May 17, 2021
A little more than a year ago, global equity markets had fallen off a cliff. Now, markets are celebrating all-time highs, with investors benefiting from liquidity tailwinds. Through its quantitative easing (bond-buying) programme, the Federal Reserve (Fed) has massively expanded its balance sheet to almost US$8 trillion, far exceeding the support it provided to markets during the Global Financial Crisis (US$4.5 trillion). Governments across the world have added fiscal firepower, in the form of stimulus packages to aid businesses and consumers. The Fed has also pledged to hold interest rates near zero until 2023.
Financial market exuberance reflects the synchronised economic recovery that is unfolding across the world, as economies start opening up again and vaccine roll-outs gain momentum. Consequently, we’ve seen a strong investor preference for “recovery” stocks, i.e. more cyclical and lower-quality stocks. This doesn’t mean that we are going to change our investment strategy because we have seen that, over time, high-quality businesses create an outperformance footprint that is attractive for investors.
Generating inflation-beating returns for our investors requires exposure to growth assets. If you look at the portfolio positioning of the Ninety One Cautious Managed Fund, we have significant exposure to foreign equities. We have stuck to our guns of backing quality businesses that will help us deliver dependable returns for investors over time. Irrespective of market conditions, we remain focused on key characteristics such as solvency, liquidity, strong balance sheets and resilient earnings.
This unwavering commitment to quality, helped us to materially limit drawdowns during last year’s market crash. While our global quality holdings have lagged the broader market over the last 12 months (as at end March 2021), we delivered strong absolute returns from these holdings.
We believe there is a lot of value in quality stocks. Interestingly, the global quality stocks in our portfolios are now the cheapest they’ve been in the last ten years – whether you consider free cash-flow yields or even price/earnings (PE) multiples.
Over the last few years, we have built a resilient SA equity position by focusing on businesses that have largely benefited from growth outside South Africa. These include the likes of Richemont, Naspers and Bidcorp. South Africa’s macroeconomic environment remains very tough, and many domestic-oriented companies will struggle to maintain earnings growth beyond this recovery year. However, pandemic-induced sell-offs have created some compelling investment opportunities. We have been increasing our allocation to domestic equities, but importantly, we have remained highly selective, maintaining our valuation discipline.
New holding Clicks is one of the standout performers in the struggling SA economy. The company has been steadily gaining market share in a fragmented industry. Clicks and closest rival Dis-Chem enjoy more than 50% of the listed pharmacy retail market share. Their dominance is expected to grow to 70% in the next ten years (Figure 1).
Figure 1: Listed pharmacy retail market share (R billion)
Source: Ninety One, Clicks Group and Dis-Chem, as at 28 February 2020.
A key differentiator for Clicks is United Pharmaceutical Distributors (UPD), a wholesale healthcare provider and distributor that is a division of the group. UPD provides Clicks with an efficient healthcare supply chain channel. The group’s nationwide footprint is a major strength. During these difficult times, cash-flush Clicks has been able to comfortably fund its organic growth. It has an impressive retail footprint of some 760 stores and 600 pharmacies. Importantly, Click’s store roll-out strategy has been prudent; it has avoided cannibalisation of existing stores. The group has a strong track record of efficiently employing capital. Currently, its return on capital (ROIC) is more than 40%, as can be seen in Figure 2. We believe this defensive, high-quality retail business is well positioned to enjoy long-term growth and maintain a sustainable competitive advantage.
Figure 2: Lease-adjusted return on invested capital (ROIC)
Source: Clicks Group.
Capitec is another interesting addition to our portfolio. It is one of the highest quality banks in South Africa, generating attractive returns on equity (FY21: 17%*). Since its launch, 20 years ago, Capitec has made inroads into the market share of the big four banks. It was the only bank to grow its market share in 2020 amid a very tough economic environment. During the past financial year,* Capitec continued to expand its active client base by an average of 160 000 clients per month – a 14% increase to 15.8 million customers. It has grown its business client base by 30% and plans to launch a business bank towards the middle of next year. Three-plus years ago, this “challenger” bank had the smallest market capitalisation of the big five banks. Today, its market capitalisation exceeds Nedbank and Absa. We believe there is still a lot of runway ahead of the company in terms of growth. Capitec’s progressive digital strategy, banking innovations and strong financial position mean that it is well placed to generate sustainable earnings over the long term.
Over the last five years, investors could hide in the safety of cash and earn real returns in excess of 2%, which is high by historical standards. The prospects for cash have deteriorated significantly given the 300bps cut in interest rates during 2020. With cash rates at 3.5%, we believe that cash will deliver anaemic real returns for investors over the next five years, based on our inflation outlook of 4-5%.
Figure 3: Returns from cash are going to be significantly lower in the future
Source: Bloomberg as at 7 April 2021. Cash yield: JIBAR 3 month.
The best local opportunity remains government bonds which offer a real return in excess of 6%. Even taking into account downside risk to the fiscus, we believe bond yields still provide a sufficient margin of safety. SA bonds are also a natural hedge against the volatility of the South African rand and bring stability to the portfolio given our exposure to offshore equities.
We believe inflation-linked bonds (ILBs) with short durations (4-5 years) are particularly attractive given the muted inflation expectations priced into shorter-dated maturities, relative to our base case inflation forecasts. In our view, these should form part of a diversified portfolio. The risk of short-term real yields rising is offset by the very low duration and, to a lesser extent, the coupon. For longer dated maturities (10-15 years), we prefer nominal bonds.
We believe that high-quality global companies are currently at the bottom of their alpha cycle. From mid-January, fundamentals have started to re-assert themselves as the earnings season provided a much-needed shift of emphasis back on actual company results over sentiment and expectation.
A number of our global portfolio companies have delivered strong results – ahead of estimates – and have been correspondingly rewarded by the market.
Valuations for domestic equities have become more attractive, but the prospects for many “SA Inc” businesses are still dependent on a sustainable local economic recovery. While South Africa will enjoy some growth this year, the economy will remain fragile. Even though the return on capital that South African companies generate remains below their cost of capital, prices need to fall further to reflect the economic reality. It is therefore important to be selective and disciplined around security selection on local growth assets.
Based on our scenario analysis, the range of future expectations for SA equities is quite wide and thus we have lower conviction in the asset class given the elevated risk. Therefore, our best local opportunity remains SA bonds.
It is tempting for market participants to assume that there are no consequences for taking risk as long as markets are awash with liquidity and central bank support is in place. While the global market recovery from the COVID-19 shocks has been swift, it took more than five years to recover losses from the Global Financial Crisis and more than seven years to recover losses from the Dot Com crash. As investors, we should never underestimate that the benefits of compounding on long-term wealth creation and avoiding large drawdowns are among the key principles of successful asset allocation decisions.
*12 months to end February 2021.
We hosted our first webinar two weeks into lockdown on 14 April 2020. Our initial licence only allowed for 1 000 attendees and by our second webinar we were faced with over 1 600 registrations! A year down the line, we have hosted 122 webinars, attended by more than 82 000 clients. Here are some of the highlights.