Corospondent - July 2019
Flagship fund update - July 2019
This article is a précis of our flagship fund commentary for the quarter; for the full insight into the positioning of each fund, as
INVESTOR NEED: LONG-TERM GROWTH
DOMESTIC GENERAL EQUITY FUNDS
Top 20 and Equity
Top 20 is a focused portfolio of our top stock picks on the JSE, while Equity invests in South African as well as global equities. Both funds are suited to investors with a long-term horizon who are seeking high growth and can ride out short-term volatility.
During the second quarter of 2019 (Q2-19), the JSE extended its first-quarter gains, albeit at a slower rate. Despite the conclusion of the much-awaited South African election, domestic sentiment deteriorated during the second quarter of 2019. The election result was broadly in line with expectations, with the ANC maintaining its majority rule despite a slight decline in support. The appointment of a new and smaller cabinet was a positive development, reinforcing the message of fiscal discipline. However, the ruling party remains plagued by factional tensions. Policy uncertainty lingers, and Eskom’s balance sheet problems remain an overhang. These factors combined to weigh on consumer and corporate confidence levels and were reflected in a very weak Q1-19 GDP print of -3.2%, dragged down by manufacturing and mining. Results released during Q2-19 and the accompanying subdued rhetoric of management reinforced how challenging the underlying economic situation is. The weak domestic economy contained inflation and favourable global interest rate expectations have increased the likelihood of local rate cuts.
In this environment, domestic stocks reported weak results. Even defensive stocks struggled to defy the pressures of several years of weak domestic economic conditions and high structural cost inflation. We expect these headwinds to persist and remain cautious on businesses heavily exposed to the domestic economy. We continue to debate whether these depressed conditions (and earnings bases) provide an opportunity to add meaningfully to domestic holdings but have made no material changes as yet.
The British American Tobacco share price declined during the period as fears related to low nicotine regulation in the US market resurfaced. However, new-generation products are gaining traction. We believe the underlying fundamentals of the business remain intact, and that new-generation products are lower-risk products and present an opportunity to grow the overall market. At current levels, the share offers a 7% to 8% dividend yield. We believe this to be very attractive for a stock of this quality and it remains a large position in the fund.
Within resources, Sasol’s share price declined meaningfully (-22%) when the company announced further headwinds to its already beleaguered Lake Charles Chemicals Project, and we added to the position on the back of this price weakness. However, we have limited its size in our portfolios due to heightened risks. Conversely, we saw strong performance from the gold miners (+29.6%) and platinum (+9.5%). Iron ore (+32.9%) has been particularly strong as supply disruptions have driven up near-term prices, supporting the fund’s large holding in Anglo American.
We remain meaningfully invested in platinum counters. We reduced our Anglo American Platinum position in response to its strong share price rise, reinvesting the proceeds into names that have underperformed on a relative basis. The demand outlook for platinum group metals (PGMs) remains strong, buoyed by increasingly stringent emissions regulations.
The financial sector (+5.4%) performed strongly, as local banks (+9.7%) defied domestic market headwinds and are expected to deliver underlying earnings growth. This growth reflects prudent management through the cycle, with limited credit extension resulting in low credit loss ratios. We hold several of the large banks, including FirstRand, Nedbank and Standard Bank.
Global equities performed well, supported by a large holding in Heineken, which has performed strongly and is a business that has consistently focused on putting investment behind its long-term prospects, building a powerful brand. This approach should deliver a combination of strong revenue growth and margin expansion over time from premiumisation and operating leverage. Heineken’s ability to compound earnings over time makes for an attractive investment opportunity in our opinion.
Political turmoil continued to reign in the UK and high levels of uncertainty undermine the economic outlook. Despite this, compelling valuation-driven opportunities exist. Quilter remains the largest single holding in the UK. This is a business with a structural growth opportunity stemming from pension reform in the UK market. While we see exciting investment opportunity in the UK market, the funds continue to tightly manage overall UK exposure, given the Brexit-related uncertainty.
Markets have remained challenging this year, with several companies reporting material earnings disappointments that have put these businesses at risk. A rigorous research process and heightened balance sheet scrutiny have protected the fund from several of these examples. We remain committed to building robust, diversified portfolios with a focus on risk management. We believe these efforts will protect the portfolio against unexpected outcomes and position the fund well to deliver inflation-beating returns over the long run.
MULTI-ASSET CLASS FUNDS
Balanced Plus and Market Plus
Balanced Plus and Market Plus offer long-term investors access to a diversified portfolio of local and international assets. While Market Plus has a stronger bias towards shares, Balanced Plus complies with retirement regulations, which limit exposure to risk assets. Both funds are suited to investors with a longer-term time horizon seeking growth.
Equity markets continued to rise in the second quarter of 2019 (Q2-19) as central banks communicated a strong likelihood of rate cuts and US-China trade war tensions eased towards the end of the period. The funds have benefited from its large exposure to global equities.
Global bond yields continued to rally in response to increasing evidence of a slowdown in global growth and rising expectations of interest rate cuts in the US and Europe. US 10-year bond yields have now traded down more than 100 basis points (bps) since November 2018 and the debt of several European sovereigns is trading at negative rates. Although global bonds have performed well, we remain of the view that yields are too low, and the risk of capital loss is considerable.
In our offshore exposure, we generally have been well positioned and contributed to performance.
In our local equity portfolio, we have maintained a solid weighting to resources, which have continued to perform well. Our very low exposure to Sasol has proved highly beneficial and with the share price now below R350, we are starting to add the counter. We remain meaningfully invested in platinum counters.
The poor performance of the South African economy remains a very worrying trend, and while share prices and earnings have collapsed in most sectors, the lack of identifiable growth opportunities leaves us still cautious on moving too quickly to invest in a local turnaround.
An area that does look compelling is the real yields available in the local bond market. Our real yields of c. 4% are the highest globally and above a number of other emerging markets that are already rated subinvestment grade. We think the concerns over the potential downgrade by Moody’s are overdone.
INVESTOR NEED: INCOME AND GROWTH
Capital Plus and Balanced Defensive
Capital Plus seeks to offer reasonable growth over the medium to long term, while preserving capital over any 18-month period, while Balanced Defensive is slightly more conservative and first seeks to protect capital and then achieve reasonable growth in the long term. These funds suit investors who want to draw an income over an extended period of time.
Capital Plus delivered a satisfactory year to date return of 6.8% (not annualised), while Balanced Defensive returned 6.3% (not annualised) over the same period.
Over the quarter ended June 2019 (Q2-19), the global economy showed more signs of slowing and the market consensus clearly shifted to pricing in a future material relaxation of monetary policy. It is this prospect of lower interest rates that propelled stock and bond markets to deliver very strong returns for the quarter and year to date.
Expectations of lower interest rates also spilled over to South Africa, where the stronger rand and contained inflation is very has allowed the South African Reserve Bank (SARB) the room to start cutting interest rates – announcing a 25bp cut on 18 Julys. Bonds and equities responded favourably to this improved outlook, as well as to the successful conclusion of the elections and the subsequent announcement of the new cabinet. Over the quarter, the FTSE/JSE All Share Index gained 3.9%, the All Bond Index (ALBI) 3.7% and listed property 4.5%. Although listed property had a good quarter, the returns over the past year are barely positive and remain negative over the past three years. The rand, which strengthened by 3% over the quarter, had the effect of lowering the impact of the strong US dollar returns of global markets.
The stocks that contributed the most to performance over the past year are Anglo American, Altron, platinum stocks Northam Platinum and Anglo American Platinum and our bank holdings of FirstRand and Standard Bank. Detractors from performance include British American Tobacco, Aspen, Sasol and Shoprite.
British American Tobacco is a stock that we have held in the portfolio for many years. We acknowledge that tobacco companies face structural volume declines. This would be a material headwind to most businesses, but tobacco companies have the pricing power to offset these declines. In addition, the shift to new-generation products and demonstrated ability to cuts costs will enable this company to protect and grow its earnings over time. The stock is, however, out of favour with investors and trades on a dividend yield of almost 8%. At this valuation, we find it very attractive.
The past quarter was one of limited trades. We sold more Hammerson property and bought a currency future to hedge against a potential weaker UK pound in the event of either a no-deal Brexit, or a new election and the prospect of Jeremy Corbyn as prime minister. Either event could result in a far weaker pound with a negative impact on the prices of some of the London-listed stocks we own, such as Hammerson, Capco and Intu. Total exposure to the London-listed property market has been trimmed to 1% of portfolio and that is now fully hedged. We also added to our existing platinum exchange-traded fund, as we feel the gap between platinum and palladium has become too large.
The portfolios continue to hold a substantial weighting in South African bonds, both fixed rate and inflation linkers. The high real yield is very attractive and provides a solid risk-adjusted building block towards achieving the targeted inflation plus 3% return.
INVESTOR NEED: IMMEDIATE INCOME
For deeper insight into Strategic Income, please refer to the article on page 31 of this edition of corospondent.
Strategic Income is a managed income fund that invests across the full range of income-generating asset classes such as government, corporate and inflation-linked bonds, listed property, offshore bonds, money-market negotiable certificates of deposit (NCDs) and preference shares. The main aim of the fund is to produce a consistent and reliable return for investors with immediate income needs.
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 8.6% remains attractive relative to its duration risk.
The fund maintains some 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).
On the local front, inflation should average 5% until the end of 2021 due to the poor demand environment and subdued services prices. Subdued growth and inflation expectations should allow the SARB to reduce interest rates by around 0.5% over the next six to nine months, which is supportive for local bonds (the first cut of 25bps was announced on 18 July). However, given the slow nominal growth environment and the need for more extensive support for state-owned enterprises (for example, Eskom), government finances are set to deteriorate even further.
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. The fund continues to hold decent exposure to these instruments (less floating than fixed), but we will remain cautious and selective when increasing exposure.
In the last quarter, as evidenced by the performance of the various sectors of the ALBI, longer-end South African government bonds (SAGBs; 20- to-30-year area) materially underperformed 10-year SAGBs. SAGBs are most likely to exit the Citigroup World Government Bond Index in the next 12 months, as pressure mounts on Moody’s to move South Africa into subinvestment territory. Therefore, in a conservative fund it is prudent to maintain a neutral to slightly underweight allocation to SAGBs at current levels. Any exposure to South African bonds should be taken in longer-dated SAGBs and shorter-dated inflation-linked bonds.
The local listed property sector was up 1.5% over the month of June, reducing its loss for the rolling 12-month period to -5.1%. Listed property has been the largest drag on the fund, primarily due to generalised equity weakness and idiosyncratic domestic issues. In the event of a moderation in listed property valuations, we will look to increase the fund’s exposure to this sector at more attractive levels.
The Preference Share Index was up 2.0% over the month, bringing its 12-month return to 19.7%. Despite attractive valuations, this asset class will continue to dissipate, given the lack of new issuance. The fund maintains select exposure to certain high-quality corporate preference shares, but will not actively look to increase its holdings.
We continue to believe that the fund’s 8.6% yield is an adequate proxy for expected fund performance over the next 12 months. As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium to limit investor downside and enhance yield.
INVESTOR NEED: OFFSHORE DIVERSIFICATION
Global Managed aims to achieve good long-term investment growth by investing in a range of opportunities available in public asset markets from around the world. It may suit investors who are seeking long-term growth with the appetite for short-term volatility.
Since the beginning of the year, the fund has returned 13.9% in US dollars (well ahead of the benchmark) and since inception it is still ahead of its benchmark, despite its heavy cash and low bond exposure over this period. The fund was defensively positioned over the second quarter of 2019 (Q2-19) and hence partially missed out on the continued bull market in equities. During Q2-19, global financial markets continued to be dominated by a shift in investors’ interest rate expectations and the unfolding trade war saga. Markets are now discounting almost three cuts of 25bps each in the US before the end of the year, a stark contrast to only six months ago when the expectation was for at least one rate increase during the calendar year.
Markets continued to take comfort from these dovish developments by bidding up risky assets, and developed markets once again outperformed over the quarter, with the emerging market universe negatively impacted by the trade war developments and some of the country-specific issues referred to above. The US was the star performer, with some help from stronger earnings growth than seen in the rest of the world and a further re-rating in the market.
Fixed interest assets performed well, and listed property had a muted second quarter, while gold had a strong quarter, which was not surprising given the lower opportunity cost on the shift in forward interest rates and the continued political uncertainty. Most industrial metals had a poor quarter on the back of a weaker growth outlook, except for iron ore where supply disappointments supported the price. The oil price was down slightly this quarter after a strong first quarter.
Over the quarter, long-held equity positions such as Blackstone, Charter Communications, Adidas and Carlyle contributed the most to fund performance, with British American Tobacco (after a strong first quarter) and Intu (and other property holdings) detracting the most. Some of the other notable contributors over the longer term include Altice US, Facebook, Airbus and Pershing Square. Other detractors were Aspen, L Brands and Imperial Brands.
Our fixed interest positioning was also too conservative, but the gold position contributed strongly. Stock selection in the property bucket detracted, as we still favour those portfolios with higher retail exposure, given that we believe they offer compelling value. We continue to be reasonably conservatively positioned in terms of asset allocation. We are concerned that the benign interest rate outlook may not materialise and could be very disappointing to investors who are expecting central banks to come to their rescue.