Looking beyond the liquidity tailwinds

It’s 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. What does this mean for investors who need to preserve capital and grow wealth over the long term? 

May 17, 2021

7 minutes

Duane Cable
Sumesh Chetty
It’s 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. What does this mean for investors who need to preserve capital and grow wealth over the long term? 

The fast view:

  • The most significant driver of growth in the Ninety One Cautious Managed Fund remains high-quality global businesses with limited sensitivity to the economic cycle.
  • 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.  
  • 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.
  • 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.

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.

Global equities remain an important generator of growth

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.  

Pandemic pullback has provided SA buying opportunities

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)

Listed pharmacy retail market share (R billion) graph

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)

Lease-adjusted return on invested capital (ROIC) graph

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.

SA bonds offer an attractive income stream for investors

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

Returns from cash are going to be significantly lower in the future graph

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.

In conclusion

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.

The prospects for many “SA Inc” businesses are still dependent on a sustainable local economic recovery.

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.

Download PDF

 

*12 months to end February 2021.

Authored by

Duane Cable
Head of SA Quality 
Sumesh Chetty
Portfolio Manager

Next article

Ninety One live webinars - some highlights

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.

Taking Stock Autumn 2021 Hub Next article

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Ninety One Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.ninetyone.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, RMB, 3 Merchant Place, Ground Floor, Cnr. Fredman and Gwen Streets, Sandton, 2196, tel. (011) 301 6335. Ninety One SA (Pty) Ltd is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).

This document is the copyright of Ninety One and its contents may not be re-used without Ninety One’s prior permission. Ninety One Investment Platform (Pty) Ltd and Ninety One SA (Pty) Ltd are authorised financial services providers.