Corospondent - January 2019
South African flagship fund update - January 2019
INVESTOR NEED: LONG-TERM GROWTH
Domestic general equity funds
Top 20 and Equity
Over the last decade, the Top 20 and Equity funds showed compelling returns of 12.8% and 12.7% per annum, respectively. However, the fourth quarter of 2018 (Q418) proved to be the most challenging period in a difficult year, with Top 20 declining by 4.9% and Equity by 7.9%.
Top 20 is a concentrated portfolio of locally listed shares only, while Equity is more diversified, with 80% invested locally and 20% in offshore shares.
Both funds were impacted by the ebbing of investor sentiment in South Africa as so-called ‘Ramaphoria’ evaporated and structural concerns reasserted themselves, particularly in the case of state-owned enterprises (SOEs). In Equity, the inclusion of global equities in the portfolio over the past three years has benefitted performance while enhancing diversification, but detracted in the most recent quarter.
The fourth quarter’s major disappointment was the withdrawal of the bid for Intu Properties by a consortium that included Intu’s current major shareholder, the Peel Group. Despite a successful conclusion of the due diligence, the other partner in the transaction decided to withdraw amid concerns over Brexit. However, we remain convinced of the value in Intu and continue to engage with the board to ensure that this is unlocked for all shareholders.
British American Tobacco, a major holding in both funds, ended the quarter at -27.4% and the year at -43.4%, on the back of negative regulatory developments in the US. Trading on 7.6 times its forward earnings and with a dividend yield above 8%, we believe the share offers exceptional value, and ultimately, we believe fundamentals will assert themselves.
The best-performing portion of these portfolios remained their resources positions, with prices for Anglo American commodities remaining strong, which allowed the de-gearing of its balance sheet. Exxaro also performed well, and recently announced further value accretion from the finalisation of its exit from Tronox, the mineral sands business. The proceeds from the sale of its final stake should be received in 2019, the majority of which will be returned to shareholders.
Meanwhile, the December decision by the Central Bank of Nigeria to reverse the $8 billion penalty it had applied to MTN for allegedly avoiding exchange controls was a welcome one for both funds. This means MTN can proceed with the planned listing of MTN Nigeria and can also repatriate profits from Nigeria, which will support its current dividend policy. However, despite the 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.
While both funds remain significantly exposed to offshore shares such as Naspers, British American Tobacco, Quilter and Mondi that happen to be listed in Johannesburg, we have increased exposure to defensive domestic holdings such as hospital groups and food retailers, resulting in a more balanced portfolio.
While this has been a disappointing quarter for both funds, given the extent of share price declines, we see compelling value in many names that now trade at significant discounts to our assessment of fair value.
Multi-asset class funds
Balanced Plus and Market Plus
While the Balanced Plus and Market Plus funds compounded at 11.3% and 11.9% per annum over the past decade, both funds declined in the last quarter of 2018, by -6.3% and -5.3%, respectively.
The funds benefitted from exposure to global equities over time, but during Q418 this detracted from performance, as global markets sold off sharply. The MSCI All Country World Index (ACWI) declined by 12.8% and the US market was down 14.0%, 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 Q418. 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 funds entered 2018 with a relatively low level of exposure to local and global equity markets, and we have taken advantage of the sell-off to increase exposure to shares, with exposures similar to the general equity funds above. We have primarily increased local equity exposure, as the South African market is offering levels of upside we have not seen since the financial crisis. While our multi-asset funds remain significantly exposed to offshore stocks, we have increased the domestic holdings, resulting in more balanced portfolios.
Overall, equity exposure is now around 70% in both portfolios.
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.
Both funds added domestic bonds during 2018 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. Share 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.
INVESTOR NEED: INCOME AND GROWTH
Capital Plus and Balanced Defensive
The final quarter of 2018 unfortunately saw the downtrend already prevailing in most stock markets accelerate to even bigger losses. Against this backdrop, the Balanced Defensive fund’s relatively high exposure to bonds helped to offset the negative returns from risky assets, resulting in a positive return of 2% for the year. Capital Plus, with relatively more exposure to risky assets, declined by 2.5% over the year. Over the past 10 years, the Balanced Defensive and Capital Plus funds returned a commendable 9.8% and 8.9% per annum, respectively – both ahead of inflation, which ran at 5.4% per annum over the period.
The Balanced Defensive portfolio carries an almost 50% exposure to domestic bonds, including inflation-linked bonds, at an expected real yield of close to 5%, while Capital Plus’s domestic bond exposure is just over 30%. Both funds’ weighting to domestic equities has been increased into price weakness and we are finding many stocks that now offer very good value. The fund’s global exposure has been trimmed marginally to make space for the more attractive local assets. We expect these bond holdings to be a key building block in the coming year to help us achieve our targeted return.
We have been adding to JSE-listed equities, taking Balanced Defensive’s exposure to 20% at year-end and Capital Plus’s exposure to 32% – the highest levels for the year. We added to a range of stocks, including British American Tobacco, Standard Bank, FirstRand and Shoprite. As far as Naspers is concerned, we used the extreme volatility in the share price to vary exposure actively.
Cash has now outperformed these funds, and most balanced funds, even over a five-year period. It is therefore understandable that investors will question the relevance of staying invested in balanced funds. In our view, cash will not deliver inflation plus 3% in the long term. One therefore requires exposure to some risk assets where the potential return is far higher.
INVESTOR NEED: IMMEDIATE INCOME
The fund returned 1.8% in Q418, bringing its total return to 7.3% for the year. This is ahead of the returns delivered by cash (6.9%) and slightly behind its benchmark (7.6%) over the same one-year period. Over two and three years, the fund remains well ahead of both cash and its benchmark.
2018 was a difficult year, with almost all investable asset classes underperforming cash. The exceptions were bonds (7.7%), preference shares (15.0%) and offshore assets (the rand depreciated 13.8% against the US dollar). Over the years, we have continuously flagged that, during times of high volatility and over shorter measurement periods, investors should expect returns that are in line with that of cash. Last year was such a year; however, the fund remains well positioned to benefit from the attractively priced assets that it currently owns.
During the year, the US/China trade war escalated, raising concerns about global growth expectations, which we now know to be too high. Around about the same time, the US Federal Reserve (Fed) started to lift its expectations for the US economy and consequently, its expectations around US interest rates.
This combination of higher-than-expected US rates, lower global investor confidence and slower global growth painted a very poor picture for emerging markets. Emerging market bonds were down 7.9% in US dollars for 2018, while emerging market bonds in their local currencies only returned a paltry 2.9%.
South Africa did not fare much better, as concerns over key policies (land, the mining charter and SOE reform) and much slower growth weighed heavily on local asset price performance. The All Bond Index was up 7.7% for 2018; however, rand weakness brought South African government bond returns in US dollars to -7.1%.
South African government bonds had a rollercoaster of a year, with the benchmark bond starting the year at 8.59%, hitting a high of 7.88%, then a low of 9.36% and ending the year at 8.87%. Inflation-linked bonds (ILBs) continued to suffer as real yields moved almost as much as nominal bonds
(I2025 – low: 3.15%, high: 2.08%), primarily due to the adjustment lower in both medium- and longer-dated inflation assumptions. Due to the higher duration that these bonds carry, ILBs only managed to eke out a return of 0.3% for the year.
The US Federal Open Market Committee (FOMC) raised the Fed Funds rate by 25 basis points (bps) to a 2.25% to 2.5% range in December. Rates markets have since priced out further US policy rate tightening in 2019.
Domestic inflation accelerated modestly to 5.2% year on year (y/y) in November from 5.1% y/y in October. In a tied 3:3 vote, the South African Reserve Bank’s Monetary Policy Committee (MPC) raised the repo rate 25 bps to 6.75% in November, with the Governor casting the deciding vote. The MPC has reiterated its desire to see CPI and inflation expectations closer to the midpoint of the target band (4.5%), implying that despite prevailing low inflation and slow growth, we can expect modest increases in interest rates in coming months.
At the end of November, shorter-dated, fixed-rate negotiable certificates of deposit (NCDs) traded at 8.45% (three-year) and 8.96% (five-year), slightly tighter over the month. The spreads of floating-rate NCDs have dulled in appeal over the last few quarters due to a compression in credit spreads. There has been a reduced need for funding from banks in South Africa, given the low-growth environment. Fixed-rate NCDs continue to hold appeal due to the inherent protection offered by their yields and relative to our expectations for a stable repo rate. However, credit spreads remain in expensive territory (less than 100 bps in the three-year area and 110 bps in the five-year area).
The fund continues to hold decent exposure to these instruments (less floating than fixed), but we will remain cautious and selective when increasing exposure. NCDs have the added benefit of being liquid, thus aligning the liquidity of the fund with the needs of its investors.
The fund maintains its healthy exposure to offshore assets, and when valuations are stretched, it will hedge/unhedge portions of its exposure back into rands/dollars by selling/buying JSE-traded currency futures (US dollar, UK pound and euro).
We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the local economy. However, we believe that the fund’s current positioning correctly reflects appropriate levels of caution. The fund’s yield of 9.3% remains attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.
INVESTOR NEED: OFFSHORE DIVERSIFICATION
The last quarter of 2018 brought misery to most investors as the market’s focus shifted to growing concerns around global growth prospects. December’s sell-off was the worst end to a year in the last 45 years. Q418 ended up returning negative 12.8% for the ACWI, and many markets officially entered bear market territory, with declines of more than 20% from previous highs. Long bond rates declined, given the poorer outlook for global growth, resulting in a marginally positive return quarter for the asset class.
Within equities, utilities and real estate (both beneficiaries of lower long-term interest rates) did the best in relative terms. For once, consumer staples lived up to their defensive reputation and outperformed the overall ACWI by about 6%. On the other side of the spectrum, energy was the laggard, given the spectacular drop in the price of oil. The indiscriminate selling of longer duration (higher growth) assets resulted in information technology shares being punished, while other cyclical sectors such as consumer discretionary, industrials and materials also performed poorly. The US equity market slightly underperformed the rest of the world, and surprisingly, emerging markets marginally outperformed the developed world over the quarter.
As mentioned above, long rates in the US declined against this backdrop, with global bonds producing a marginally positive performance. Credit spreads, however, widened, given the concerns over global growth, resulting in a negative quarter for credit. Global listed property yielded a negative return of 5.5% over the three-month period, which was better than equities but still disappointing, given the drop in long rates. Europe was particularly hard hit, and the UK had a disastrous period with the increased uncertainty around Brexit and a significantly poorer outlook for the sector. Commodities, as expected, had a very tough time because of global growth concerns, and gold, for once, lived up to its safe-haven status in a world of increasing uncertainty. The gold price rose by 7.5% over the quarter.
Bonds yielded a negative return of just over 1% for the 2018 calendar year, as did property with a negative 4.7% return. Gold was also marginally negative, highlighting the fact that investors really had no place to hide but in US dollar cash. There were no major moves in the currency markets over the quarter, but over the last 12 months the US dollar strengthened by about 14% against the euro, and by about 4% against the yen.
During these turbulent times, the fund did not perform well. It was down 10.7% over the quarter, underperforming its benchmark by over 3%. Most of the underperformance took place in the month of December. This was particularly disappointing given our defensive asset allocation, but a combination of stock-specific issues and a weak property market more than offset our lowish equity allocation. The fund is now slightly behind the benchmark since inception. This unsatisfactory situation is receiving our full attention, and we are determined to correct it.
Positive contributors over the year include Advance Auto Parts, a position we have now exited in favour of shares where we anticipate greater upside from current levels, on a risk-adjusted basis. Other notable positive contributors over the last year included long-time holdings such as Amazon, Alphabet and Blackstone. After a period of underperformance, Pershing Holdings also contributed positively.
Our position in the tobacco stocks were the biggest detractors, costing the fund about 2% in relative performance. Limited Brands, Tata Motors, Aspen, JD.com and Comcast were other detractors. We have exited Tata given the increasingly murky outlook for auto sales in China and we have sold out of Comcast because of the concerns around future capital allocation decision-making. The other detractors remain in the portfolio, with our assessment of upside in many of these cases being very appealing.
Spotify, the leading global music streaming platform with almost 100 million paying subscribers, is a relatively new position in the fund. We expect to see continued strong growth in Spotify’s user base, as people increasingly embrace streaming. We therefore believe that Spotify is well placed in a recovering music market that only returned to growth in 2015 (driven solely by streaming), after almost two decades of decline.
Although currently loss-making, Spotify is cash generative and has a growing cash balance of around $2 billion (9% of market capitlisation) along with a valuable stake in China’s dominant music platform, Tencent Music Entertainment (8% of market capitalisation). We believe Spotify has multi-year growth potential (management’s target is 25% to 35% per annum) and a roadmap to sustained profitability as the dominant player in a changing, but growing, global music market.
When assessing the prospects of our holdings in the fund, we are excited about their potential. The equity holdings are managed by capable executive management teams, and most of them have strong value propositions for their customers. While it is difficult to assess where we are in the equity market cycle, we see more opportunities following the recent sell-off and we have added to some of the longer-duration stories such as Spotify and Facebook.
We have also increased the equity allocation somewhat to the fund’s highest level in more than six months. We continue to be positive about the prospects for our property holdings and we are starting to find selective value in the credit market. We are clearly not satisfied with the fund’s more recent performance, but have not changed our process or philosophy, and remain confident that those factors that have yielded success over the longer term will continue to serve us and our clients well in future.
For more information, please refer to the fund fact sheets