Corospondent - January 2020
Flagship fund update - January 2020
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.
In stark contrast to the last quarter of 2018, the final quarter of 2019 (Q4-19) finished on a strong note, with general support for risk assets globally as sentiment improved on easing of the trade tensions between the US and China. The Equity Fund returned 17.2% and Top 20 delivered 15.9% in 2019 (For full performance details, refer to the fund facts sheets)
While 2019 was a much better year for South African equities, medium-term returns for domestic growth asset classes remain below average. The JSE’s returns were boosted by the South African resource sector, which gained 28.5% for the year. Industrials and financials were considerably weaker, delivering 8.9% and 0.6%, respectively, for 2019 as a whole, with the higher domestic exposure of the financial sector weighing on performance.
It was pleasing to see shares that detracted from performance in 2018 contributed strongly in 2019. Most notable among these were the platinum group metals (PGM), with portfolio holdings Northam (+186%) and Impala (+291%) up particularly strongly. Other notable performers for the year include our Equity portfolio’s global holdings, while Quilter (+38%), British American Tobacco (+36%), Naspers (+22%) and Anheuser-Bush InBev (+23%) contributed to the performance of both the Top 20 and Equity funds. Both portfolios’ underweight positions in domestic businesses contributed positively, as the challenges of a lacklustre consumer environment and persistent structural cost inflation eroded earnings.
Naspers had a busy year with the unbundling of Multichoice; the establishment of Prosus – an Amsterdam-listed entity that houses its international assets; unbundling of a portion of Prosus (26%) to shareholders; and a bid for Just Eat, a multinational food delivery player. Due to the attractiveness of the underlying assets and the holding company discount, Naspers and Prosus constitute a significant holding in our portfolios. Their major asset, Tencent, is growing rapidly in online payments and financial services, a market segment many times larger than the gaming market they currently dominate.
British American Tobacco continued to deliver on its strategy, growing revenues, widening margins and through strong cash conversion. This was despite the fact that US regulators are becoming increasingly concerned over youth recruitment and the potential harm of alternative tobacco delivery methods like vaping. The magnitude of the threat posed by this category to its traditional business now looks reduced.
Platinum-group companies benefited from rising prices given growing demand and a limited supply response, the remedy to which will require significant capex with long lead times. While we have cut our holdings into price strength, we still have meaningful exposure. Northam’s strength also reflected an easing of investor concerns on the overhang of the BEE deal funding, which becomes less dilutive at a higher share price.
In contrast to the big winners, most of the South African-focused companies that we did own performed poorly. Similarly, the fast-moving consumer goods (FMCG) retailers continued to struggle to show any share price appreciation, despite delivering commendable results in a tough environment. This has allowed us to build meaningful positions in what are very high-quality cash-generative businesses at attractive valuations. FMCG retailers are far less sensitive that retailers are to the performance of the domestic economy and should also benefit from the pick-up we have seen in food inflation recently. In addition, in the case of a retailer such as Shoprite, stock-specific issues, which should not recur, will see earnings pick up without much help from top-line revenue growth.
Sasol (which we discussed in detail in the previous edition of Corospondent) suffered a tumultuous year, collapsing on the back of further cost overruns relating to the Lake Charles Chemicals Project and a delay in its financial results. The share has rebounded c. 20% off its recent lows. We continue to manage the position size carefully as risks in the company remain high.
Distell was the standout in our basket of South African stocks last year. The company has defended and grown its market share without having to resort to sacrificing margins, resulting in a pleasing growth in profitability. Looking ahead, we should see further growth in profitability as its African operations return to more normal operating margins. It remains a solidly defensive and strongly cash-generative investment. You can read more about our investment case on page 17.
While it was pleasing to see market recognition of the value inherent in some of the funds’ larger positions during 2019, we continue to see attractive opportunities for disciplined, long-term investors that should generate inflation-beating returns overtime.
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.
Global equity markets rose strongly in 2019 in response to looser monetary policy in the US and Europe, and trade war fears receding. All eyes remain on US President Donald Trump as he stands for re-election in 2020 and the reverberating effect his policy will have on US-China tensions. Elections in the UK saw a stronger-than-anticipated majority for the Conservative Party under Boris Johnson and moved the country closer to a withdrawal from the EU in January 2020. Emerging markets also performed strongly in US dollars in 2019 and Q4-19. Notable performances included Russia (+53%), Brazil (+26%) and China (+24%).
Locally, investor confidence remains weak, as impatience has set in with the slow pace of much-needed reform. The plight of Eskom remains concerning and unplanned outages pose a major threat to economic growth. The severe loadshedding experienced in December is expected to have taken a toll on retailers’ Q4-19 earnings. Growth continued to disappoint, with a contraction in both the first and third quarters of 2019. Low domestic growth and low inflation (3.7% CPI for 2019) should lead to rate cuts. However, the South African Reserve Bank has been reluctant to cut rates, believing that dovish monetary policy will have a limited impact, given the high structural impediments to growth. As a result, real yields of local bonds are at very attractive levels and they therefore have a meaningful role to play in our multi-asset portfolios.
We are more cautious on domestic property, where we expect companies to struggle to show distribution growth over the medium term as high rentals that are up for renewal are rebased to market levels.
Equity exposure was the big driver of performance for both funds, with the strongest return coming from our exposure to global emerging markets, followed by developed market equity exposure. The South African equity market also delivered good returns, albeit less than the other equity allocations within the funds. We are especially pleased with the significant alpha added over and above the market returns.
We have continued to trim the global equity exposure as developed markets, in particular the US, have delivered very strong returns and look fairly fully priced. In contrast, we have maintained our emerging market exposure as we think the majority of these markets remain cheap and should benefit from an improved global trade environment as well as a potentially weaker dollar in the years ahead.
We have added to our South African equity exposure where we have consistently held an overweight position in global companies listed on the JSE and particularly resource shares. Taking into account our direct offshore exposure as well as our high exposure to global companies in our local equity holding, we still have fairly low exposure to pure domestic assets.
We have moved quite quickly to build up a meaningful position in longer dated local government bonds. The budget risks and likelihood of a sovereign downgrade are all well known, and in our view, fully priced into the bond market. South African bond spreads over equivalent US treasuries are well above other sub-investment grade issuers. With inflation sticky at around 4%, the opportunity to pick up domestic bonds with real yields in excess of 5% is a very attractive investment, with relatively low risk. Given the lack of absolute return in the global bond space, we have virtually no bond exposure outside of South Africa.
Our property allocation remained static, as we prefer to take our yield exposure in the bond market. Having said that, we do see yields looking attractive, now even in the blue-chip property names. This is an area that we will watch closely in the new year. Globally, we hold positions mainly in European real estate investment trusts where yields are significantly above sovereign bond yields, offering attractive returns in hard currencies.
We continue to manage the funds in a cautious manner but look to take advantage of the significant mispricing of assets. The mix of different jurisdiction equity positions, combined with high yielding local bonds makes for a portfolio that should be able to ride out the tumultuous period ahead, delivering growth and yield to continue beating inflation.
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.
The funds exceeded their ‘inflation plus’ targets for the year, but they did not succeed in taking the three- and five-year returns to the targeted level. Since inception, the fund returns remain comfortably ahead of their targeted returns.
Major contributors for the year include Northam Platinum, Naspers, British American Tobacco, Anglo American, Altron (in the case of Capital Plus) and Anheuser-Busch InBev (in the case of Balanced Defensive). Detracting from performance were Sasol, Shoprite, Nedbank, Advtech and Woolworths. The contributors far exceeded the detractors and the funds’ equities delivered returns of between 9% and close to 11% for the year. Domestic bonds delivered a total return of roughly 9.5% (in both funds), but property investments lost 13% (in the case of Capital Plus) and 4% (in the case of Balanced Defensive) of its value. Foreign assets were the best performing asset class in both funds, with a total return of between 19% and 21%.
We increased our exposure to the local bond market due to the highly attractive real yields on offer. The bond component of our portfolios carries a yield of more than 9%. While we do expect inflation to rise somewhat from the current sub-4% level, it leaves us with a comfortable margin of safety. The high yields in the domestic bond component helped to keep us below the maximum offshore exposure, where yields are extremely low. The high real yield on bonds is also an argument for limiting domestic equity exposure to less than our maximum allowed.
It remains difficult for companies linked to the local economy to grow earnings due to a lack of top-line growth in almost every sector. While the earnings base is low and ratings generally attractive without a rise in confidence, spending will remain depressed. Our exposure to equities remains skewed towards the global stocks listed on the JSE, such as Naspers, British American Tobacco, Anheuser-Busch InBev and others. Exposure to the so-called ‘South Africa Inc.’ stocks is held mostly through banks and defensive retailers.
Looking forward, we are of the view that the targeted ‘inflation plus’ returns are achievable. The bond component alone has a high enough yield to deliver the required real return and is supported by a good selection of quality domestic and global equities that are reasonably valued. It is, however, crucial that government passes a budget early in the new year that adequately addresses the deteriorating fiscal situation. Some tough decisions need to be made to curtail spending and stop the bleeding at the State-owned enterprises (SOEs). Lower interest rates will also help the economy and should be viewed positively by the markets.
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 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 due to a compression in credit spreads. There has been a reduced need for funding from local banks 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. The fund continues to hold decent exposure to these instruments (less floating than fixed), but we remain cautious and selective when increasing exposure.
Inflation is expected to average close to 4.5% over the next two years, while growth is not expected to reach 1.5% until 2021 (South Africa’s growth has averaged sub-1% since 2015), while global growth is expected to average just above 3%. The Monetary Policy Committee (MPC) has reiterated that it wants inflation closer to the midpoint, so that it can use monetary policy more effectively during times of crisis. South Africa’s economy is struggling to grow and although monetary policy is a blunt tool, it can be used to boost confidence and relieve some consumer pressure.
Local bond and equity markets underperformed their global peers. The domestic economy has been plagued with low growth, ballooning government finances and a volatile global geopolitical environment. Low growth and well-contained inflation suggest the trajectory for policy rates to be lower over the next 12 months. In addition, local bonds have continued to underperform relative to their global and emerging market counterparts, suggesting an increased risk premium given South Africa’s precarious economic backdrop. At current levels, South African government bonds seem adequately priced relative to underlying risks, which suggests a neutral allocation in portfolios.
Moody’s is the only ratings agency that has South Africa as investment grade, which keeps us in the World Government Bond Index (WGBI). However, it is very likely that they will downgrade South Africa in 2020, which should see outflows from the local bond market of between R70 billion and R120 billion. This may seem like a big negative but we should not forget that South Africa has a very deep, liquid bond market; a large, sophisticated saving industry; that this deterioration and associated risks have been well flagged over the last few years, so investor positioning has adjusted accordingly; and that South Africa is less than 1% of the WGBI, so at current valuations, investors might choose not to exit. And, even if the 2020 February Budget fails to restore confidence and South Africa does exit the WGBI, it does not mean the end of the world for South African government bonds. It is more likely that we will see some fiscal effort in the budget and with regard to SOEs, which will at least keep policy trajectory headed in the right direction.
Listed property has been the largest drag on performance. From a valuation perspective, the sector remains attractive. If one excludes offshore exposure, the property sector’s yield is greater than 10%, which compares favourably to the benchmark bond. The fund maintains holdings in counters that offer strong distribution and income growth, with upside to their net asset value. In the event of a moderation in listed property valuations (which may be triggered by further risk-asset or bond-market weakness), 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.
2019 was a year to make money. In fact, of the 38 asset classes Deutsche Bank tracks, all were up on an annual basis – the first time this has happened since the inception of the dataset in 2007. In the face of inverted yield curves, ongoing US-China trade tensions and Brexit drama, the US stock market posted its strongest gains since 2009 – in the 11th year of this bull market! On reflection, it was very hard for investors not to post gains.
Years like this are beneficial to wealth creation. But after a sustained period of strong equity returns, declining interest rates, reduced tax rates, expanding profit margins and rising valuation multiples, investors should, in our view, recalibrate return expectations lower. The conditions in place today are quite different to those in place a decade ago. We have no special insight into short-term market moves, but feel that absolute returns could very well be lower over the next 10 years compared to the last 10.
In the case of Global Managed, strong equity markets combined with good stock selection were the primary drivers of the fund’s strong return in 2019. Global equity markets returned 26.6%, with the portion of our portfolio invested in equities outperforming by a handsome 15%, delivering 41.9% for the year.
Despite the fund’s current equity weighting (60%) being approximately equal to that of its benchmark, it is important to note that, in aggregate, Global Managed looks very different to the benchmark. Although we will be held to our benchmark over time, our aim and intention in managing the fund has a number of additional dimensions:
- Deliver attractive absolute returns (meaningfully ahead of inflation).
- Offer some downside protection from equity market volatility (though with equities as a core building block, investors in the fund should not expect to be fully shielded from market sell-offs).
- Do not expose the fund to excessive risk, even if such exposures are large in the benchmark (such as developed market government bonds today).
Executing on these additional dimensions over time will, in our view, not only lead to a satisfactory return outcome, but one that continues to be ahead of the benchmark.
Our property stocks recovered in Q4-19, but the annual return remained disappointing. Considering the minimal risk carried, we are satisfied with the 3.4% fixed income return for the year, even though it lagged the benchmark. Prices for most fixed income assets have been pushed to very high levels, in our view, and we will continue to hold very little duration or interest rate risk until value emerges. Finally, gold was a notable performer, increasing 18% for the year.
You can read more about our current portfolio construction in the comprehensive fact sheet.
In the case of Optimum Growth, the fund ended Q4-19 with a 72% net equity exposure, equivalent to that of the prior quarter-end. Of this net exposure, 61.2% was invested in developed market equities, 33.1% in emerging market equities and 5.7% in South African equities.
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 accompanying risk. Only 4.8% of the fund is invested in bonds.
The fund also has 4.3% invested in global property and a physical gold position of 2.7%. The balance is invested in cash, largely offshore.
As has been the case for many years, the bulk of the fund (over 90%) is invested offshore, with very little exposure to South Africa.
You can read more about our current portfolio construction in the comprehensive fact sheets.