Riding out the market firestorm

In the middle of an equity bull market, it’s easy for investors to forget that the ‘good times’ don’t last forever. Fortunately, bear markets also come to an end. Both up and down markets are part of the economic cycle. Anticipating the start or end of the different phases of the economic cycle is not a perfect science because every cycle is different. Therefore, maintaining a disciplined investment approach through the cycle is crucial when you invest in equities for long-term wealth creation. As active managers, our aim is to uncover equity opportunities when others are fearful, sell into strength when overoptimism clouds market consensus, and to hold the line on high-conviction stock positions, which may be experiencing short-term dips in performance.

Earnings resilience

Central banks are having to cool down their economies to fight stubbornly high inflation. A withdrawal of liquidity and a sharp rise in interest rates are weighing on equity markets. Companies face material headwinds, such as higher capital and input costs, pricing pressures and lower demand, which in turn could put a squeeze on their earnings (profits).

Given this difficult operating environment, we are allocating capital to companies with earnings resilience. So, we prefer companies whose business models are robust enough to withstand the pressures of higher interest rates, stubborn inflation and a potential recession. Essentially, we assess:

• Pricing power – does the business have the ability to put through price increases and maintain volumes?
• The variability of the cost base – are cost savings sustainable, and will these measures impact future revenue growth?
• Leverage – debt-laden businesses face higher financing charges that could impact earnings.

Besides these factors, we also consider environmental, social and governance issues that could have a material impact on the earnings outlook of a company and its valuation.

It is our belief that the share price of a company moves in correlation with a series of upward revisions in earnings forecasts. On the flip side, downward revisions in earnings forecasts usually drive a company’s share price lower. This is why we assess the direction of a company’s earnings, i.e. do we expect a company to have a series of earnings upgrades, or will an earnings upset spark a series of earnings downgrades? Macro shocks such as the US Federal Reserve’s aggressive interest rate hikes can cause sudden changes in earnings direction.

The next big reset

While investors still had access to cheap money, global equity prices rose to levels that generally did not reflect the fundamental value of stocks. In contrast, the South African equity market did not benefit from the excess liquidity, as evidenced by a lack of foreign flows and much lower valuations than developed markets. While we’ve seen sharp corrections in equity markets, we believe the next leg of weakness could be triggered by the heightened risk of earnings downgrades, especially in the consumer cyclical sectors.

We continue to have a more favourable view on domestic equities as we are finding more stock ideas where companies’ valuations and earnings revisions profiles match our selection criteria. Consequently, we have not increased the Ninety One Equity Fund’s exposure to offshore equities this year. The current offshore weighting is approximately 23%.

A shift to global defensives

On the global front, we have materially increased our exposure to more defensive companies at the expense of cyclicals and growth stocks. Given increased risks of earnings disappointments, we have gravitated towards companies with more stable and sustainable earnings growth profiles, underpinned by strong cash flows. For example, within healthcare, our holdings include Elevance Health and United Health Group. Despite challenging conditions, these companies are still able to deliver double-digit earnings growth and attractive dividend yields.

We have also increased exposure to defensive energy utilities with growing renewables businesses, such as NextEra Energy and Iberdrola.

NextEra Energy – a defensive compounder in a structurally strong green energy sector

Our investment mandate allows us to cast the net wider than South Africa, which means we can invest in industries such as the alternative energy sector that we cannot access within the local market. NextEra Energy is a good example of a dynamic player in the transition from ‘dirty’ energy to green energy. There are two parts to its operations: the historic utility business in the US state of Florida from which the company derives the bulk of its earnings (65% of EBITDA)¹ and the other is the renewables business (35% of EBITDA). Over time, NextEra Energy has materially improved the efficiency of its traditional utility business, which has enabled it to pass on expenses to customers – but at levels that are below the average rate of inflation. It has also changed the electricity mix, materially reducing exposure to fossil fuels, such as coal.

Because of NextEra Energy’s scale and size, and its successful track record in the regulated utility industry, the company has been well positioned to win government contracts for its renewable energy business. It should also benefit from the US Inflation Reduction Act (the Act), which aims to reduce greenhouse gas emissions in the US. The Act contains tax breaks for renewable energy companies to stimulate more growth in this space. Besides doing business with government, the company also has contracts with large US companies, such as Walmart and Amazon, which are committed to reducing their carbon footprint over time. NextEra Energy has a healthy pipeline of business and has consistently delivered attractive earnings and dividend growth to shareholders.

Figure 1: NextEra Energy – alternative energy that is not accessible in SA

Source: Bernstein, Bloomberg

Better return opportunities in SA

As mentioned earlier, we see more opportunities in our home market than globally and still favour select ‘SA Inc’ counters (companies that are geared to domestic economic activity). The portfolio has a healthy allocation to South African banks. Despite material upgrades over the last few months, we see further upside to banks’ earnings. The Covid economic shocks meant that SA banks had to make substantial provisions for bad debts, and many of those provisions were overly conservative. Banks are experiencing fewer non-performing loans than anticipated. Non-interest income and transactional activity have also exceeded expectations, while net interest income is supported by the rising interest rate environment. Valuations remain attractive.

Figure 2: Increased allocation to SA banks supporting returns

Exposure to banks (% of SA equities)

Source: Ninety One, as at 30 September 2022.

The portfolio also has exposure to select apparel retailers, such as Mr Price, Pepkor and Woolworths. We also maintain meaningful exposure to Shoprite. The group continues to gain market share in both the low and top end of the market through its Usave and Checkers brands. An aggressive debt reduction strategy and rationalisation of its supermarkets in Africa (ex SA) have increased returns and profitability

Conclusion

Difficult market conditions highlight the value of bottom-up stock picking. Our disciplined investment approach means that we don’t let emotions such as fear and greed cloud our judgement. We focus on finding reasonably valued companies that we believe will have positive future earnings revisions. We look at our portfolio holistically, ensuring that our offshore assets complement our SA holdings. A key part of our approach is assessing how offshore investment ideas stack up against SA opportunities.

Deciding on the local and global equity mix is a dynamic process. We continuously scour the local and global universe for compelling investment ideas – some of which may only come to fruition once we’ve passed the eye of the global recession storm. In the meantime, we are laying the groundwork so that we are ready to capture opportunities ‑ both global and local ‑ when the time is ripe to do so.

¹ Earnings before interest, taxes, depreciation, and amortisation.