Optimum Growth is an unconstrained worldwide flexible fund, aiming to meaningfully grow wealth for long-term investors. The Fund appreciated by 3.3% in the third quarter of 2020 (Q3-20), bringing the year-to-date return to 22.5%, which is more than 11% ahead of benchmark. Over the past decade, the Fund returned 16.8% p.a. The Global Emerging Markets (GEM) Flexible Fund aims to give investors access to the best equity opportunities in emerging markets. The Fund returned 5.4% during Q3-20, which is in line with the benchmark. Since inception 13 years ago, it has outperformed the benchmark by 1.9% p.a.
This quarter was less eventful compared to the first six months of the year, which exhibited extreme volatility. The markets remain volatile as the Covid-19 pandemic continues to cause disruption around the world, with various governments responding in different ways, which continues to create a disruptive operating environment for many businesses.
OPTIMUM GROWTH: PORTFOLIO POSITION
Optimum Growth is positioned without taking a strong view as to when normalisation will occur across the world, as the last nine months have indicated once again that trying to predict the future is inherently difficult. The Fund holds a collection of businesses that we feel are attractively priced and can operate in what we deem to be a highly complex and fast changing environment.
Optimum Growth ended the quarter with 69% net equity exposure, slightly lower than at the end of June. 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 that do not compensate for the risk undertaken. Only 1.4% of the Fund is invested in bonds. The Fund also has c.2.8% invested in global property – largely Vonovia (German residential) and Unibail (European and US retail property). Lastly, the Fund has a physical gold position of 3.9%, along with a 0.7% holding in Barrick Gold Corp, the largest gold miner globally. The physical gold position was added to during the quarter for its diversifying properties. The balance of the Fund 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.
CONTRIBUTORS TO OUTPERFORMANCE
Optimum Growth’s largest positive contributors in the quarter were Alibaba (+30%; 0.7% positive impact), Salesforce (+31%; 0.6% positive impact) and JD.com (+25%; 0.5% positive impact). The Fund incurred unrealised losses on a collection of put-option and short-index positions, which provided valuable protection in the first quarter of this year but detracted from performance this quarter. Collectively, these put options and short-index positions had a 0.9% negative impact during the quarter, but owning them continues to provide the Fund with protection should there be a market selloff. The one other notable negative detractor was Unibail-Rodamco-Westfield (-37%; 0.3% negative impact), which came under renewed pressure post the announcement of a proposed rights issue to deleverage the balance sheet.
NEW BUYS IN THE PERIOD
Notable buys/increases in position sizes during the quarter were NetEase, RELX Plc and Visa.
NetEase is the second-largest gaming company in China, with a long history of successful execution over its more than 20-year history. Netease benefited from the social distancing tailwind and has been very successful in incubating new businesses. NetEase own the second-largest music streaming service in China, which operates in a duopoly with Tencent Music Entertainment. It also owns a rapidly growing online education business (Youdao), which was separately listed late last year, with NetEase still holding c.58%. Both the online music business and the online education business are lossmaking, but should start to contribute both profits and cash flow to the combined group in the next 18 to 24 months. NetEase also has just under 20% of its market capitalisation in cash and trades on a c.6.5% 2021 free cash flow (to enterprise value yield), which we feel is attractive.
RELX is a global provider of information-based analytics and decision tools for professionals and business customers. Its revenue is largely recurring in nature and the company’s tools are deeply embedded into its customers’ workflows. The company has recognised brands within the scientific, legal and risk analytic markets and has done a good job over the years to transition its products to the digital realm. Its risk analytic business is made up of a significant proprietary dataset, which is hard to replicate and creates real value for its clients (insurers) who access it to make critical business decisions. Growth should be driven by continued penetration into existing clients and expanding the company’s service offerings. The business is highly cash generative as most of its revenue is received in advance, and the bulk of its free cash flow has been returned to shareholders in the past. We estimate the business should be able to grow earnings in the high single digits which, coupled with a c.2.5% dividend yield, should generate double-digit total returns in hard currency.
Visa is a business the Fund has owned for many years due to our positive view on the structural growth driver (the transition from cash to electronic payments) supporting the business fundamentals. Covid-19 has potentially accelerated this transition due to rapid increases in e-commerce penetration and a behavioural shift away from handling cash. There are some headwinds brought about by a curtailment in travel, but we believe this is transitory as opposed to permanent and, ultimately, the move away from cash has been accelerated due to the pandemic. Cashless penetration (as a percentage of personal consumption) globally was just under 50% last year – up nearly 20% from a decade ago. We expect this trend to continue, with penetration approaching 70% over the next decade. This is supportive of growth for Visa, with the business generating very high incremental margins due to low incremental costs in supporting these additional volumes. Against this backdrop, we expect high single-digit revenue growth, which should translate to low double-digit earnings growth.
GEM FLEXIBLE FUND: CONTRIBUTORS TO OUTPERFORMANCE:
The largest contributors to the return of the GEM Flexible Fund in Q3-20 were Wuliangye Yibin, JD.com and Yandex.
Having clamped down hard and early – we have heard interesting first-hand accounts of the restrictions placed on daily life in China during their lockdown – China’s economy has stabilised and returned toward normality faster than anticipated, and many Chinese shares have benefited from this. This includes Wuliangye Yibin, a Baijiu (local Chinese spirits) producer, which returned 34%, providing 0.9% of alpha and JD.com, up 29% to add 0.7% to alpha.
JD.com can be thought of as the ‘Amazon’ of China; a large part of what it sells is its own inventory and deliveries use its own fulfilment infrastructure. China was already the country with the highest e-commerce penetration in the world prior to 2020 due to the presence of highly innovative e-commerce retailers that the mediocre pre-existing physical retailers struggled to compete with. The high level of adoption of digital payment methods further enables e-commerce. Despite being already well established in the minds of the consumer, JD.com has benefited tremendously from the demand uplift that accompanied lockdowns. We spoke about the 21% revenue growth in Q1-20 in our last commentary, but Q2-20 results (reported mid-August) were even better, with revenues up 34%, well above consensus of 27%. Even more impressive was the rise in operating profit, up 75% year on year, with margins rising to 2.8% from 2.1% in the same period last year. This led to a 50% increase in earnings per share. All this was driven by a 30% rise in active customers. Most importantly, this operating performance was accompanied by strong free cash flow generation. Unsurprisingly, the share reacted very positively after the results announcement, moving from around $64 to as high as $83.
Like several other US-listed Chinese companies, JD.com did a secondary listing in Hong Kong, raising $4bn and ended the quarter with $18 billion in cash, around 15% of market cap. The secondary listing was part of a wider move by prominent Chinese companies to reduce their exposure to US capital markets over fears the US might unilaterally impose onerous requirements on Chinese companies that they might not be able to meet, as the Chinese government are not fond of foreigners exercising regulatory oversight of Chinese-domiciled businesses. The list of companies that have done this now includes other Fund holdings like Alibaba, NetEase and Yum China. This transfer of trading volume toward Hong Kong is part of the investment case for the Hong Kong Stock Exchange, which is a small position in the Fund (0.5%).
Russian holding Yandex increased 30% in Q3-20 and added 0.5% to alpha. Yandex has more than doubled from the low it reached in March and we have trimmed the position to 2.1% of Fund as it has appreciated. The current position size reflects the reasonable valuation and positive long-term outlook for Yandex, which has evolved beyond search to be a meaningful player in many other sectors, such as ridesharing and e-commerce. More recently, Yandex has bid to acquire TCS, Russia’s largest digital bank.
The largest detractors from performance during Q3-20 were underweight positions in Taiwan Semiconductor Manufacturing Company (TMSC), the third-largest stock in the index, and Alibaba, as well as holdings in Mexican holding company FEMSA and Naspers/Prosus (the latter was partially offset by not owning Tencent directly).
TSMC was up 43% in the quarter and the underweight cost the Fund 0.7%. We are very positive on the company but feel that a 3% position is more appropriate, given its risk-adjusted expected return and internal rate of return relative to the rest of the investment universe. TSMC reported excellent results for the first half of 2020 (net income up close to 90% versus last year). There have also been continued stumbles by one of its main competitors, Intel, which announced that it is at least a year behind schedule in manufacturing the next generation of 7nm chips. This means that TSMC’s competitive positioning is arguably the strongest it has ever been.
FEMSA (2.6% of Fund), fell 8% in the quarter and cost 0.5% of alpha. Mexico continues to struggle in dealing with the coronavirus and most of FEMSA’s main assets were negatively affected. The largest contributor to FEMSA, the convenience store chain Oxxo, saw its operations hampered by lockdowns and bans on the sale of alcohol (a large contributor to sales). FEMSA’s 15% stake in global brewer Heineken was also hurt by the 8% decline in the share price of Heineken. Heineken has been under pressure as they index disproportionately toward premium beers, which tend to be sold on-premise (where margins are higher) rather than in supermarkets (lower margin). With global curbs on socialising, Heineken has seen volumes fall 12% in the first half of 2020.
NEW BUYS IN THE PERIOD
We bought Samsung Electronics, BGF Retail and PagSeguro in our emerging markets funds during Q3-20. Samsung needs no introduction. Developments in the chip and memory industries, which are increasingly consolidated and with returns accruing to the top players disproportionately over time, led us to repurchase it into the Fund. Unlike TSMC, Samsung’s share price remains below where it was before the Covid-19-induced market selloff that started in February. Despite a 40% recovery from the lows reached in March, Samsung still trades on less than 12 times forecasted earnings for the 2021 fiscal year with a 3% dividend yield and close to a third of its market cap in cash.
BGF retail is a South Korean convenience retailer and was bought into the Fund for the first time. BGF operate in the convenience value service segment, which is attractive in a country like South Korea where there is very high degree of urbanisation, high population density and small household size. The segment has doubled market share over the last decade to 7%, but this is still below regional peers Taiwan and Japan, with similar demographics. With challenged formats like department stores, hypermarkets and specialty stores still making up over 50% of retail sales in the country, there is reasonable market share up for grabs. BGF trades on 14 times forward earnings, has a net cash balance and consistently generates returns on equity in excess of 20%.
PagSeguro is a Brazilian financial services company catering primarily to small merchants in that country. Small merchants make up the long tail of customers in Brazil and have traditionally been averse to accepting card payments due to the high fees charged by the other acquirers and banks for this facility. PagSeguro already has 5.5 million active merchants using its payment functionality and 3.7 million using its fully digital bank accounts. Like StoneCo, a Fund holding we wrote about in the March quarter, PagSeguro is looking to take market share away from the incumbent acquirers and banks in Brazil as they earn outsized returns for the value they provide to customers. It is estimated that only 30% of micro-merchants currently accept cards. Together with the 1.2% position in StoneCo, which benefits from similar market share gain potential, the Fund now has +/-2% invested in the Brazilian payment providers covering the small- and medium-sized merchant segments.
STOCK POSITIONS EXITED
The GEM Flexible Fund sold South African food retailers Shoprite and Spar during the quarter. These were small positions (combined 0.8%) and we felt the opportunities were better elsewhere, such as the new buys above. The most notable sale was that of 58.com, which we have held in the funds since late 2016 and has been a top 10 stock in the Fund for some time. 58.com was bought out by a private equity firm, which added the founder to the buyout consortium after their initial bid, in order to secure the support of his high voting shares. We believed the buyout price significantly undervalued the business and was very opportunistic – the share had traded 25% higher than the proposed price as recently as January this year – and we lobbied the board to prevent the founder from exercising his voting rights due to the inherent conflict this represented (as he was both buyer and seller). These actions were not successful and only a nominal increase in the offer price was requested by the board; as a result, we sold the remaining exposure as the share price converged to the new buyout price.
We are now just over nine months into the Covid-19 pandemic, yet there still remain many unknowns as to the ultimate length, how governments will respond and what permanent consumer behaviours will manifest post the pandemic. However, against this backdrop we feel the portfolios have been built bottom up, while ensuring adequate diversification with limited exposure to potential hard-to-predict future trends.