A differentiated approach to investing in SA equities in turbulent times - Angles & Perspectives

A differentiated approach to investing in SA equities in turbulent times

July saw horrific scenes as parts of the country were engulfed by riots and looting. While social unrest is not a new phenomenon in South Africa, the enormity of the destruction and the inadequate security response have left emotions running high and many unanswered questions. South Africans are rightly wondering what happened and what can be done to prevent such occurrences in future. At the time of writing, we were waiting for clarity on the events and response from Government. That said, the events were clearly very damaging to already fragile business and investor confidence. However, if one takes a balanced view, we should recognise that good may come from disaster. Hopefully, we will see concrete steps to restore public confidence in security as well as a speeding up of the path to economic reform.

In times like these it is important to discount one’s personal emotions when making investment decisions. We should remember that our country is mired in a deep crisis, confidence is very low and domestic assets are very cheap. Our country faces many challenges but sensible investing could yield very favourable results. Recent events should not overshadow the longer-term picture when it comes to investment decision-making.

Divergences in valuations have been a notable feature of global financial markets in recent years. The valuation gap between the expensive and cheap parts of the market reached levels last seen in the dotcom era. We believe that this has presented a very attractive opportunity to allocate capital to carefully selected cheap stocks where the market is underappreciating the quality and growth prospects. The Covid-19 panic significantly enhanced this opportunity.

In South Africa, many good businesses are cheap
South Africa, along with other emerging markets, is an amplified version of the global value picture. Our market is blessed with quality businesses trading at deeply discounted valuations in times of market indices surging to new highs. This has given rise to an excellent opportunity for long-term returns from asset managers that are prepared to pick stocks and invest in the underperformers of recent years. The reason that most of the stocks on the JSE are cheap, is readily apparent. We have had a very poor economic climate in recent years amidst elevated political risk. This has given rise to dismal levels of business and consumer confidence. Domestic investors have fled underperforming local equities in favour of income funds and high-flying global investments. Foreigners have materially reduced exposure to SA equities over a number of years, partly as a result of our lower weighting within emerging market indices but also due to poor sentiment towards ‘higher-risk’ emerging markets. This backdrop has created an excellent opportunity for differentiated long-term investors – i.e. those who are willing to look for opportunities outside the trend. Just like in 2003, good businesses in this country are very cheap as the global economy emerges from a deep recession. In this scenario, we think it highly likely that companies will grow profits substantially over the next few years. If domestic stocks rerate at the same time that they grow profits – which they usually do – total returns could be remarkable, even before considering the very attractive 2021 dividend yields on offer. All in all, an enticing prospect, and one investors may be starting to recognise.

DP World’s bid for Imperial Logistics – a conviction holding in our funds – is an excellent example of the current mismatch between the quality of many domestic stocks and their share prices. Imperial has attractive assets in Africa and Europe that are clearly coveted by international players. Current conditions are supportive of opportunistic bids by foreigners or private equity for cheap SA stocks. Imperial is not the first and will not be the last.

Local retail investors remain sceptical of the opportunity
Small wonder that many local asset managers are now more positive on domestic equities, particularly when compared to developed markets, and some (including ourselves) have been reducing offshore exposure in favour of domestic opportunities. However, while many local institutions recognise the superior long-run returns available in the domestic market, we have failed to convince retail investors. Confidence remains low and to date there are no indications that retail investors have begun to unwind the exodus out of domestic equities into offshore and income products. The tragedy of this situation is that many local investors had endured poor returns from local assets for several years until 2020, and they capitulated and sold near the lows during the market crisis. Unfortunately, if history is anything to go by, they will only regain confidence in the local market after prices have risen substantially. This tendency to allow emotion to cloud our investment decisions explains why research continues to show that the average investor tends to underperform the index.

We pursue broader exposure to the SA Inc. opportunity set
A review of fund commentaries by local managers indicates that they are becoming more positive on domestic stocks, the so-called ‘SA Inc.’ trade. The tried and tested way of expressing this is to buy banks and retailers – sectors that are fairly liquid and heavily geared to the economy, consumers and interest rates. Banks and retailers became very cheap last year and while most stocks have recovered spectacularly, banks still look attractively priced. Our clients have exposure to these stocks. That said, we think we can currently identify superior domestic opportunities. The local market is extremely concentrated, which forces very large managers to focus their attention on a limited number of highly liquid SA Inc. opportunities, hence the preference for large cap banks. As a medium-sized manager, we have access to a far wider range of opportunities that can have an impact on client outcomes. When we compare what is on offer within a broader universe that includes mid-caps and ideas outside the subset of popular stocks, we have identified some compelling investments.

Our clients are invested in businesses. If you look at the nature of our highest conviction domestic holdings you will observe a few things:

• These are businesses of scale with strong competitive positioning and pricing power.
• They have competent, aligned management teams.
• The prospects are improving.
• The companies are in good shape, proving their resilience during the pandemic, balance sheets are strong, and costs are well controlled and in many cases were substantially reduced in 2020.
• Cash conversion rates are high.
• Future dividend yields look very attractive.
• Most are coming out of deep bear markets and the upside to our estimate of intrinsic value is substantial.
• Many have sizeable businesses outside of South Africa, yet attract the ‘SA Inc’ rating.

Further on, we discuss the merits of the Discovery investment case, as a good example of an easily overlooked domestic opportunity. Discovery is currently investing for future growth, so it is not one of the big dividend payers that dominate our portfolios, but otherwise it meets all the criteria highlighted above.

Low starting valuations and a strong revenue cycle are a good combination for shareholder returns
While the SA economy is currently enjoying a strong recovery from the very low base of 2020, it is worth remembering that many local industries were in the doldrums before 2020. Accordingly, they are very well positioned to benefit from strong global and improving domestic economic cycles. The prospects for some sectors are particularly strong. For example, our export markets (metals and agriculture) are enjoying strong pricing. Tourism and hospitality should enjoy a strong bounceback in demand when travel resumes. And, there are encouraging signals that large ticket infrastructure projects are starting to be awarded, after several years of hiatus. Our clients have a healthy exposure to infrastructure through the likes of Raubex, WBHO, Afrimat, AECI and Grindrod, and also are sizeable shareholders of gaming and hospitality businesses via Sun International, HCI, Tsogo Gaming and Tsogo Hotels.

We also make mention of another of our top holdings, AECI, as an example of quality on sale. We remind clients that this business has generated above-market returns on capital for most of the past two decades. We expect all their businesses to perform strongly in the years ahead as the economy recovers and local infrastructure projects commence. Importantly, their mining division (chemicals and explosives), which contributes 70% of profits, is very well positioned in a booming market. Yet, AECI trades at a very attractive 7 times what we consider to be normalised profits, and should then offer a 7% plus dividend yield on current share prices. A simple assessment of the valuations of comparative global mining explosive and chemicals businesses indicates a material undervaluation of the group, and we conclude that we get the other industrial businesses for free at current levels. It is worth remembering that the last time AECI was this cheap (in the early 2000s) and on the verge of strong multi-year profit growth, shareholders enjoyed 15 years of 21% compounded annual returns (between 2000 and 2014).

This opportunity set bodes well for long-term returns from this part of our portfolios. Importantly, domestic stocks could deliver strong returns at a time when expensive global stocks battle. It remains to be seen whether the domestic retail investor base misses out on this opportunity.

Domestic opportunity: why we are confident that Discovery will be a future winner
Our clients have owned Discovery for a number of years, but like many South African stocks, returns over the last five years have been poor (10% total return for the five years to 30 June 2021 vs JSE All Share’s 48%).

We believe that there are several reasons the stock has not performed in line with the underlying value creation within the franchise over the past five years:

• Emerging market and in particular South African stock valuations are generally depressed.
• The company is at the end of what has been a long and painful investment cycle and substantial capital (and debt) has been used building a number of new initiatives.
• Several of the larger businesses have recently faced temporary challenges such as above-average Covid-19 life claims and low and volatile interest rates, which have depressed reported profitability.

These factors have combined to obscure the substantial latent strength and growth potential of a global platform business poised to deliver substantially higher earnings power and cash flow in coming years.

It seems likely to us that each of the headwinds enumerated above will fade or turn into tailwinds with the benefit of time. We do not expect the life claim losses nor the interest rate headwinds which are currently depressing earnings to recur, and we see encouraging signs of the new investments starting to bear fruit. Among these, the group’s Chinese healthcare business (a partnership with Ping An), the global Vitality Group platform and the domestic short-term insurance business are growing extremely quickly and will shortly contribute earnings in excess of R1 billion. The domestic bank has been the largest source of recent expenditure, but the fixed base is now installed. We expect to see substantial earnings leverage as the company accelerates customer acquisition coming out of the pandemic, and as it transforms its rapidly growing retail deposit base into profitable lending opportunities.

The competitive advantage embedded by the Vitality shared-value model is unique in its application and scale and results in a strong moat for the franchise, with economic evidence visible in market share growth, leading profit margins and the ability to originate new business ideas in adjacent and complementary areas. We think it likely that the common perception of Vitality as a vanilla loyalty scheme fundamentally misunderstands its potential, which lies at the intersection of human behaviour, data and products such as healthcare and financial services. A rarity in South Africa, Discovery’s management is substantially aligned to shareholders (the founders still run the business and retain large shareholdings). Their track record of organically building multiple businesses to significant scale across multiple markets and product lines is a feat unique to them as far as we can tell. The sum total of this enterprise is currently priced well below our estimate of its potential worth, as the market seems unwilling to value the latent earnings power which we believe is likely to be revealed in the coming years. Notably, we think any of four different components of the group (namely, the SA business, the UK business, the global Vitality business and the Ping An joint venture) have the potential to match the current market value of the entire group in coming years. Perhaps we only need a couple of these levers to work.

Discovery is a notable absentee from the portfolios of most large local managers. We think this has helped create the current opportunity as foreigners may appreciate the fintech opportunity better than locals but find themselves bearish on SA. We have interrogated the widely held domestic concerns related to capital and insurance accounting, and have concluded that they are overstated or misunderstood. This is a complex business and early-stage businesses are cash hungry, but we believe that those that are prepared to get under the skin of the long-term global opportunity will be well rewarded.

PSG Asset Management.