Feb 23, 2021
Given the extraordinary developments during 2020, there is little history that was particularly relevant to what we experienced. This meant that we did not have past patterns to fall back on, or from which to extrapolate. If you have never experienced something before, you cannot say you know how it is going to turn out. Therefore, a major theme of 2020 was analysing the financial resilience of companies to determine if they would be able to weather the pandemic.
Even before the global market crash in March last year, South Africa’s equity market had struggled to beat inflation over three and five years. The COVID-19 chaos and extraordinary volatility notwithstanding, it was gratifying that the market recovered all its losses by the end of 2020. As Figure 1 shows, this year started strong, with every indication that we are well positioned for further recovery.
Figure 1: Equity markets have recovered all their losses with a strong start to 2021
Source: Bloomberg as at 5 February 2021.
This is largely thanks to a string of recent positive macro developments. The Brexit trade deal agreed in late December, improved political alignment in the US post the election, an EU-China trade agreement, and cooperation among OPEC members on oil supply have all contributed to a greater sense of confidence.
We also expect central banks to stay as accommodative as they can. The US Federal Reserve has committed to keeping interest rates as low as possible through at least 2023. We have also seen a lot of government fiscal support, stimulus packages, and a commitment to assist small businesses and consumers through this recovery.
We are not entirely out of the woods, however. The next few months will probably see further waves of the pandemic, with markets facing a lot of stopping and starting, before vaccines help facilitate a global growth recovery from the second half of the year.
Against this backdrop, coupled with a weak US dollar and tight supply-and-demand dynamics in some commodities, it follows that equity markets should continue to grind higher. Currently, a lot of liquidity is targeting equity markets and, more specifically, emerging markets such as ours, as investors search for attractive real returns.
We construct our portfolio using intensive fundamental research and bottom-up stock selection. Our investment philosophy allocates capital to stocks where expected future earnings are being revised upwards, and we like to buy these at reasonable valuations. We believe that what moves the share price for a particular stock from its current level is the market’s change in earnings expectations – if these are revised upwards, it drives the share price higher, and similarly, if these are revised downwards, the share is likely to underperform.
Excluding Naspers, we believe the SA equity market offers a potential dividend yield of 4-5%, arguably equivalent to the current cash rate. Added to that, we also need to consider the earnings recovery profile of some of the stocks, which we believe to be stronger than the consensus 10 or 15% built into many models.
Accordingly, we have tilted the domestic portion of the portfolio towards a more cyclical recovery trade, with exposure across four broad sectors.
Close to 40% of our domestic equities are allocated to global cyclicals, due to the clear tailwinds we see in this sector.
Resource stocks are set to benefit from the recovery in China’s economy and tight commodity markets, coupled with improving global consumer demand. Figure 2 shows how both the large diversified miners (Anglo American and BHP Billiton) and the platinum group metals (PGM) miners are seeing positive earnings revisions as the market catches on to robust commodity pricing, driven by a global demand recovery.
Figure 2: Average earnings revisions of SA mining sector (Jan 2020 = 100)
Source: Bloomberg, Ninety One, as at 5 February 2021
We have a material allocation to PGM miners. As vehicle sales rebound, demand for platinum and palladium used in auto-catalysts continues to recover. Investment into PGM production has also been lacking over the past few years, leading to insufficient new supply coming to market. This means that the platinum and especially palladium and rhodium markets, should continue to stay constructive and tight.
In the beaten-up South African economy, some of the SA Inc stocks have seen a lot of negative revisions but these are starting to bottom out, while the shares continue to trade at attractive valuations (Figure 3). As these companies start reporting, forecasters are noting that they may have been overly cautious. Several SA banks, for example, had to make provision for bad debts in the third quarter of last year, when we were still under stricter lockdown conditions. We believe many of those provisions are overly conservative. The recovery in retail sales, as well as collections for banks, is exceeding most expectations.
Figure 3: Average earnings revisions for different market sectors (Jan 2020 = 100)
Source: Bloomberg, Ninety One, as at 5 February 2021
We have accordingly switched some exposure from global defensives like British American Tobacco, to local cyclicals, which now comprise approximately a third (31%) of the portfolio. A key consideration for inclusion is balance sheet quality. We have select positions in financials where valuations are attractive and earnings revisions have bottomed, such as Sanlam, FirstRand and Capitec, as well as exposure to some retailers, including The Foschini Group and Pepkor.
We have actively reduced our exposure to global defensives from approximately 40% in June last year, to currently just over 20% of the portfolio. While we are constructive on the outlook for the rand, we believe these stocks will provide protection against any rand weakness should it materialise. Our holdings include Naspers and Prosus, which give you Tencent at a discount, as well as Richemont, Anheuser-Busch InBev and Bidcorp.
Our smallest allocation is to local defensives. The position has remained fairly stable at just below 10% since the middle of last year, as we do not believe earnings revisions and valuations are compelling. We have select exposure to some food retailers and producers, such as Pick n Pay and Tiger Brands, and a moderate allocation to MTN.
Looking at the portfolio as a whole, we have reduced our overall offshore exposure from 30% to approximately 25% in light of our constructive view on opportunities in the local market. We believe the global stocks we hold complement the resource and SA Inc shares that comprise the lion’s share of our domestic holdings. Leveraging off the research of our global colleagues in the 4Factor team, we have exposure to technology stocks such as Microsoft, Amazon and Alphabet, and some Asian opportunities, including Samsung Electronics and Lam Research (semiconductors), and Z Holding – the Yahoo of Japan.
In summary, as the recovery takes hold, we believe the appealing valuations and a strong earnings recovery profile should drive attractive returns for SA equity investors over the medium term. The portfolio is actively managed with exposure adjusted to tap into those opportunities where earnings expectations are improving.
TFSAs are a great initiative from government to encourage savings in South Africa. However, it is important to set them up correctly as long-term investments in order to maximise an investor’s lifetime tax benefit from the product.