Video: Where to from here for SA equities – CLICK HERE
Nazmeera Moola: Welcome to our discussion on the outlook for markets post the recent events in South Africa. Joining us today, we have our South African 4Factor and Quality teams’ Portfolio Managers, Duane Cable and Rehana Khan, together with analysts in the respective teams, Ann-Maree Tippoo, Achumile Mashalaba and Yaser Survé. We are going to start with Duane and Rehana, discussing their views post the recent riots in KZN but also the impact of COVID and the events that we are seeing playing out globally at this point in time.
So, Rehana, if I can start with you right now, what we have seen in South Africa is a stronger than expected macro bounce-back. The economy is certainly in a better position now than we expected it to be at the advent of COVID. This is due to a range of factors. Part of it is the resilience in the economy but there has also been the strength in commodity prices, the sharp cut in interest rates, which has supported the consumer in South Africa, and the wealth effect from the higher equity markets. How has all this fed in to your outlook for the equity markets in South Africa, particularly the events of the recent unrest in KwaZulu-Natal and Gauteng?
Rehana Khan: Thanks, Naz. So I think, if we take a step back and we just look at the global macro backdrop, which then feeds into South Africa, I think our belief is that we have transitioned from early cycle market conditions into this mid-cycle stage; early cycle where growth is really buoyant and, you know, markets are really strong, growth rates are strong and, as you transition into this mid-cycle, what tends to happen is growth rates start to slow but in our mind that growth rate is still going to be at about [trend growth] or slightly above and that cocktail then is very, you know, it is constructive for risk assets to do well albeit, when you are in the mid-cycle stage, risk assets tend to be a little bit more volatile.
So we expect a bit more volatility but the fact is that these things will continue to grind higher and I guess, given that global backdrop, it has been supportive for South Africa. I mean, as you mentioned, you can see it in the commodity prices. Whilst they are off their highs at the moment, the supply/demand dynamic sitting behind that gives us a lot of comfort that these prices, you know, can remain stronger for longer. If you unpack that a little bit, you know, on the demand side you have got inventory levels globally at very, very low levels. So you have supply chain restocking that needs to happen across all supply chains, so that is supportive of demand and, on the supply side, you have got the COVID disruptions and the fact that a lot of these businesses haven’t invested in capex for the last 5 years. So you land up in a position where there is not a lot of supply to meet that demand. So it keeps the tension in commodity markets [tight].
What that means for South Africa is that, you know, these commodity prices have helped us, helped the fiscus with extra revenue, helped in terms of trade dynamics and the rand has been under control, etc., which then, you know, gives South Africa a nice underpin and, in addition to that, I think, while it is very slow-moving in terms of how the wheels have started to turn, we are seeing positive movements on the front of reforms, be it leadership changes that have happened in key bodies or the semi-privatisation of SAA, etc., So, slowly but surely, policy is starting to move in the right direction. There is a long way to go still but those kinds of things just provide some support to the South African investment case.
Naz, you mentioned the riots. You know it did set us back a little bit in terms of the momentum that was starting to build. I think, because it was region-specific and localised, what we found with a lot of the companies that we own was that the impact on their earnings wasn’t that material. Then, to put that into context, our numbers for a lot of these companies were ahead of market forecasts to begin with. So when the riots happened, we did shave some of our numbers but the numbers weren’t material. So it gave us confidence that we still have potential earnings from a lot of the businesses that we own at the moment. So, overall, constructive on the backdrop for SA assets from here.
Nazmeera Moola: I think if we look at growth forecasts for South Africa this year, we have got a number around 4.5%. The Reserve Bank has a number of 4.6%. We had a discussion recently with the Deputy Governor of the Reserve Bank, Kuben Naidoo, and his point was that, without the riots, you would have seen their growth forecast being lifted above 5%. So there is this loss of around 0.5% from the growth outlook for this year but it is still at relatively strong levels for the bounce-back. Maybe the last question before I move on to Duane is do you think there needs to be an increase in South Africa’s equity risk premium because of these riots?
Rehana Khan: Interesting that you say that and I guess the reality of an emerging market is some of these things are kind of expected and it is part and parcel of investing in emerging markets. I think it would have been a much different story if it was a market where, you know, it was unforeseen and the riots happened out of nowhere and then you would see that risk premium moving quite quickly. I guess, with South Africa, it kind of – you can say it is kind of expected that this is part and parcel of investing in South Africa. That being said, over the medium term, and this is where we have to keep a close eye, is that I spoke about the impact of the riots being, you know, like a one hit wonder kind of situation but what we are keeping a mindful eye on over the medium term is the impact on investment and job creation on the back of what has just happened and, if that impacts that over the next few years, that means obviously we will adjust our growth forecasts and, therefore, that idea of the risk premium increasing is a sound assessment, if that is the case.
Nazmeera Moola: And I think that bringing it back to the impact on private fixed investments is really important because you see that in terms of the growth outlook. What determines our ability to grow in future is the amount of investment being made now and we are seeing very depressed levels of private fixed investment at this point in time. Maybe a little bit later in the discussion we can bring it back to what sort of events can change that. For our purposes now, trend growth in South Africa is roughly 1.5 to 2%. Duane, we know that you take a longer-term view, a longer-term horizon in terms of your investment holding period. How does that trend growth affect the way you think of South African stocks at the moment and then have the riots changed your assessment of that in any way?
Duane Cable: Thanks for the question, Naz. I mean again those are the two pressing questions I think investors with a longer-term horizon need to be able to articulate in terms of trying to find opportunities in the market today. I mean, firstly, when we think about trend growth, I mean certainly our base case assumptions, when we are modelling companies and thinking about their longer-term valuations, certainly our base view is that we do not see over the next 5 years, once South Africa has gotten through the carnage of COVID, that our trend growth will be materially different from that 1.5 to 2%. That is certainly what we put into our base case assumptions over the longer-term.
The country certainly today is in a very different space economically than where it was in the early 2000’s and, therefore, I think it is important for investors, when they are making comparisons around the cheapness of the South African market, is to put it into the context of what is that longer-term trend growth for South Africa. And I think what the riots, no matter how sad those events have been over the last few weeks, have demonstrated is that the key problem facing South Africa is that we have got a growth challenge and, given the extent of the divide in terms of equality, wealth levels, unemployment, until we deal with structural growth impediments and get us to the higher levels of trend growth than what we are currently assuming of that 1.5 to 2%, I think some of these challenges will remain and, therefore, investors should expect continued volatility when it comes with the outlook for SA equities.
Therefore, lastly, just answering your question around what has it done to the risk premium, I mean, like Rehana has correctly said, certainly South Africa is an emerging market and, therefore, we know it comes with great political risk, currency risk and certainly with respect to an outlook in terms of it needs to compensate equity investors for that risk premium. Based on all the work that we have done, certainly as the Quality capability, we think that risk premium should be in the region of 5% and, unfortunately, when we look at the valuations today for the South African market, for those shares, which is about 40% of their market, which we classify as SA Inc., where their revenues are linked to the outlook for the South African economy, we struggle to see many shares that are giving – that are compensating investors for that equity risk premium based on our outlook for growth and then certainly the equity risk premium that is allowed to compensate investors to be allocating capital into this environment. So, certainly, we would be a little bit more cautious over the longer-term outlook.
Nazmeera Moola: So does that mean you are not finding any opportunities in SA Inc. at this point?
Duane Cable: So that is certainly not the case and I mean, again, it is the one where certainly we are not structural bears on South Africa. We will get to the asset allocation discussion perhaps a little bit later but I think, importantly, what we are seeing in today’s market is certainly it is a stock-picker’s market for people with a longer-term horizon. If you look at perhaps where we are finding pockets of value is certainly in those higher quality South African shares like a Clicks that has got structural growth, like a Capitec, like a JSE, like a Santam, where you don’t need to make heroic macroeconomic assumptions and still offering really good value. So we are finding pockets of value in South Africa for some good businesses whereas certain parts of the market we are finding a little bit more downside. So definitely a stock-picker’s market but certainly one where there is definitely value to be had for investors with a longer-term horizon and a quality focus.
Nazmeera Moola: So I think before we move on to the analysts, just to wrap up a little bit, what we are seeing is commodity prices relatively well-supported though they are off their highs and this helping to provide some underpin to the South African economy and we are seeing this reflected in the macro numbers, in the revenue numbers at this point in time and, more generally, the 4Factor team is taking advantage of this across the market. I think what the Quality team is saying is the longer-term obstacles remain intact and, therefore, they are focusing on specific opportunities that don’t rely on that macro underpin solely.
Duane Cable: Naz, maybe if I can just add one point? I mean I think it is important. South Africa has really benefited from these high commodity prices and what it has done for our economy and the state of our fiscus. So certainly one of the things that we are concerned about in the Quality team longer-term is the sustainability of these commodity prices and, in an environment where commodity prices do roll over, what is the outlook for the economy and for some of these businesses that are reliant upon the very buoyant commodity prices that we have experienced to date.
Nazmeera Moola: So keeping an eye on commodity prices as well. So maybe now if we can move on to the analysts. Let’s start with Achumile. Let’s start with the retailers. Your team has been quite bullish domestic South African companies this year. You have relatively significant positions in the retailers. How has that view changed after the riots? How has that affected your thinking and your positioning?
Achumile Mashalaba: Thank you, Naz. As Rehana has mentioned, if I look back to last year around June/July, when I compared my bottom-up numbers and compared that to market forecasts, I was well ahead of consensus for all five discretionary retailers. So we made a macro call. We bought all of them and we remained ahead of consensus even as these companies started reporting better than expected revenue numbers, better than expected earnings numbers.
What has subsequently happened in the last few weeks and last few months is that consensus has started to revise their numbers higher. I have started to revise my numbers lower and now we are at a point where there are some select retailers where I am ahead of the market, namely Truworths and Pepkor. We are still very confident in their earnings growth trajectory over the next few years and we are still happy shareholders in those companies but there are some companies, like Mr Price, for example, where I think the market has overshot to the upside and my numbers over the next 3 years are well behind the market. So that is a company where we don’t own as much as we did before and we are quite concerned with the growth numbers that the market is forecasting.
So basically, in summary, what has happened is that consensus has moved closer to my numbers. I have moved a bit lower but there are some select companies where we remain ahead of consensus and where we think these companies can continue to do well for us.
Nazmeera Moola: Now are there any companies that were particularly affected by the riots or do you think it was relatively evenly spread?
Achumile Mashalaba: Yeah, thanks for that, Naz. I think, if you look at what the retailers put out in terms of the stores that were damaged, Pepkor had the highest proportion of stores that were damaged, I think at 9%, and that is largely due to the fact that they have the highest footprint across the country. They have 0-5000 stores across the country and, if you think about how their store footprint works, is that they have a big allocation to furniture and appliances. I think it is close to 16% of their portfolio and, obviously, those stores were hit quite a bit. So they were heavily hit in terms of stores but, speaking to the management team, they are well-covered in terms of insurance, support for stock theft and also the business interruption. So I think, in terms of earnings impact, I am not too concerned with Pepkor.
Nazmeera Moola: Great, Achumile. If we can move on to you now, Ann-Marie, so we have heard what is happening at the retail level but the property sector has been pretty badly hit over the course of the last 18 months. COVID hasn’t been particularly friendly, particularly if you are an office, and now we had the riots coming through. How has this affected your thinking on the property sector going forward? What do you like right now? Do you think there is value there?
Ann-Marie Tippoo: Thanks, Naz. As you rightly said, the property sector has been hard hit over the last 18 months. It has been a tough season although, along with kind of the global value rally from Q4 last year, the property sector has recovered to a marked degree. So where we sit now is that, yes, fundamentals remain weak due to COVID and, to a degree, to the riots that we saw in July and a lot of these are as a result of the COVID pandemic, the restrictions that accompanied them but what is key to understand is I think that the market has grossly exaggerated the impact that COVID would have on both the retail and the office sector in some instances.
So we have seen that the property sector has actually not recovered to mirror or to show value commensurate with the fundamental situation. Now don’t get me wrong – the fundamentals in the property sector are weak but they are starting to show signs of troughing. So the prints that we have seen in the recent two months, vacancy numbers are high but, in the case of retail, they are stabilising at around 5%. Reversion numbers, i.e. what are leases signing at the next time a lease is renewed, again are negative but are stabilising and so we are actually seeing an improvement in expectations or rather that the market is starting to realise that what we expected from COVID and from the riots was perhaps too exaggerated.
So there is, and remains, a lot of value in the sector. Metrics such as price to NAV, price to net asset value, net asset value ratios remain attractive, in some cases up to 45% discounts redefined, for example, well-diversified South African play with some international offshore exposure still pricing at a discount of around 45% to its net asset value.
In terms of looking forward and parts of the South African economy or the subsectors within property that we find most attractive, I think at the onset of COVID most people thought retail would be the hardest hit. Sort of fast-forward 12-18 months, we understand that actually office is probably going to remain the structural loser with respect to COVID and, as such, we remain kind of opportunistic or we believe that there are opportunities within the retail space, in particular, so counters such as Hyprop which have exposure to malls like Canal Walk, dominant position, a very particular type of offering and actually also showing great value. So a little bit of retail; where we can, avoiding office and still playing in those stocks that show great value, particularly from a price to net asset value perspective.
Nazmeera Moola: The story of the property sector is there certainly has been a hit from these factors. It is just not as bad as the market has already discounted. Yaser, if we can move on to you at this point, so Duane said there are specific stocks that your team remains interested in, specific domestic-focused SA Inc. stocks that your team remains interested in and two of them that you and I have talked about previously are Clicks and Capitec. So maybe if you can explain your thinking around these stocks to us.
Yaser Survé: Thanks, Naz. So, as Duane said, as much as we have a long-term negative outlook on the South African economy, we have been able to find idiosyncratic growth stocks within the South African Stock Exchange, being Clicks and Capitec, and I happen to think that those businesses are actually best in class globally in what they do and there are three elements that they both share which make them such good businesses.
The first is that they have extremely low cost of doing business, which allows them to take market share, become bigger and benefit from increased economies of scale and then lower their costs further and lower their prices and then take market share based on that. So there is a virtuous circle going on with both of those companies. For Capitec, they have only got around 4% deposit market share in South Africa, which is really low if you think about how much airtime the business gets in the press, and it is competing with lazy incumbents. Clicks has 20% market share but 50% of the market is occupied by independents, so the market is very fragmented and those independents cannot compete with Clicks’ low cost of doing business. Overall, both companies, because they have such low costs, in my view, they have been able to structurally lower the cost of the products that they sell and benefit the lives of millions of South Africans over the last 20 years.
The second component that I like about these businesses is that they have strong balance sheets. Clicks is in a net cash position. Capitec has a capital ratio which is almost three times that of the other banks and it invests its capital extremely conservatively. Most of that is sitting in short-term government securities.
And the third component is capital allocation. The best way to look at how good management have allocated capital is to look at the return on capital. For Clicks, it is 40%. That is a first quartile global best in class return on capital. For Capitec, they have a 25% ROE, which is better than all of the other banks but that ROE is purposefully suppressed by the management team because, as I said before, they have so much capital, excess capital, that they hold. They expense all of the investments through the income statement and their accounting policy, when it comes to loans, is extremely punitive. They write off loans much faster than the other banks. So we think that Capitec’s ROE is probably closer to 50% and not 34 to 25%.
But I guess, you know, it doesn’t take a rocket scientist to work out that these are high quality businesses. Where our variant perception is is on the durability of the growth of these companies and the valuation of these companies because the biggest push-back that we get is that these are high PE businesses and that will lead to poor returns over the long run. So I have got three responses to that. The first is that just because a business is on a higher PE, it doesn’t necessarily mean that it is expensive. It just means that it is highly rated.
The second point is that, if you look at over a hundred years of stock market data across many different countries, the single biggest component of return over the long run is earnings growth, then the income or dividend and a very, very distant third is the change in the multiple. So when someone says that Capitec is expensive on 25 times forward earnings, they are drawing a conclusion about the overall valuation by looking at the least important component of return historically.
And the third response that I would have is that we are long-term investors. We typically own shares for 5 years or more and, when you are a long-term investor, the starting multiple matters less because the derating is diluted over an extended period of time and, conversely, the compounding of earnings growth is accentuated over a long period of time. For both of these businesses, we can underwrite earnings growth of easily double nominal GDP for at least 15 years and, when you put that into a model, that gets you with a very, very attractive result at the end. So, because we have a long-term view on stocks and because we are able to get confidence about the durability of the growth of these businesses, we find them extremely attractive, not only from a quality point of view but also from a valuation point of view.
Nazmeera Moola: What we are hearing is that there are still solid investment opportunities in the SA market on a longer-term view, companies with good business models, strong balance sheets and the ability to grow earnings. In some sectors where maybe we were very worried a year ago, actually what you are seeing is the results haven’t been as bad as expected and the market has priced with our worst outcome than has eventuated.
So if we are seeing opportunities from a bottom-up perspective in the equity market, I think maybe it is time to turn beyond the SA equity market. Let’s talk about bonds. Let’s talk about offshore a little bit right now with Rehana and Duane. Your analysts have explained to us the opportunities they see, where they think that you should be putting money to work, where you are putting money to work in the equity market but I know that both of you also have reasonably large positions in South African bonds at this point in time. So, Rehana, let’s start with you. How have the recent events affected your view on bonds, South African government bonds, at this point in time and how are you thinking about them going forward right now?
Rehana Khan: Thanks, Naz. We have a healthy allocation and a positive view on SA bonds at this juncture. I guess we marry that against the SA Inc. exposure that we have got sitting inside the equity part of our portfolios, so a little bit more, you know, tilted towards the SA Inc. opportunities in equity over bonds at this juncture but we have, as mentioned, a healthy allocation to bonds. I think the key thing about the bonds in SA, you are getting really good real yields from these bonds versus emerging market peers. I mean, you know, we don’t have any exposure to any developed market bonds because there is no yield on offer. So all that underpins a positive investment case for SA bonds within the portfolio construction.
Nazmeera Moola: As a recent discussion I was part of when Duane’s team pointed out is that the steepness of the curve gives you quite a bit of benefit as the bonds roll down the curve. So, Duane, Quality has had a long-term signature position in South African bonds. How are you thinking about that right now?
Duane Cable: Where I would agree with Rehana and Naz is that we are finding SA government bonds incredibly attractive right now and we think certainly it has got a very important role to play in portfolios. If you look at the flagship portfolios for the Quality team in South Africa, our clients expect an outcome where we deliver inflation-beating returns, so inflation plus 4 in the case of Cautious Managed and inflation plus 6 in the case of the Opportunity Fund, while trying to manage the downside risk.
Certainly, when we look at the real yields on offer for South African government bonds, we find them incredibly attractive and all the valuation metrics we look at, whether it is benchmarking it relative to cash over the long term, whether it is doing all the work that we have done within the broader Ninety One context in terms of debt sustainability and what is being priced into the market, we certainly think there is an asymmetric risk or pay-off profile when it comes to South African government bonds and certainly we think they are incredibly attractively priced and certainly we have allocated, and continue to allocate, a healthy proportion of our portfolios into SA government bonds.
Maybe the last thing I would say is, just with respect to the role that SA government bonds play in the portfolio, certainly given our view, [we are] more optimistic on global equities, certainly we do find that, from a correlation perspective, having a large allocation to South African government bonds certainly has a very important role to play when we are constructing our multi-asset portfolios within the Quality team.
Nazmeera Moola: I think the views that you have expressed explain why the South African government was able to fund itself locally through COVID. The banks buying bonds played a big part of that but the resilience of the South African financial markets was really tested last year during COVID and what we saw was the government could issue as much as it needed to into the local market. There was a price to be paid for it but it could issue.
Moving on from the local markets and maybe looking a little bit further afield is what we are seeing right now is markets that are looking well-priced globally. Some would call them expensive, some would call them well-priced but, Rehana, where do you see opportunities for future returns in the offshore equity markets at this point?
Rehana Khan: Thanks, Naz. So when we came into this year, because we were at the early cycle stage of the market, I think we had a very big cyclical tilt sitting inside our offshore equity portfolios. Mid-50% of the portfolio was in cyclical companies and sectors. As we have transitioned into this mid-cycle kind of phase and the strong performance of a lot of those cyclical counters, we started to reduce some of those sectors. We had a Japan automation basket, for example, that we took down.
So now we are sitting with cyclical exposure in the mid-40’s in terms of overall offshore equities at the moment and we recycled that money into these quality compounder companies that kind of lagged the recovery. You know, towards the – from the vaccine announcement towards the end of last year, going into this year, those companies, they did well but they lagged that broader recovery. So we started to allocate some of that money into that sphere, be it in healthcare or software services, where those opportunities had become available. So at the moment, on an overall basis, we still have a cyclical tilt in our offshore equity portfolio but it is much more reduced than where we started the year and we balance that out with some quality compounders to balance the profile of the positioning.
Nazmeera Moola: Duane, that provides a good segue to you. Rehana is investing in quality compounders. Where do you see offshore value at this point?
Duane Cable: Thanks, Naz. I mean what Rehana said was music to my ears because I mean again it does speak to the opportunity set of why we are so excited within the Quality capability about the outlook for our portfolios, where, certainly globally, global equities remains our most attractive asset class and, given how strong markets have been, I think investors might be confused by that, given where overall levels are, but what you miss is just the extent to which these quality businesses have actually lagged and underperformed the market over the last year post the announcement of the vaccine. Certainly, we know these businesses incredibly well. As the Quality capability, we are globally integrated and cover all of these stocks and we certainly have found a collection of high quality stocks that we think offer exceptional value for investors with a longer-term horizon.
Our outlook for these high quality global equities that we own over the next 5 years, based on the mid-point of our range, should be able to deliver close to a 14% per annum compound return for South African investors in rands. We think that is incredibly attractive and certainly more attractive than some of the opportunity sets that we can find within local equities.
Nazmeera Moola: So both of you seeing solid opportunities from the offshore. So maybe to finish it off now, bring it back to South Africa. So we know the structural growth rate of 1.5 to 2% and we know that we need to see structural reforms to change that. The good news is we have started to see moves with the ports, with the corporatisation of the Transnet Ports Authority and also the move with self-generation from a cap of 1 MW to 100 MW, which is particularly advantageous to the mining sector at this point in time. So, Duane, I am seeing some positive moves in SA. We need to see a whole lot more, a whole lot faster, but what would you need to see to become more excited about South Africa’s structural growth?
Duane Cable: Naz, I mean those are excellent points. Again, it is the one where there is no doubt that recently we have seen lots of positive traction, whether it is on dealing with corruption, whether it is opening up certainly the economy for the private sector. Certainly, there are positive green shoots that we are seeing. I mean certainly we – what would need to get us to change our view in terms of the outlook, in terms of how that trend growth within South Africa gets closer to 2.5 to 3% real, which, certainly in our view, would mean that we have underestimated the value available in the local market, what would need to change is certainly our confidence that a lot of these structural reforms will result in employment growth, investment and real GDP growth accelerating to a sustainable level that is higher than what we have factored into our base case.
So certainly, while there have been positive signs, I think we need to see a lot more before we get conviction that, ultimately, South Africa is on a more stable footing going forward and we can deal with the longer-term structural growth challenges that we have been facing over the last 5 years.
Nazmeera Moola: Thanks, Duane. So I think let’s wrap up there and I think, as a parting point, as we deal with these structural challenges, I would hope that the government takes much more advantage of the private sector. I am about to get my second vaccine tomorrow and I think that has been a perfect example of private sector working with government and delivering excellent world class results in terms of the vaccine delivery. It was late but it is being rolled out at a very impressive pace right now. Thank you all.