NOTWITHSTANDING THE LINGERING Covid-19 uncertainty and distressed macro conditions around the world, equity markets continued to grind higher on the back of the post Covid-19 anticipated economic recovery, aided by unprecedented fiscal stimulus and record-low interest rates. During the quarter, the MSCI All Country World Index (+8% in US dollars for the quarter) rallied to recover all of its losses for the year, and US equity markets in particular were incredibly strong, with the S&P 500 (+8.9%) and Nasdaq (+12.6%) indices both reaching new all-time highs. Our large global equity weighting added to performance during the quarter.
The FTSE/JSE Capped Shareholder Weighted All Share Index appreciated 1% for the quarter, thereby pulling the rolling 12-month return back into positive territory. Positively, some good stock selection in the Portfolio added to our returns. The resources sector had another very strong quarter and was up 6%. Platinum stocks in particular were up strongly on the back of a rising platinum group metals basket price and companies reporting good annual results. The industrial and financial sectors (both down 2%) continued their recent underperformance, while the property sector had another challenging quarter and ended down 15%.
Against this market backdrop, the Portfolio had a reasonable quarter, delivering a return of almost 2.5%, with all asset classes bar South African property contributing positively to the quarter’s return.
On the domestic front, the South African economy contracted severely in the second and third quarters of the year as the brunt of Covid-19 lockdowns impacted activity. We expect a tepid recovery as the year progresses and only expect the country to return to 2019 levels of GDP growth by early 2023, in nominal terms. Globally, the virus seems to be staging a second wave and there are many significant uncertainties, including the outcome of US elections, the Brexit negotiations, and geopolitical tensions between China and various countries. In general, however, these economies seem better positioned to recover from Covid-19 due to quicker access to vaccine treatments, better support from government programmes and more coordinated economic policies.
BROADER MARKET OFFERS VALUE OPPORTUNITIES
The Portfolio has steadily increased its effective global exposure from the beginning of the year to 26% currently. We have mainly increased our holding of global equities as the other asset classes look expensive (global bonds) or face structural headwinds (global property). While certain equity indices such as the S&P 500 look expensive and have rallied hard from the bottom, it has been a narrow market with a few shares delivering the bulk of the performance. There remain many compelling valuation opportunities in the broader market.
We have also increased our equity allocation on the local side. Most of our exposure is to attractively valued rand hedge shares such as British American Tobacco and Anheuser-Busch InBev. Despite South Africa’s ban on the sale of alcohol and tobacco during the hard lockdown period, these businesses have generally managed to trade their products in many other countries. We think these businesses are defensive and can show real revenue and earnings growth in hard currencies over the medium term. Most importantly, they are strong free cash flow converters and will use their cash to de-lever their balance sheet and return cash to shareholders. This combination of decent earnings growth and dividend returns is attractive for our portfolios.
In particular, we find British American Tobacco’s 8% dividend yield to be very compelling. In addition, unlike a government bond, we do not believe the company is ex-growth and would expect this yield to grow. The market remains concerned around a possible menthol ban in the US (US menthol makes up c.25% of group profits). However, tobacco legislation tends to play itself out over periods of many years in the US. A menthol ban in Canada saw a limited reduction in smoker numbers and 99% remain with their current cigarette brand. British American Tobacco is also well placed to be one of the winning companies in next-generation products, such as e-vapour and heated tobacco.
We have also been adding to domestic businesses that we think have resilient franchises and healthy balance sheets, and can deliver earnings growth in a constrained economy. Low expectations are baked into market prices and if we see a better-than-anticipated recovery in earnings bases, we think there will be a robust real performance from our selected basket of equities.
The Shoprite share price appreciated 30% during the quarter and contributed meaningfully to performance. After a difficult two-year period in which much work was done internally, it was particularly pleasing to see the company deliver an excellent set of full-year results in which it started regaining market share, expanded operating margins, delivered a very good cashflow performance and announced decisive action to deal with its underperforming African portfolio. We remain positive on the prospects for this high-quality business and have maintained a sizeable position in the portfolio.
The increase in global and local equities has been funded from our South African fixed income allocation. South African bonds still offer very attractive real yields, especially in the long end of the curve, and the portfolio still has a healthy 45% allocation to a mix of government bonds, inflation-linked bonds and corporate credit. But we also recognise that a rising government debt burden and widening fiscal deficit will require some serious intervention by the finance ministry. While government acknowledges the seriousness of the economic situation, we think that there is a non-negligible risk that we do not see the decisive policy changes and expenditure reform plans the economy needs to avoid a debt trap.
We remain very cautious on South African property and have not increased our exposure here. Most real estate companies entered the Covid-19 crisis with stretched balance sheets. Pressure on net rental income is likely to intensify and we think a capital restructuring will be necessary for many counters. We had a small allocation to South African property, and we have seen a significant de-rating of this sector. Despite this, we don’t think valuations are compelling enough to increase our allocation.
VALUATIONS REFLECT THE RISK OUTLOOK
The Portfolio has found it difficult to beat its inflation-plus target, as very few asset classes have delivered inflation-beating returns in the last five years. Risk assets, in particular domestic equity and domestic property, have shown sub-inflation to negative returns over this period. Safer assets such as South African cash and South African fixed income have outperformed domestic risk assets on a relative basis. However, rising risks for domestic bonds and cash returning less than 4% mean that these assets have become less appealing. As we sit now, the outlook for risk assets is certainly not rosy but valuations have more than reflected this and we have thus increased our risk asset exposure. We remain mindful of the Portfolio’s dual mandate and use asset class diversification as well as appropriate put protection to preserve capital. While the outlook remains uncertain, we believe this creates attractive investment opportunities and that a considered increase in risk exposure is justified at this point to enable the Portfolio to deliver on its mandate in the future.