, particularly given its size and dominance within a single, centrally controlled market such as China. During the past year, delays in Chinese gaming licences have proved a headwind. Despite this, we expect strong growth to continue. Tencent is building a payments business in a financial services market segment many times larger than the gaming market, and is growing rapidly in areas such as cloud services and advertising. Within Naspers, streamlining of the portfolio continues, with more focused investment in core pillars such as the rapidly growing food delivery businesses. A planned unbundling of the MultiChoice business in 2019, as well as a potential offshore listing of some of the internet assets, further underpin management’s commitment to reduce the discount to fair value.
While our equity and balanced portfolios remain significantly exposed to offshore stocks, we have increased the domestic holdings, resulting in a more balanced portfolio.
Domestically, we believe earnings bases are low, as cost bases have been trimmed and companies have faced several years of a tough economy with little volume. The food retailers owned in the portfolio are a good example. Rising food inflation and a (hopefully) stronger economy should provide food retailers and producers with the ability to raise prices and recover cost increases. A little bit of volume should deliver positive operating leverage, given the lean cost bases.
The resource sector performed well over the full year; Q418 declines can be attributed to the rising uncertainty over Chinese economic growth. Resource companies have benefitted from tight markets due to disciplined capital expenditure and Chinese environmental reform. China’s commitment to environmental reform remains, but slowing growth means a finer balance may be needed between economic growth and environmental reform. While uncertainty exists, we believe a reasonable position can be justified. Miners are trading on high free cash flow yields and returning a fair amount of this to shareholders. The portfolio’s core holding in Anglo American contributed to performance for the year, buoyed by Amplats. Other key portfolio holdings include Northam Platinum and Mondi. Northam has underperformed the other platinum miners, but its cost quartile position should improve as it ramps up production in the next few years.
Within the financial sector, performances were divergent. Banks and insurers outperformed the property sector, which was hit by a weak economy, undermining the position of landlords. The financial holdings in the portfolio are more skewed towards the banks, with a large holding in Nedbank, which trades at a significant discount (PE 9.2 times) to the banking sector average. We also see value in a few of the high-quality property companies, notwithstanding the risk of an Edcon bankruptcy later this year.
Shares with exposure to the UK remained under pressure due to high Brexit uncertainty, as was reflected in the very poor share price performances of Intu and Hammerson. Both shares trade at massive discounts (>50%) to their underlying net asset value. The premium nature of the shopping centre assets in both counters should be far better placed to navigate the shifting retail environment. We feel this thesis was affirmed in 2018 when Intu received its second expression of interest at a significant premium to the share price. Unfortunately, after requesting an initial extension, the consortium walked away during Q418 due to macroeconomic concerns related to Brexit, which remain an overhang.
Earlier this year, we added to the position in domestic bonds as yields rose and valuations became more reasonable. Domestic bonds have generated a positive return for the year, but we believe the position remains justified, given reasonable valuation.
It has been a challenging year. Shares prices plummeted on disappointing news flow, and there have been few marginal buyers for assets with uncertainty. Given the extent of share price declines, we see compelling value in many names which now trade at significant discounts to our assessment of fair value. The team continues to do as we have done before; cut out the noise, work hard to interrogate investment theses and invest for the long term, where we believe the inherent value in many of our holdings will reassert itself.
Calendar year 2018 was a tough year for equity investors globally. Frontier markets were no exception, with the MSCI Frontier Markets Index down 16.4% over the period. This followed a positive 31.9% return in 2017. The pain was broad based, with all major markets, bar Kuwait (+0.6%), in negative territory. The strategy was down 8.5% in 2018. While a year where capital is lost is never easy, outperforming the index by 7.9% is significant and something we are certainly proud of. Over the past 25 years of investing at Coronation, our value investment philosophy has most often outperformed in bear markets. Buying shares with a significant margin of safety provides some protection when market sentiment turns. This approach paid off in 2018, with the strategy outperforming both the MSCI Frontier Markets Index and the MSCI Emerging Markets Index, which fell 14.6% in 2018.
Over the year, the worst performing frontier market was Argentina (-50.2%). The government was forced to approach the IMF for a $60 billion package as inflation spiked and capital fled the country. This saw the peso halve in value against the dollar. At the start of the year, due to concerns around valuations, the strategy had limited Argentine exposure (2.9%) through a single holding and sold out completely in the first quarter of 2018 as its share price moved past our fair value. This helped limit the impact of the crisis on the strategy, despite Argentina being one of the largest constituents in the MSCI Frontier Markets Index. More recently, the currency has stabilised. Interest rates have been hiked and the IMF deal-related policies have gone some way to restoring investor confidence.
With valuations having become significantly more attractive, particularly in US dollar terms, we have selectively added some high-quality Argentine corporates to the fund. Bottom-up fundamentals look appealing, and the margin of safety has increased to an attractive level. Argentina made up 7.7% of the strategy at year-end. The strategy’s largest exposures are Egypt (15.4%) and Bangladesh (12.9%). As always, country weights are a function of the attractiveness of individual companies in each market rather than a macro or index view. In fact, for much of the year, the fund held no exposure in Argentina and Vietnam – two of the largest weightings in the MSCI Frontier Markets Index – due to valuation concerns.
A number of the other major markets were down significantly in 2018, including Pakistan (-25.1%), Sri Lanka
(-20.3%), Nigeria (-18.6%), Kenya (-16.9%), Bangladesh (-15.2%), Egypt (-13.8%), Vietnam (-11.2%) and Romania (-9.0%). Each country was impacted by its own internal dynamics; however, the result was largely the same – negative. Kuwait (+0.6%) was the only positive performer as its ‘safe haven’ reputation and noise around an upgrade to emerging market status kept the market in positive territory, albeit barely.
On a stock-specific basis, Ceylon Tobacco (a Sri Lankan tobacco manufacturer) and Stanbic Holdings (a Kenyan bank) were the largest contributors, with Al Eqbal Tobacco (a global shisha producer) and Hum Networks (a Pakistani TV broadcaster and producer) the largest detractors.
While years like 2018 are always difficult to stomach, they do have the effect of resetting valuations across many of the companies that we look at. For the first time in a while, we are seeing upside in a number of high-quality companies with long-term compounder economics. These are businesses that we would have loved to buy in the past, were it not for excessively optimistic valuations. Many of these shares have now re-rated to levels that we believe are attractive, and we have added some to the portfolio recently. In its Frontier Markets in 2019 research note, Citibank calculate the forward price to earnings in Frontier Markets as 10.7 times. This is the most attractive level in three years. They go on to exclude Vietnam and Kuwait, two of the more expensive markets, resulting in a forward PE of 8.7 times. This is the lowest level in five years for these markets. While market PEs are always going to be a blunt instrument, they do corroborate what we are seeing on a stock-specific basis in our own fair value ranking table. We are unsurprisingly bullish on the portfolio’s prospects over the long term.
After a strong start to the year, 2018 turned out to be largely negative, with Nigeria (-18.6%), Kenya (-16.9%), Egypt (-13.8%) and Morocco (-10.2%) all experiencing meaningful declines.
The fourth quarter of 2018 showed a similar picture, with Egypt (-11.3%), Kenya (-7.3%), Nigeria (-3.8%) and Morocco (-0.9%) all declining. However, we have seen that the volatility in African markets present opportunities to acquire stakes in high-quality companies operating in high-growth markets.
In the quarter under review, British American Tobacco Kenya was up 23.7%, while Eastern Tobacco was down 11.6%. It was the most significant detractor over the quarter, but remains one of the largest contributors to the strategy’s performance over longer periods. Eastern Tobacco is the largest position in the strategy. It is a business with excellent fundamentals where we believe there is significant potential to continue to grow earnings for many years to come.
At the start of the year, we saw a lot of optimism in Zimbabwe ahead of the elections. Unfortunately, the liquidity situation deteriorated during the year. Up to now it has proved difficult to attract foreign investment and the government’s expectation that they would see large funding from various countries and institutions after the elections is yet to materialise. We saw a deterioration in the liquidity situation in the country, particularly over the past three months. One data point which shows this is the Old Mutual dual pricing discount, which fluctuated around 40% at the beginning of 2018, but widened to almost 90% in October 2018. This has since improved somewhat to a discount of around 80%.
Despite the tough environment, the Zimbabwean companies we own in the strategy continued to perform well. For example, the mobile money business of Econet Wireless Zimbabwe (Econet) has close to 100% market share in a country where virtually all payments now happen electronically. As a result, Econet has seen a dramatic increase in profitability. Given that there has not been an improvement in the liquidity situation in Zimbabwe, we continue to value the in-country Zimbabwean assets at our assessment of fair value, which is significantly lower than the quoted share prices.
The consideration of environmental, social and governance (ESG) issues in the investment process is something that is very topical and front of mind for many investors, but it is one of those things that is often hard to quantify. At Coronation we are big supporters of ESG, and as part of our investment process we spend a lot of time on ESG analysis. We do not only do this for the impact that good ESG practices have on society; we also believe it offers real financial returns to investors.
In frontier markets we have seen a number of examples of companies where corporate governance is not particularly good, but in our experience, this is mostly due to ignorance rather than intent. These are often still early-stage businesses, companies that might still be controlled by the founding family, or which have not yet introduced all the procedures that one finds in large, established multinational businesses. We believe there is a huge opportunity for investors in these markets. Investors are willing to pay much higher multiples for companies that are good allocators of capital, with strong corporate governance. When the governance at a company goes from poor to good, the re-rating one sees in the share price is usually quite significant.
In our view, the most important responsibility of a management team is to allocate capital appropriately to the benefit of all shareholders. When meeting with management teams, we often spend large portions of these meetings engaging on, debating and frequently challenging their strategic decisions and views on capital allocation. There are also various examples where we have voted against resolutions at the annual general meetings of companies we are invested in. We make a point of communicating our reasons to the company if we are not in support of a particular resolution, and we have seen that this has resulted in management teams taking our suggestions on board and committing to implement certain changes.
A recent example which demonstrates how seriously we take corporate governance, is our engagement with the management and other minority shareholders of Econet over the past few months. While we believe that Econet’s underlying business is very good, we are extremely unhappy about certain proposed transactions, which in our view were going to benefit the founder at the expense of minority shareholders.
In 2017 Econet had a deeply discounted rights issue where the company forced shareholders who wanted to take up their rights to subscribe for debentures. By issuing debentures it was not necessary to increase the company’s share capital – which would have required a 75% vote – and the resolution was passed with a simple majority. The highly unattractive nature of the debentures, however, excluded a number of minority shareholders from participating, given that their underlying investment mandates did not allow holding this type of debt instrument. As a result, Econet Wireless Global (EWG) – the largest shareholder and a company owned by the founder – ended up owning the bulk of these debentures.
In November 2018, Econet announced that it intended to convert all debentures to shares at the same discounted rights issue price. This would effectively amend the 2017 rights issue and place debenture holders in the position they would have been in had they subscribed for shares. This is a material change in the terms of a pure debt instrument that was never meant to be converted into equity. The conversion is extremely attractive for debenture holders and will be very dilutive for equity holders, as it will increase the shares in issue by more than 40%. With EWG owning a disproportionate number of the debentures, the conversion will increase their stake in the company from approximately 43% to around 47%.
When the proposed conversion was announced, we wrote a letter to the board, made a call to one of the directors and communicated our concerns to the Zimbabwe Stock Exchange. We also had calls with a number of other minority shareholders who shared our concerns. The result was that the company did not gain sufficient support for the debenture conversion; we strongly believe that it was in the best interest of minority shareholders that the conversion did not take place.
Another example during the quarter was the letter we wrote, together with other minority shareholders, to the board of Global Telecom Holding, to share our views on the offer they received for their businesses in Pakistan and Bangladesh. In our view this offer from the largest shareholder significantly undervalued these businesses and the end result was that the transaction did not go through.
Going forward, topics such as governance and capital allocation will remain key in our engagements with the companies whose shares we own on behalf of our clients. We are very excited about the year ahead. The valuations of many high-quality businesses have reduced meaningfully over the past year and they now offer exceptional value. By owning these businesses that trade well below our assessment of intrinsic value, we believe investors will be rewarded over the long term.
Thank you for your support. It is particularly valued in years such as 2018. We do not take your faith in us for granted and continue to work hard to select companies across global frontier markets that trade well below our estimate of their intrinsic value. Over time, we expect that the market will come to realise this and that our investors will be rewarded.
GLOBAL EMERGING MARKETS
Please refer to the detailed review of our global emerging markets views.