Corospondent - October 2019
Flagship Fund Update - October 2019
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 our Equity fund invests in South African and 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.
Overall, the JSE experienced a disappointing quarter. The weakness was broad based, but the financial and resource sectors fared the worst. Our equity holdings, skewed towards the global stocks that happen to be listed on the JSE, performed well on a relative basis. We have used the weakness during the quarter to add to positions.
Recent domestic economic data reinforced how dire the underlying economic situation really is. This has flowed through to corporate earnings and we have been bombarded with company profit warnings over the quarter. Investor and consumer sentiment continue to remain very weak and government urgently needs to deliver on much-needed structural reform to restore consumer and corporate confidence and kickstart the economy. However, it is in this tough environment where active management can add significant value and we remain excited about the positions in the funds and the potential for good long-term returns from these levels.
The listed platinum miner Northam Platinum delivered a return in excess of 40% this quarter as the price of the overall platinum-group-metals (PGMs) basket rose, and the company showed improving results and strong cash generation. The fundamentals driving the higher prices in the PGM markets remain firmly in place, as continued demand from automobile manufacturers due to tightening emissions standards meets declining supply from an industry that has not invested in new mines for close on a decade.
Limiting our portfolios’ exposure to Sasol was beneficial this quarter. The Sasol share price is down 54% over the past 12 months as further cost overruns relating to the Lake Charles Chemicals Project (LCCP) emerged. Management also had to announce a delay in the reporting of their full-year results to further investigate a breach of internal controls. As it stands, we have yet to see Sasol’s June year-end results, but we believe that the delay is as a result of control weaknesses identified around the project budgeting process and is not centred around the financial statements themselves. Although further cost overruns are unlikely, our biggest remaining concern is that the budgeted profitability for LCCP disappoints on the back of ramp-up issues or pressure on commodity prices. Nevertheless, we expect the company to now shift to a phase of debt reduction and improved free cash flow generation. Sasol trades on four times 2021 earnings, calculated using relatively conservative currency and oil price assumptions. This is very attractive for a business of its quality. We have used the share price weakness to increase our exposure, but remain cognisant of the risks surrounding recent announcements and are managing the position size carefully.
South African-facing companies struggled in the quarter. The sentiment locally remains poor, and the brutally tough economic environment means there is very little revenue growth to be had for purely South African companies. Foreign investors have generally been sellers, putting more pressure on the share prices of most domestic stocks.
During the quarter, Naspers listed and part unbundled 26% of Prosus to its underlying shareholders in an effort to try and narrow the discount at which Naspers trades relative to its underlying intrinsic value. A foreign listing of Prosus will assist Naspers in pursuing its ambitions to become a leading global consumer internet business by giving it access to a wider pool of investors and capital. Furthermore, the two-tier corporate structure provides Naspers with more financial flexibility and the ability to more efficiently manage the discount to its underlying intrinsic value by using capital allocation tools such as share buybacks. In this corporate action, we elected to take the full allotment of Prosus shares, given the potential value unlock opportunity.
Global macro conditions remain fragile, as trade wars and extreme political events remain prevalent. Charter Communications (Charter) is a relatively new addition to the Equity fund and is already one of our largest international holdings. It has performed well since its introduction and is up 12% in rands over this quarter alone. Read more in the article about Charter.
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.
It has continued to be an exceptionally difficult market, with many asset classes struggling. Against the backdrop of a slowing global economy, an escalating trade war and a revival of central bank stimulus measures, the MSCI All Country World Index ended the quarter flat in US dollar terms. Geopolitical risk in the Middle East, with escalating US-Iran tensions and a missile strike on a Saudi oil refinery – which is responsible for almost 5% of world oil supply – added to equity market volatility during the quarter.
The FTSE World Government Bond Index appreciated by just under 1% in US dollars for the quarter. In September, the European Central Bank (ECB) announced its biggest package of rate cuts and economic stimulus in three years as President Mario Draghi warned governments that they needed to act quickly to revive flagging eurozone growth. Soon thereafter, the Federal Reserve Board (the Fed) also cut rates by a further 25 basis points (bps), although the accompanying commentary was more hawkish than the market was expecting. Negative interest rates have led to significant distortions in asset markets. Currently roughly $15 trillion of global debt trade at negative yields – meaning you are likely to lose money if you hold these instruments to maturity. The extent to which central banks continue to distort debt markets is concerning and we remain cautious on the outlook for global bonds. Read more analysis on the bond yield curve.
During September, the South African Reserve Bank (SARB) held the policy rate unchanged at 6.5%, but the SARB's statement was more dovish than in July when it did cut rates. Although the SARB’s view is that monetary policy is not the solution to South Africa's poor growth outlook, we believe that given the weak domestic economy, contained inflation and favourable global rate expectations, the SARB has room to further cut rates. Against this challenging economic backdrop, the rand weakened by almost 7% against the US dollar. The portfolios were well positioned for this move.
With local bond yields ticking up, the All Bond Index returned only 0.7% for the quarter. However, over the past year bonds have performed strongly (up 11.4% over the rolling 12 months). Given the attractive real yields, local bonds continue to offer reasonable value. The property stocks have been battered by the weak economy, which is playing itself out through increasing vacancy levels, large rental reversions and reduced rental escalations. Much of the sector will struggle to show any distribution growth over the medium term.
While the banks we own all showed decent earnings numbers for the half year, they have all sold down further as concerns over the general outlook for South Africa, and worries over potential debt downgrades, has weighed on sentiment. Large rand-hedge stocks such as Naspers (flat), British American Tobacco (+14%), Anheuser-Busch InBev (+16%) and Bidcorp (+6%) held up well.
We continue to be optimistic about the return potential of the portfolios and we feel that forward-looking returns can be significant. A number of the positions in the portfolios are now very attractively priced and should be able to deliver strong returns over the next several years.
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 over 12 months 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.
This quarter, we have seen the continuation of a very volatile and unpredictable global environment. The escalation of the US-China trade war and the unfolding Brexit soap opera has been further compounded by rising tensions in the Middle East and ongoing protests in Hong Kong. While these events have played out, the outlook for global growth continues to slow. Policymakers are trying to support the global economy, with more central banks around the world cutting interest rates, led by the Fed and the ECB. As a consequence, sovereign debt yields are trading at zero to negative real rates and we have even seen some corporates issue bonds with a zero coupon. This is an unusual state of affairs, and, as such, we think the global bond space is not attractive from a risk-return perspective.
South Africa’s economic outlook continues to be muted, despite many self-help options. The lack of political will to implement urgently needed reform at state-owned enterprises (Eskom in particular) has been disappointing. It is difficult to see how business and consumer confidence will return with continued inactivity on this front. Our base case is that the South African economy will continue to show lacklustre growth until these structural issues are addressed.
Given this context, the funds’ positioning is weighted towards local fixed income assets. This exposure has been a positive contributor to the portfolios’ performance for the quarter. However, both South African equity and South African property produced negative returns in the quarter.
During the quarter, we took the opportunity to increase our local equity exposure marginally by adding selectively to some domestic equity counters where valuations have become too cheap to ignore. An example of this would be Dischem, which we think is well positioned to show organic growth as well as take market share from independent pharmacies. The combination of robust earnings growth and a strong balance sheet means that this share presents attractive long-term upside. Dischem is one of the few shares that can show growth in a stagnant South African economy.
We remain very selective in our domestic equity holdings and our local allocation is thus weighted towards rand-hedge shares.
We have largely maintained our offshore exposure in the portfolios. This has been a positive contributor to performance this year and we have trimmed some of our holdings on the back of strong returns generated.
We think the portfolios are correctly positioned to navigate this uncertain environment. As we have already seen this year, it is not easy to predict the most accurate political or economic outcome, but with the balanced mix of risk assets and yielding assets, our funds can meet their return targets.
INVESTOR NEED: IMMEDIATE INCOME
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 8.48% remains attractive relative to its low duration risk.
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). These instruments are used to adjust the fund’s exposure synthetically, allowing it to maintain its core holdings in offshore assets. This has the added benefit of enhancing the fund’s yield when bringing offshore exposure back into rand.
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 100bps in the three-year area and 110bps 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.
Overall, inflation pressure remains benign. Given this and ongoing low growth, the market still sees some room for policy rate easing in the coming months. The Medium-Term Budget Policy Statement at the end of October and the Moody’s credit review in November remain key event risks the SARB will be monitoring before its next Monetary Policy Committee meeting in November.
The global environment remains supportive for emerging markets and South Africa, especially given the renewed monetary policy easing embarked on by global central banks. However, South African government bonds (SAGBs) trade at fair value at best and have a limited margin of safety against a turn in global sentiment or a worsening in local economic conditions. Therefore, it is prudent to maintain a moderate allocation to SAGBs at current levels.
Listed property has been the largest drag on the fund’s performance. Despite the underperformance, from a valuation perspective, selected counters remain attractive. The fund maintains holdings in shares that offer strong distribution and income growth, with upside to their net asset value. 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.
Despite attractive valuations, the preference share asset class will continue to dissipate, given the lack of new issuance as bank issues risk being classified as eligible loss-absorbing capital (only senior to equity). 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 yield of 8.48% is an adequate proxy for expected fund performance over the next 12 months.
INVESTOR NEED: OFFSHORE DIVERSIFICATION
Global Managed & Optimum Growth
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. Optimum Growth aims to maximise long-term investment growth by investing in a range of opportunities available in public asset markets from both South Africa and around the world. Our intent is to provide competitive after-inflation returns measured in rand over all five-year periods.
The narrative around the short-term driving forces of global equity markets has not changed materially since the previous quarter, nor since the beginning of the year. Investors are still fixated by the anticipation of lower interest rates in the US and the ebb and flow of trade war rhetoric between the US and its major trading partners. During the third quarter, these variables resulted in essentially a zero-return generated by global equities. The year-to-date benchmark index return (MSCI Country All World Index) of 16.2% speaks more to a low base from the fourth quarter of last year (the 12 months lagging return is only 1.4%) than to better news on the economic or corporate profits fronts. The three-year return of 9.7% p.a. is slightly above long-term averages.
The US equity market continues to perform better than its counterparts around the world. It has outperformed Europe by 6.5% over the first nine months of the year and by over 4% over the last 12 months. The performance of its financial sector relative to that of Europe, as well as the strength of the information technology (IT) sector in the US explains the majority of this outperformance. Japan had a better quarter in relative terms, but still lags the US materially over longer periods.
Emerging markets continue to underperform their developed market peers, primarily as a result of poorer corporate profit growth and some self-inflicted economic pain. Emerging market currencies have been reasonably strong.
Global bonds continued to rally, reflecting lower yields, as concerns about global growth prospects lingered, with no visible signs of inflationary pressures in the developed economies. However, in dollar terms, most bond markets generated negative returns as a result of the stronger US dollar. Over the last year, global bonds have generated very strong returns despite the stronger US dollar over this period. Our negative view on global bonds remained unchanged as a large portion of developed market sovereign bonds offer negative yields to maturity, with the follow-on effect that most corporate bonds also offer yields which do not compensate you for the risk taken.
Global property performed well over the quarter, handsomely outperforming equities, and, over the last 12 months have now generated better returns than equities. Japanese property stocks did the best, with the US not far below. Hong Kong Real Estate Investment Trusts and developers lost value in the light of the escalation in violence in the territory.
The US dollar continues to strengthen against its major trading partners, causing more angst in the Trump administration about the competitiveness of US exports. The Japanese yen was the only major currency that strengthened against the US dollar over the last year.
In light of the increased global uncertainties, it is not surprising that gold continued to do well, generating a positive return of almost 4% over the quarter. However, given the extent of the perceived risks around the globe, we are slightly disappointed by the performance of the precious metal.
We continue to be excited about the prospects for our holdings, tempered somewhat in the short term by being mindful that the world is a volatile place right now.