This quarter will be remembered for a number of records; none of which we would ever want to repeat. Globally this will go down as the worst first quarter in stock markets in recorded history. In the US, the S&P 500 Index recorded the fastest bear market (defined as a 20% fall) in history, compared to 1929 when it took 36 days. This was followed shortly thereafter by the highest ever print in unemployment claims in the US.
What this has meant for the funds is that it has been a torrid quarter for absolute performance, with Market Plus and Top 20 declining by 17.7% and 20.5%, respectively, since the beginning of the year. It is cold comfort to us that we have managed to outperform benchmarks (the Top 20’s benchmark fell by 22.9% this year).
One of the best performing counters has been our large overweight position in Naspers/Prosus. Despite being domiciled in China, where the original virus outbreak occurred, this company benefited, as its main source of revenue is virtual products (gaming, video, music, online content, etc.), all of which was uninterrupted and, in fact, generally boosted by a move to self-isolation.
Naspers has appreciated by around 11% so far this year, benefiting from the much weaker rand as much as from its holding in Tencent. It has also proved fortuitous that their attempt to buy Just Eat for a cash purchase price of $8 billion fell through, so that they were not saddled with a new food delivery business during a lockdown. They now have that cash war chest to pick up potential casualties from the global rout in markets.
Given that Tencent has actually increased by around 23% in rand terms so far this year (and by implication, Naspers has underperformed this move) and the Naspers group is in such a solid position with a very strong balance sheet, we remain holders despite the very strong relative outperformance in the funds. By our calculations, Naspers trades in excess of a 50% discount to its underlying assets.
The second-best performer for the quarter was the funds’ large holding in British American Tobacco. After having been a major underperformer in 2018, we increased our holding to a top three position in both funds. A global staple, trading on a single-digit earnings multiple, seemed to be a very attractive proposition. It has proven to be a very defensive stock to own through this period of global volatility. With a globally diversified footprint and strong cash generation, British American Tobacco remains one of our top three holdings.
The third best performer was our holding in Shoprite, which managed to eke out a small gain for the quarter. This position was built up last year as the market turned sceptical on the growth prospects for the African retailing giant, after a couple of quarters of poor performance. Our analysis indicated that most of these tough results were from one-off factors, and that the core underlying franchise remained exceptionally strong. While its African business will always remain susceptible to economic cycles on the continent, it represents a compelling retail footprint that you were not paying for in the share price. Since self isolation and then lockdown were implemented, fast-moving consumer goods (FMCG) retailers have benefited from a huge burst in ‘pantry stocking’, and they are also continuing to trade during the lockdown period. While this is ultimately just a case of future purchases being brought forward and will impact sales later on, the FMCG retailers should be one of the few business sectors that will emerge from this period relatively unscathed. Our other FMCG retail holding, Spar, was our fifth best-performing share in the period.
PMGS TARNISHED; BANKS HURTING
The greatest disappointment during the quarter was the performance of our platinum shares. While the rand platinum group metal (PGM) basket was up in excess of 50% for the quarter, the share prices of Northam and Impala have fallen around 44% and 46%, respectively. A starker divergence between the economic fundamentals and the actual share prices would be hard to find. There are many factors at play, both for and against the outlook of these companies, yet the share prices appear to be only pricing the most negative of outcomes. Based on our assessment of normal PGM prices (much lower than today’s levels), platinum shares are all trading on very low single-digit earnings multiples. The hiatus in demand from the shutdown in global auto manufacturers is offset by a lack of supply from South Africa as a result of the lockdown. Given this favourable outlook for the sector, we added to our holdings in the month of March.
The domestic equity sector that hurt the funds the most has been the banking sector. As the lockdowns came into place, the banks sold off dramatically, with further negative moves post the Moody’s downgrade. We think the Moody’s downgrade is a non-event for the banks. The real damage to the banking system will come from the lockdown. Any stress in a regional economy always ends up in the banking sector. It is the primary mechanism for extending credit into an economy, and any contraction in that economy will be felt in the banks’ credit losses. With every small business now under threat of going out of business, and plenty of mid-size and large enterprises as well, the risks of a major spike in credit losses are very real. On the positive side, the banking system is extremely well capitalised. While South African banks didn’t suffer direct fallout in the Global Financial Crisis (GFC), they were required to implement all the new capitalisation standards that were approved post the GFC. This means that banks have very significant capital buffers and can handle a substantial deterioration in credit losses. The South African Reserve Bank (SARB) has also started to relax capital buffers to allow banks to cope with the influx of Covid-19-related bad debts, without having to resort to raising new capital. All of this means that the banks should easily be able to handle the stress, if the lockdown is lifted at the end of April as planned. Should it continue in this extreme form for longer, then the stresses will magnify, and the banks could end up in a loss-making position, which, while not threatening their existence, will take a number of years from which to recover. Given the above, we have continued to hold our positions in the bank shares but have not added to them.
We are keeping an underweight position in pure domestic names, despite the significant sell-off. The economic damage being wrought by the shutdown will continue to be felt for many months, if not years, and on a relative basis we find better value elsewhere.
The Market Plus portfolio was overweight offshore exposure, which benefited from the weaker rand, but within our offshore weighting we were overweight equity, which performed significantly worse than global bonds. Where we did benefit was having a number of S&P 500 Index put options, which reduced our equity exposure into the sell-off. We have judiciously removed most of these options, banking the premium earned and increasing our equity exposure close to the recent market lows. This should stand the fund in good stead as market valuations recover.
In the fixed interest space, US bond yields went from the ridiculous to the absurd, joining the ranks of ultra-low interest rates in most developed economies. In contrast, the South African yield curve blew out spectacularly, as urgent sales for liquidity hit a market and banking sector that were not prepared to take on additional risk. The moves in the local bond market were of an order of magnitude that we have not seen since the GFC. Given that this has been accompanied by a collapse in final demand in the economy and a record fall in the oil price, inflation expectations have dropped as well. The net result is that real yields available in the bond market are truly exceptional, with longer duration bonds offering upwards of 7% real returns. This makes a compelling investment case, risks to the sovereign balance sheet notwithstanding.
We have, therefore, continued to add to South African government bonds in Market Plus. Unfortunately, lost in all the noise around Covid-19 was a very fiscally prudent Budget by our Finance Minister, in which he tackled the key problem – a bloated civil service cost base. We think this is a courageous step and one that would have put us on the path to a more sustainable debt basis. Given the events subsequent to the Budget, this is no longer as clear, and we wait to see what stimulus is ultimately provided to the economy and how it is funded. In the interim, buying into high real yields gives us some measure of comfort. In a world of zero and negative interest rates, the potential to earn a meaningful real yield is very attractive.
The impact of lockdowns is felt most extremely in the property sector. With large tenants refusing to pay rentals and small tenants going insolvent, there is significant pressure on this sector, and it will certainly not emerge unscathed. We expect dividend holidays to be announced and certain counters will require additional equity. In this environment, we have not added to exposure in Market Plus, and remain in holdings with significant balance sheet strength to see them through the tough year ahead.
Lockdowns are in place around the world. In the UK, this has meant that any plans of turning around the fortunes of Intu (the UK-based shopping centre portfolio) have been impaired. Prior to the crisis, the company was already struggling with significant debt levels and tough trading conditions, but they had a plan to largely resolve this. The impact of Covid-19 will see further retailer insolvencies in the UK and further declines in centre valuations. We have therefore decided to sell out the remaining holding in Intu in both funds, which had largely been completed by the quarter-end.
As Top 20’s portfolio stood at the beginning of April, our models show the stocks we own have a total upside of 68% to our analysts’ fair values. This is the highest potential total return the portfolio has offered in a decade. Obviously, there are assumptions in these valuations, but we have moved quickly as a team to ensure we have priced in the effects of the pandemic and the lockdown on our fair values. While the moves have been extreme and brutal so far, we think the worst has been priced in and, from here onwards, we expect a rebound. Portfolio quality has continued to improve, and we have used the sell-off to buy high quality businesses on low ratings, which will stand the funds in good stead over the long term.