South African companies: The outlook after lockdown
Our local equities team recently presented their views on the outlook for South African equities and how this is reflected in the positioning of the Denker SCI Equity Fund*. Listen to a recording of the session to learn more about:
• the team’s sector views against the backdrop of the current environment,
• where they see opportunity, and
• what they believe will be catalysts for recovery,
as these relate to financials, small and mid caps, and property.
Changes in our investment process – we have incorporated environmental, social and governance (ESG) criteria into our process.
- Including ESG criteria as part of the investment process is gaining momentum around the world – many studies have shown a strong correlation between investments in ESG-aware companies and improved alpha.
- As signatories to the UN Principles for Responsible Investment (PRI), we have added ESG to our investment process as well.
- This enables us to identify companies with improved returns on invested capital, which is a key driver of understanding the intrinsic value of a business – one of the pillars of our investment process.
- We are integrating ESG into three of the four parts of our process: our fundamental research, company valuation models, and our risk management dashboard. This enables us to identify companies that are not fully ESG-compliant from a bottom-up point of view. We have also incorporated ESG into our process from a portfolio construction perspective, bringing it into our relative value ranking tool.
- We use the MSCI ESG rating methodology to rate companies. While it’s still early days for ESG in South Africa, the top-rated local companies from an ESG perspective are Old Mutual, Investec and Vodacom (all AAA-rated), with Harmony the worst-rated (CCC).
- The Denker SCI Equity Fund is currently fairly attractive from an ESG point of view, relative to the benchmark.
Looking back before we look forward – the performance of the South African equity market this year.
- At the trough of the crisis towards the end of March, the FTSE/JSE ALSI was down 35.3% for the year. There was a massive divergence between sectors, with resources and gold mining up 11.9% and 81.6%, while property suffered a devastating decline of 46.4%.
- Of a universe of 163 stocks, 77% had negative returns, half of which declined by more than 30%.
- The 23% that delivered positive returns were concentrated in resources (in which the fund is underweight, mainly because we don’t own gold) and the likes of Naspers and Prosus (in which we have an overweight position).
- Previous crises have taught us not to waste a good crisis – these events create opportunities to improve the quality of the portfolio at attractive prices. In fact, we see significant upside potential in the local market, specifically in cash retailers such as Mr Price and Pepkor.
Financials – the sector is well positioned for a recovery.
- There are three factors that need to fall into place for banks to recover to 2019 levels from an earnings and return-on-equity point of view:
- South Africa’s economic conditions need to improve.
- Interest rates, down a cumulative 300 basis points since Covid-19 hit our shores, need to increase.
- Credit loss ratios, which are at extremes due to the impact of the pandemic, need to normalise.
- The three factors are inextricably linked – economic recovery will lead to a rise in interest rates and improved credit loss ratios, so government’s drive for economic recovery is critical.
- We believe the sector is well positioned to recover – banks are adequately capitalised, and balance sheets are robust and in good shape.
- In addition, valuations are attractive – Covid-19 has caused a dislocation between price and value, presenting clear buying opportunities.
- We have acted on some of these quality opportunities: We have increased our exposure to FirstRand and Sanlam at entry points that are far more attractive compared to historic levels, and to Investec, which offers significant upside based on our assessment and analysis.
- There is also still significant value in global financials, and the fund consequently has a 9% allocation to the Denker Global Financial Fund.
Small and mid caps – with significant exposure to SA Inc. we remain cautious for now.
- Both small and mic caps are heavily exposed to SA Inc., which reflects the impact of Covid-19 on the South African economy relative to global economies.
- Our combined small and mid caps exposure is close to the benchmark’s weighting.
- While Altron and Libstar have outperformed, other small caps have performed in line with SA Inc. exposed stocks (some down 30%).
- Although we believe there’s significant value in this space, we have been cautious to allocate capital in the current economic environment since it’s effectively adding to SA Inc. We did, however, add marginally to Libstar and Hudaco, and followed our rights in Curro’s rights issue.
- Going forward, the catalyst for recovery would be a recovery in top-line growth, with companies’ revenue severely affected by lockdown. Cost cutting will also be important.
- These recovering metrics should also affect large cap industrial stocks and financials that are offering upside, e.g. Old Mutual currently being down 60% and Bidvest trading at lows, and sooner than in the small cap space, providing opportunities.
Property – balance sheet risks remain too high.
- We have not held property in the portfolio for a while because of the significant balance sheet risk. In addition, property companies have no control over their cost line – 70% of costs are costs on municipal charges, with no limit to what municipalities can charge and no consistency between what’s charged and what’s delivered.
- Covid-19 has worsened the situation – going forward, the sector faces tough local conditions and the outlook remains murky. Balance sheets remain very challenged, and more or less the same management teams are in charge.
- There are many other opportunities in other sectors that do not pose massive balance sheet risk.
What is needed for the Denker equity strategies to perform going forward?
- While we are all well aware of the macro challenges, the investment theses on our stocks do not necessarily require an improved macro environment.
- We focus on identifying companies with strong competitive advantages in their sectors, great management teams, without significant balance sheet issues, trading well below our assessment of intrinsic value, and if they do have debt, we look at liquidity and cash flow conversion in the business, i.e. good quality businesses that are able to gain market share in a fairly tough environment.
- While the market is implying it will take three to four years before companies return to pre-Covid-19 levels of profitability, some (e.g. AB Inbev) have already almost recovered.
- The subsequent returns following crises in the past have been enormous – this time should be no different.
- Over the past 13 years there have only been three years when we underperformed the market, and despite the challenges this year, we remain ahead of the market year-to-date.
If you have any questions, please contact me at email@example.com
*The legal registered name of the fund is the Denker Sanlam Collective Investments Equity Fund. In this presentation it is referred to as the Denker SCI Equity Fund.
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