Corospondent - October 2018
Quarter in review - October 2018
SOUTH AFRICA GLOBAL BALANCED VIEW
Globally we continue to reduce exposure to what looks like a very expensive US market in favour of the rest of the world where valuations are more reasonable. Emerging markets continued their recent underperformance, returning 1% for the quarter (with returns now flat over a rolling 12 months). Although the portfolios have benefited from their exposure to global equities, our position in emerging market equities has detracted from performance. Notwithstanding this detraction, we believe that our emerging market equity exposure currently offers compelling value.
In the US, on the back of continued robust economic growth and rising short-term rates, the US 10-year government bond yield ended above 3.0% at quarter end, its highest level in almost seven years, lifting most developed market bond yields along with it. The Citigroup World Government Bond Index (WGBI) declined by 1.6% in US dollars for the quarter. The two-year rolling returns for the WGBI are now a negative 2.2% per annum – a stark reminder that bond investments are not riskless. The portfolios have benefited from being underweight in global bonds.
The US economy is notably strong (the unemployment rate just hit a 50-year low) and other advanced economies are still growing faster than long-term sustainable rates. This, coupled with central bank policy rates that we believe are still too low for a non-crisis global economy, makes it appear almost inevitable that interest rates will rise. We therefore continue to remain cautious on the outlook for global bonds.
The impact of tightening global financial conditions and US dollar strength has already been felt across a number of asset classes – especially in emerging markets where domestic and external vulnerabilities have been exposed, and a number of emerging market currencies have demonstrated extreme volatility and have depreciated significantly.
The rand has not gone unscathed and depreciated a further 3% against the US dollar over the quarter, bringing the total depreciation to almost 13% for the year to date. Given the unfolding global macroeconomic environment, coupled with weak domestic economic fundamentals, the currency continues to look vulnerable. Domestically, things remained tough during the quarter under review as the local economy dipped into recession. In September, President Cyril Ramaphosa announced a new economic stimulus package, but despite this being a step in the right direction, it is likely that it will take time to gain traction.
Looking at the markets, domestic consumer-facing businesses reflected this harsh reality, with numerous companies reporting results below expectations.
Overall, the JSE experienced a difficult quarter, with the FTSE/JSE Capped Shareholder Weighted All Share Index declining 1.7%, dragging down rolling 12-month period returns to a paltry 0.4%.
The poor returns for the quarter were driven by weak performance from the industrial sector (-8%). The financial sector performed strongly, mainly driven by the life and non-life sectors that were up 12% and 17%, respectively. The resources sector had another good quarter and was up 5%, with platinum stocks (+26%) having a very strong three-month period on the back of a rising platinum group metals basket price.
With local bond yields ticking up, the All Bond Index returned only 0.8% for quarter. We continue to maintain our very low exposure to fixed-rate bonds, with this position partly offset by our overweight position in listed property, which we believe offers very attractive risk-adjusted returns.
We continue to maintain reasonable exposure to resources based on our assessment of their long-term value. Our preference for Anglo American (+6%) over BHP Billiton (+2%) – based on a more attractive commodity mix and valuation – continued to contribute to performance for the quarter. Our platinum exposure, mainly through Northam (+9%), also added to performance during the period under review.
In the media sector, Naspers’ declined on the back of a pull-back in the Tencent share price, of which the short-term earnings expectations have been revised downwards. This is due to delays in the licensing of new online games, and proposed regulations to protect minors from the adverse effects of online games. We think tighter regulations will favour established players like Tencent, and as such we remain optimistic on the longer-term prospects for their online gaming business.
We are also encouraged by opportunities across the business, as well as its outstanding investment portfolio, which we believe is still underappreciated by the market. A further positive is the management team’s actions around portfolio optimisation and the steps taken to reduce the discount to its underlying intrinsic value. This includes the unbundling of Multichoice – most likely to be completed in the first quarter of 2019.
The MTN share price declined after surprise announcements by the Central Bank of Nigeria (CBN) and the Nigerian Attorney General that MTN was in violation of certain foreign exchange control regulations and that it should repatriate $8 billion to the country and pay an additional $2 billion in back-taxes.
These actions have undermined the investment case for foreign investment in Nigeria; as a result the tone of more recent public announcements by the CBN has been more constructive. We believe a worst-case scenario is more than reflected in the current MTN share price and remain hopeful that an amicable resolution can be found.
Some of our consumer-facing domestic holdings had a very challenging quarter and experienced double-digit share price declines. At this point we are asking ourselves whether the weakness is a cyclical or structural phenomenon. Has the earnings quality of food producers and retailers structurally changed? We do not believe this to be the case.
In an economy with high structural inflation, it is extremely challenging for management to navigate a low-volume growth environment. Only a small recovery in economic growth will significantly ease this burden.
The issue has been exacerbated by the current low food inflation environment and, for producers, by additional imports on shelves because of a strong rand at the beginning of the year. As such, we believe some of these pressures will abate and continue to selectively add to the consumer stocks.
We continued to build a position in Quilter, the second largest advice force and platform in the UK, following its recent unbundling from Old Mutual. The UK savings market is substantial and the need for financial advice has increased dramatically, given recent pension reforms which give individuals more control over their retirement savings. This should act as a structural tailwind for the business.
UK property had another disappointing quarter, mainly due to the economic uncertainty surrounding Brexit and, in some instances, concerns around gearing levels. While we are cognisant of the risks surrounding the investment cases of the stocks we hold, we believe that they are incredibly cheap.
This has certainly been a testing quarter but in this volatile and uncertain world, our objective remains building diversified portfolios that can absorb unanticipated shocks. We will stay focused on valuation and seek to take advantage of attractive opportunities that the market may present to us and, in so doing, generate inflation-beating returns for our investors over the long term.
GLOBAL EMERGING MARKETS
The Coronation Global Emerging Markets Strategy had a poor third quarter, with the largest negative detractors over the period being Indian Financials, YES Bank and Indiabulls Housing Finance. Other notable detractors were JD.com, Magnit and Naspers. Having no commodity exposure also detracted in what continued to be a good period for commodity prices.
The declines in YES Bank and Indiabulls Housing Finance merit further discussion, even though there has subsequently been some recovery in the shares. The default of one of the Indian property financing companies (IL&FS), together with rupee currency depreciation and rising Indian bond yields, triggered a large sell-off. However, in our view the long-term prospects for the industry remain very attractive due to a young, urbanising population, low home ownership and attractive economics.
Aside from strong long-term drivers of the financial services industry in India and ongoing market share opportunities for private banks, YES Bank (the sixth-largest private bank) has a strong franchise and a long track record of delivery.
With volatility at above-average levels in emerging markets, we were more active than usual, having made five new buys during the quarter – four in China and one in Brazil.
The largest new buy over the quarter was a 1.6% position in New Oriental Education & Technology Group (which we discuss in more detail here), one of the leading after-school tutoring businesses in China, which we increased to 2.6% into weakness during October. The recent share price declines in the sector were driven by a number of factors, including the impact of trade wars on equities in general and regulatory tightening.
In our view, given the increasing emphasis on quality education in China and the fierce competition for entry into tertiary institutions, Chinese tutoring businesses have attractive long-term prospects.
The second-largest new buy during the quarter was a 1.2% position in Wuliangye Yibin, the second largest premium baijiu (a local Chinese white liquor) company in China. The baijiu spirits market in China makes up almost 90% of all spirits consumption in China. Wuliangye’s baijiu offering covers the whole market (with price points as low as $5 a bottle), but a shift over time to the ultra-premium and premium Wuliangye products provides both higher revenue and higher margins.
There were smaller buys in Li Ning (China; sports apparel), NetEase (China; online gaming) and Itau Unibanco/Itausa (Brazil; private bank).
The strategy’s total Brazilian exposure was 9.7% of strategy at the end of September (with a large part of this in the two leading tertiary education companies, Kroton and Estácio), but this has increased due to market movements (positive moves in both equities and the currency) in October to around 11% of strategy.
Members of the team continue to travel extensively to enhance our understanding of the businesses we own in the strategy, their competitors and the countries in which they operate, as well as searching for potential new ideas. Over the past 20 months we have done detailed work (modelling, fair value and research report) on 43 new companies, 10 of which have made it into the portfolio, making up 24% of the strategy today.
In the quarter there were two trips to China as well as trips to India and Russia. The coming months will see trips to China, India and Brazil.
Despite more clouds gathering on the horizon of global growth prospects during the quarter, global equity market participants preferred to focus on continued strong profit growth numbers – especially out of the US – to register very strong returns over the period.
The MSCI All Country World Index returned 4.3% over the quarter, almost matching the year-to-date number of 3.8%. At the same time, investors have had to adjust their interest rate expectations for the US upwards. This was in response to a US economy continuing to surprise on the upside in terms of growth and its sustainability. We continue to monitor escalations in the trade war dialogue, primarily between the US and China.
However, we believe investors should use their judgement when headline-grabbing pronouncements are being made. As we argued in the prior quarter, we think the bigger issue that investors need to focus on is the process of interest rate normalisation in the US.
The Global Bond Index generated negative returns over the last three months, resulting in a negative 1.3% return over the last year. We continue to exercise caution with regards to the bond market, despite the weakness over the last few years.
Another notable development over the quarter was the increased cost of capital in emerging market equities, which underperformed their developed market peers by 6%, on top of an underperformance of almost 10% in the prior three-month period. This has meant that over most periods, emerging markets have now underperformed developed markets, with the US equity market continuing to be the stand-out performer over the last decade.
Emerging market currencies shared in this adjustment, with the Russian ruble, South African rand and Indian rupee all depreciating by around 12% during 2018. The Turkish lira is down almost 37%, but we view this as mostly self inflicted. Developed economies’ currencies generally depreciated only slightly against the US dollar over the quarter (around 2%).
Healthcare was the best-performing equity sector this past quarter, with information technology again registering a strong performance. Laggards were energy (after a very strong second quarter), utilities and real estate.
Listed property had a tough quarter, with essentially a flat performance. UK property continued to suffer from a weaker fundamental outlook, with further uncertainty regarding the Brexit outcome muddying the waters.
Against the backdrop of rising interest rates, it was perhaps not surprising that the gold price came under more pressure. We have added marginally to our position in physical gold and continue to view it as a hedge against a world ruled by uncertainty.
Notable winners over the year included Advance Auto Parts (discussed below), Amazon, Airbus, Twenty-First Century Fox, (in response to sale of bulk of the business to Disney), and Alphabet.
It is worth taking a closer look at Advance, the second-largest retailer in the auto parts sector in the US, serving both do-it-yourself customers and the professional mechanical workshop. We initially invested in this stock in August 2017 after we met the new management team at a conference in the US.
At the time their operating margin was about half that of the industry leader, and the new team had concrete plans to partially close the gap. At the same time, unusual weather had also adversely impacted industry sales, and there was a lot of speculation about Amazon making a stronger push into the category. We thought the weather issue was temporary and believed that the category was less attractive to an online retailer than generally believed. While the management team has yet to deliver on its promise to increase margins, a more normal winter has seen industry volumes pick up again. The Amazon threat has also subsided, with the result that the stock has been our biggest contributor to alpha over the last year.
Our equity exposure is below benchmark, and we have continued to reduce our credit positions. We have added marginally to property but are mindful of the risks posed by further increases in interest rate expectations.
AFRICA AND GLOBAL FRONTIERS MARKETS
On 1 October, the Coronation Africa Frontiers Strategy turned 10 years old. The past decade of investing in Africa has been one of ups and downs, delayed flights, dodgy meals and strange ailments, but also a decade of inspiring meetings, new friends and exciting experiences. How these years and events have impacted our lives would take far more than a quarterly commentary to communicate, but there is nothing like turning a year older and passing a significant milestone to spend some time in reflection.
If someone told us that we would need to navigate coups, currency shortages, the Ebola virus, the Arab Spring and terrorism attacks, we might have thought twice about what we were getting ourselves into.
While macroeconomic and political headlines have been depressing, how have markets performed? Regrettably for index investors, not well. The FTSE/JSE Africa (ex-SA) Top 30 Index has returned -1.4% per annum over the past decade, while the MSCI Africa (ex-SA) Index has not done much better and is down-1.8% per annum.
It has been a particularly tough period for Africa investors. We estimate that during 2015 and 2016, Africa (ex-SA) assets under management fell 48%, with 11 funds closing and another 11 left with less than
$10 million assets under management – a truly unforgiving 24 months for the asset class.
Most of the markets have had tough recent years, with Egypt the only major market up in US dollars (+4.2%), while Kenya (-5.5%), Zimbabwe (-7.5%) and Nigeria (-9.0%) were down over the past year.
Egypt continues to benefit from the structural reforms and an IMF deal implemented two years ago. Company fundamentals remain very healthy and operating results have generally been strong. Nigeria and Kenya have suffered from government missteps. In Nigeria, the $2 billion tax claim and $8 billion dividend repatriation dispute with MTN have resulted in its country risk premium increasing for many investors.
Unsurprisingly, the market has come under pressure. It was hoped that Kenya would finally lift its interest rate cap, but parliament decided that the cap was here to stay. This, coupled with an increase in taxes on mobile money transactions, weighed on Safaricom and the banking sector which make up a big part of the Kenyan market.
In Zimbabwe we recognise our holdings at internal fair values, as we have done since September 2017. The currency market remains challenging and we believe that this is the most appropriate valuation methodology at this time. During the past month we have updated fair values for the annual results and changes in the operating environment.
Looking forward to the next 10 years, we remain energised and excited. There are many businesses with strong fundamentals and exciting prospects that the market has yet to appreciate. We cannot wait to see how they perform over the coming decade.
The past quarter was tough for frontier markets. Following a large sell-off in the previous quarter, Vietnam (+4.2%) was one of only a few markets with a positive return over the past three months. Nigeria (-15.1%), Kenya (-14.1%), Sri Lanka (-11.4%), Egypt (-10.2%) and Argentina (-9.4%) all had meaningful declines.
In US dollars, the stock market in Argentina is down approximately 46% over the past 12 months. During the quarter, the pressure on the Argentine peso intensified. The currency moved from 29 peso/US dollar to more than 40 peso over the past three months and has now lost more than half of its value since the start of 2018 when it traded at around 19 peso to the dollar.
In August, the central bank increased interest rates to a staggering 60% in an attempt to stabilise the currency, and at the end of September, interest rates were increased further to 65%.
We met with a number of Argentine companies in September. Given that the macroeconomic environment in Argentina is clearly very challenging, we were expecting management teams to be fairly pessimistic. However, the meetings with individual companies showed that a number of businesses are in fact performing very well. Several businesses have revenues linked to hard currency and are benefitting from the devaluation.
Despite the difficult macro environment, these businesses should see profit margins expanding. On top of this, we were impressed with management teams’ thinking around capital allocation, with several companies using their depressed share prices as an opportunity to buy back shares. This is something which we believe will create significant long-term value for shareholders.
At the start of the quarter, the strategy had no exposure to Argentina, despite Argentina being a very large constituent of the MSCI Frontier Markets Index. We base our investment decisions on bottom-up valuations of companies and not on their weight in a particular index. Following the large declines in share prices in Argentina, the valuations of a number of these businesses now look very attractive, trading well below our assessment of fair value. As a result, we had increased exposure to Argentina to 8% by the end of the quarter.
We have said before that Vietnam is an exciting country with strong GDP growth, booming exports and several quality businesses that we would love to own at the right price. Between April 2018 and July 2018, the stock market in Vietnam lost almost 25% of its value, while the earnings of businesses continue to grow. This offered an opportunity to achieve exposure to Vietnamese businesses at attractive valuations and, by the end of the quarter, Vietnam accounted for 5% of the fund.
Our valuation-driven investment approach helped us to avoid overpaying for shares in Argentina and Vietnam at times when these markets were incredibly well liked. In the same way, we believe this approach helps us to identify opportunities to buy quality businesses at attractive valuations when these markets fall out of favour.
We believe that Argentina is currently a great example of a country where there are good businesses that are temporarily out of favour. While there might be a lot of volatility in the short term as the country works through its economic issues, we believe that the businesses we hold in the strategy should provide investors with attractive returns in the longer term.
The detailed strategy commentaries are available here.