Ninety One Opportunity strategy update

It’s astounding to think that at the start of 2020 we were musing over how the US’s continued economic expansion was the longest uninterrupted period of growth in its history. The novel coronavirus SARS-CoV-2 has turned the world upside down. With the majority of the world under some form of lockdown, the global economy has ground to a halt, while economists scramble to gauge the severity of this sudden stop on the global economy. How are we responding in the Opportunity strategy?

Apr 28, 2020

6 minutes

It’s astounding to think that at the start of 2020 we were musing over how the US’s continued economic expansion was the longest uninterrupted period of growth in its history. The novel coronavirus SARS-CoV-2 has turned the world upside down. With the majority of the world under some form of lockdown, the global economy has ground to a halt, while economists scramble to gauge the severity of this sudden stop on the global economy. How are we responding in the Opportunity strategy?

Market background

It’s astounding to think that at the start of 2020 we were musing over how the US’s continued economic expansion was the longest uninterrupted period of growth in its history. Things certainly have changed a lot in a very short space of time.

The novel coronavirus SARS-CoV-2 has turned the world upside down. With the majority of the world under some form of lockdown, the global economy has ground to a halt, while economists scramble to gauge the severity of this sudden stop on the global economy. Will the global economy shrink by 3% or 10% in 2020? There is a lot of uncertainly and no one with all the answers. What we do know is that the toll is going to be high, not only in crude economic terms but also in terms of our humanity, with many losing loved ones and even more losing their livelihoods.

The response of governments and central banks has been immense. Central banks have led the charge, slashing rates and pumping liquidity into capital markets to ensure their smooth operation. Earlier in March, the US Federal Reserve (Fed) off proceedings with an emergency 0.5% rate cut – the first since October 2008 at the height of the global financial crisis (GFC). Governments have also brought out the heavy artillery, fiscally-speaking. The US alone is planning to spend US$2 trillion as part of its economic rescue package. The total extra global fiscal stimulus is estimated to be greater than what was doled out during the GFC. To fund this stimulus, government debt levels are set to soar to unchartered levels. How this debt is going to be repaid is a question few are asking.

Financial markets reflect this turmoil in the wider economy. Equity markets have fallen by significant amounts. The US benchmark S&P 500 Index fell by 20% over the quarter in US dollars, with investors flocking to the perceived safety of government bonds. The yield on the US 10-year Treasury dropped below 1% for the first time, ending the quarter at 0.7% (yields fall as prices rise).

South Africa has not been spared from the carnage. In addition to the pain inflicted by the COVID-19 pandemic, the country suffered an additional blow as Moody’s Investors Service downgraded the country’s sovereign credit rating to one notch below investment grade. As a result, South Africa will no longer form part of the FTSE World Investment Grade Bond Index (WGBI) as of 1 May 2020. After starting the year yielding 9%, the yield on the benchmark SA 10-year government bond spiked to 13% before pulling back to end the quarter at 11%. The JSE ASSA All Bond Index closed 9% lower for the quarter. Local equities were left reeling, in line with the worldwide selloff in risk assets. The South African benchmark FTSE/JSE All Share Index lost 21% over the quarter, while the Capped SWIX closed even lower, down 27% for the quarter. It was a brutal three months for the listed property sector, which almost halved in value.

Performance review

It is precisely during these challenging times when the merits of the Quality investment philosophy manifest. While the portfolio delivered a negative absolute return, we are pleased with how it held up amid the turmoil in global financial markets over the quarter.

Offshore equities and Gold provided double-digit returns in rands, and outperformed broader market indices as well as returns in excess of local cash.

Within the offshore equity component, absolute performance was largely driven by quality companies such as Microsoft, Nestle and Verisign.

Locally, listings such as Assore, Naspers and British American Tobacco also contributed to performance. In addition, a depreciating rand resulted in an extra boost in gains for our offshore and rand-hedge holdings.

Diversified miner Assore, deserves special mention. The position has been in client portfolios for more than 20 years, and has been an impeccable example of capital allocation, a sound financial model and secular outperformance despite being in the cyclical resource sector. The company will delist in May from the Johannesburg Securities Exchange with management taking the business private.

Our meaningful commodity holding in the NewGold exchange-traded fund (ETF) provided counter-correlated performance as bullion benefitted from the risk-off environment. The cash holding in the portfolio also added value.

These positive gains were more than offset by the negative performance of our local equity holdings, namely; Sasol, Bid Corp, Standard Bank and Distell. The significant sell-off of local bonds over the period also resulted in our bond component detracting from absolute performance.

Portfolio Activity

We are not short-term traders. Instead, we prefer owning positions in high quality companies that offer good value. Typically, these positions are held over long periods of time. During this quarter we opportunistically added to existing positions in Naspers, Mondi, PSG and Bid Corp. The small remaining position in Sasol was sold.

The movement in bond yields surprised us to the upside with record real yields on offer. We used the spike in bond yields as an opportunity to increase the fund’s holding in South African government bonds.

Outlook and strategy

The unfolding turmoil in financial markets has highlighted, among many things, the merit in our investment philosophy’s deliberate avoidance of companies with a lot of debt. Highly indebted companies the world over, have come under pressure and many have been forced to withhold dividends.

Our preferred asset class remains global equities. However, as-bottom up stock pickers, we are highly selective in the individual assets we hold. Our preference is for what we perceive as high-quality companies that have enduring competitive advantages, form barriers to entry and provide pricing power. This in turn enables these companies to generate long-term growth and generate sustainably high levels of profitability. The global equities we hold, while trading on similar valuation metrics to the MSCI All Countries World Index, collectively generate significantly higher returns on capital than the other companies in the market.

The outlook for the South African economy has worsened further. While it may be convenient, South Africans should be careful of laying the blame for our troubles solely on COVID-19. Long before COVID-19 reached our shores, South Africa’s economy was already in recession. The fiscal situation in South Africa had been deteriorating steadily over the past decade. Coronavirus was merely the straw that broke the camel’s back.

The sovereign credit rating downgrade by Moody’s, relegating South African bonds to junk status, is a strong signal that we are fast approaching a fiscal cliff. Government debt is rising to dangerous levels. The South African economy is crying out for structural reforms that will spur growth and curtail expenditure. Factors such as policy uncertainty, an inflexible labour market and the lack of a reliable electricity/water supply do not inspire investor confidence. Business confidence is at multi-decade lows and consumer confidence, too, is on the decline. COVID-19 is a massive setback for the economy. GDP in 2020 will likely shrink by more than 5%.

Despite this low growth outlook and despite the South African Reserve Bank (SARB) cutting interest rates by 1% at March’s policy meeting, South Africa’s real interest rates (the interest rates after subtracting inflation) remain among the highest in the world. Given these high real rates, the weak outlook for economic growth and the low inflation expectations (helped in part by the collapse in the oil price), we remain of the view that there is room for the SARB to cut interest rates further.

Locally, we believe the best opportunity remains South African government bonds. With yields of around 11%, these instruments offer higher risk-adjusted return potential than most South African stocks. While we have been increasing our allocation to domestic equities, we remain cautious and believe the local equity market may not be adequately pricing in the risks that companies may face in the coming months. The correct forecasting of complex global macroeconomic outcomes is almost impossible (as evidenced by recent events). Even if it were, positioning an investment portfolio precisely for such an outcome is even more challenging. We thus do not believe it appropriate to position the portfolio for any particular event. Instead, we maintain a balance of exposures which offers protection against a range of potential outcomes.

As always, we remain unwavering in our commitment to growing your capital in a judicious and discriminate manner.

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Important information

The information contained in this Viewpoint is intended primarily for professional investors and should not be relied upon by private investors or any other persons to make financial decisions. All of the views expressed about the markets, securities or companies in this document accurately reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Ninety One SA (Pty) Ltd in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. We do not undertake to update, modify or amend the information on a frequent basis or to advise any person if such information subsequently becomes inaccurate. Ninety One SA (Pty) Ltd is an authorised financial services provider.