The events of Monday, 9 March were the biggest ‘risk event’ in global markets since the global financial crisis (GFC). Thus far, there have been three key contributors to the current turmoil in markets:
Firstly, a quarantine that began in northern Italy crystallised fears around the spread of the coronavirus. Then, Italy placed the whole country under lockdown. Fears have centred on the life-threatening effects of the virus globally, and the economic impact of control measures to impede or stop the spread of the virus.
Secondly, the fallout between Saudi Arabia and Russia has resulted in the collapse of the oil price as ‘OPEC+’ effectively fell apart. Saudi Arabia has vowed to regain lost market share in the oil market by slashing prices.
Thirdly, we witnessed another major collapse in equity markets following the US suspension of travel from Europe, while the World Health Organisation finally declared the coronavirus outbreak a pandemic. Markets sold off as investors began to assess the potential damage to the world economy from the stringent lockdown measures being employed as well as the lack of detail and clarity on the US fiscal front to limit the economic malaise.
It is fair to say that the market reactions we witnessed in recent weeks were initially a product of investor sentiment rather than any evidenced appraisal of the economic impacts. While the outbreak began in China and as such, the infection and mortality statistics were heavily skewed to China, significant outbreaks have since spread across the globe. In a highly interconnected world and facing a virus with such a long, contagious incubation period, this was perhaps inevitable. The fact that other governments have had far greater warning than China may prove beneficial in managing the fallout, but recent evidence paints a mixed picture. The daily infection rate in other regions is currently trending upward. Governments around the world have enforced stricter containment measures.
One positive takeaway is that the situation in China appears to be stabilising, with the rate of new infections reported by the health authorities falling. Temporary treatment clinics in Wuhan have been shut down as people have begun to recover. For now, it seems China may be past the point of maximum pessimism as the government switches focus from fighting the virus to getting the economy back on track, which could influence the return of some positive sentiment in the Chinese market at least.
For broader market positivity, we may have to wait until we see evidence of infection rates in other parts of the world similarly shift from growth to decline.
From a portfolio perspective, we are cognisant of the potential implications of this outbreak on some of our portfolio positions. That said, we believe it is paramount for us not to deviate from our disciplined investment process – picking stocks with positive earnings revisions at a reasonable valuation – even in the face of such event risks. The combination of objective factor-based screening and bottom-up fundamental research allows us to cut through inefficiencies, enabling us to avoid behavioural biases and to deliver repeatable and dependable returns.
In fact, we believe thorough bottom-up fundamental analysis is required to understand the source of earnings revisions. It is important to establish whether changes to earnings estimates are due to permanent or temporary factors. This is key to the successful implementation of our investment philosophy.
Some of our key positions include:
Naspers/Prosus
We expect the advertising and payments businesses to be negatively impacted due to the disruptions of overall economic activities in China, while the mobile gaming and subscription video business should benefit from people staying at home with little else to do. Although it is hard to quantify the overall effect on Tencent’s earnings at this stage, any potential impact on its earnings revisions profile should be temporary. We do not believe the coronavirus has changed the earnings power of the Tencent platform, one which the market underestimates in our view.
Resources
The virus outbreak is expected to have a negative impact on steel production in Q1 and Q2 of 2020 as reportedly six provinces remain under quarantine, while the entire country has been slow to resume work after the extended lunar new year holidays. After having spoken to commodity traders and analysts in China, we expect weak Q1 2020 production data as port inventories are rising for various commodities and manufacturing has ground to a halt. The government has, however, reportedly instructed provinces and financial institutions to inject liquidity into the economy, including the issuing of infrastructure-specific bonds. This added liquidity is likely to benefit steel manufacturing commodities such as iron ore, coking coal and manganese, which will be supportive for prices as seaborne supply remains very disciplined. Our assessment is that the demand disruption for commodities is non-permanent and we should see a strong recovery in demand in Q3 2020. As such, we have not made any changes to our portfolio as a result of the coronavirus outbreak. We continue to evaluate our investment decisions based on the fundamentals for each commodity and stock-specific investment cases.
When building and managing our portfolios, we believe the best approach to mitigate company-specific risk is through:
Macro variables and event risk all have a significant impact on stock returns. It is thus tempting to forecast these and position the portfolio accordingly. Our experience, however, is that these variables and risks are extremely difficult to forecast. Further, there is insufficient breadth in this type of risk taking – the outcome is typically binary. We prefer the breadth of a stock-picking strategy where we are able to diversify risk across a wide range of individual stock positions.
Our aim is to maximise the benefits of our individual stock insights; hence, we closely monitor macro risks which may unintentionally be embedded in the portfolio as a result of the aggregate individual stock selections. Where necessary, we take action to avoid macro risk.
The composition of our portfolio is diversified, with some capital invested in global cyclical companies geared to the global economic cycle and exhibiting favourable earnings revisions profiles such as Naspers (and Prosus) as well as platinum group metals (PGM) investments. More defensive positions include AngloGold Ashanti, Bid Corp, British American Tobacco and Reinet Investments. We also have exposure to select ‘SA Inc.’ plays, including Capitec Bank, FirstRand and Sanlam.