The most important determinant of investment success is the price you pay for an asset, and valuations for many quality companies are the cheapest they have been for a long time. Presenting via Zoom webinar, Duncan Artus discusses the Allan Gray Equity Fund’s positioning and prospects – and where he is seeing potential. Watch this 35-minute summary and see below for key takeouts from the presentation.
The Allan Gray Equity Fund (the Fund) invests not only in South African shares but also offshore up to 30% in the Orbis equity funds, as well in Africa ex-South Africa. The FTSE/JSE All Share Index (ALSI) is a concentrated index and the offshore allocation gives us more options to generate returns and of course provides diversification.
A look at the local investment context
Absolute returns from SA equities have been low. The market has underperformed inflation over three and five years and is flat since 2014, and from 2006 when measured in US dollars. This is despite the extraordinary performance of Naspers.
It was disappointing that we did not protect capital better in the downturn. In our view, the market was not expensive before the COVID-19 sell-off and we found a lot of value in March and April. Most of the detractors from our performance, other than Sasol, have been local financial and consumer shares. However, we believe some of these provide long-term opportunity. We are also underweight Naspers, BHP, Anglo and Richemont, which have substantially outperformed the rest of the market. This positioning hurts in the short term, but we are excited about some of the opportunities we are finding.
The yield on our 10-year government bond is a transparent barometer on how we are doing financially as a country. After the large sell-off in the first quarter to over 12%, the yield has settled back at 9.2%. This is still a very high cost of borrowing if we consider inflation is around 3%. In other words, markets are only willing to lend to South Africa at a real interest rate of 6%. This is a very high cost of capital, partially due to our rapidly deteriorating financial position, which has been exacerbated by the fiscal response to the pandemic and collapsing tax revenues. We expect the fiscal deficit to be over R700bn in 2021. Put simply, South Africa cannot afford it over the medium term. We need strong economic growth which requires strong sensible leadership to get out of this hole.
Significant disparities in global markets
There is significant disparity in global markets, and a disconnect between fundamentals and the level of equities. This will only be known for sure with hindsight, but what we do know, is that central bank balance sheets have expanded rapidly. This excess liquidity often finds its way into asset prices. The US Federal Reserve’s balance sheet has increased from US$4tn to US$7tn in response to the pandemic.
The disparity can be seen by comparing the performance of US equities to the rest of the world. US markets have hugely outperformed and, in fact, the MSCI All Country World Index excluding the US is lower than it was in 2007.
While the US market has outperformed, like the ALSI, it has also been driven by a small number of shares. The so-called FAAANM shares (Facebook, Amazon, Apple, Alphabet, Netflix, Microsoft) are up 4 times (January 2015-July 2020), while the rest of the market is only up 26%. The offshore portion of the Fund has little exposure to these shares, other than small positions in Facebook and Alphabet, as we believe that while they are great businesses, the valuations look stretched. Any kind of mean reversion could result in strong outperformance of the Index.
Pessimism presents opportunities
Yes, the economic outlook is dismal, but it is in times of great pessimism that great value is found:
The most important driver of our market has been the spectacular performance of Naspers (including Prosus). This in turn has been driven by its stake in Chinese internet company, Tencent. When measured in rands, Tencent has more than doubled since its December 2019 low and is now valued at US$680bn. Tencent, like many of its gaming, e- commerce and internet peers, has benefited from lockdown on a relative basis and continued to produce excellent results.
Given the run-up in the share price, we believe Tencent is fully valued on a standalone basis but we are able to buy it through Naspers at a lower valuation due to the large discount Naspers trades at to the sum of its parts. Naspers owns substantial businesses outside of Tencent such as their online classified and food delivery divisions to which the market is ascribing very little value. There is a significant opportunity to unlock this value over time.
One of the largest differentiating positions in the Fund is our holding in Glencore, which is our fourth biggest share. Glencore is our preferred resource share and has underperformed its peers BHP and Anglo American by a large margin. This is mainly due to Glencore having no exposure to iron ore, which is a significant contributor to the earnings of BHP and Anglo. In addition, there is a regulatory overhang as Glencore is the subject of several investigations. We like Glencore’s commodity basket and its marketing business, which generates stable returns through the cycle. Based on our estimate of normalised commodity prices we believe it trades at an attractive discount to intrinsic value.
Sasol has clearly been the largest disappointment in the Fund and our estimate of intrinsic value has come down. The Lake Charles Chemicals Project (LCCP) is now largely complete but the cost overruns and delay in starting production have left Sasol with a weak balance sheet at a time of low oil and chemical prices. Sasol is undertaking measures to strengthen its balance sheet, including selling assets and, according to media reports, a stake in LCCP. Higher oil and chemical prices have seen a strong rebound in the share price from an oversold position and we continue to think about the balance between risk and reward when assessing its size in the portfolio.
As mentioned previously, the Fund is overweight financials and we have done a lot of work on the downside risks and balance sheets of our banking sector. Given their pivotal role in an economy we know that problems and weakness are going to show up in their loan books. We believe this is more than discounted into the current level of share prices. Our banking system earns higher returns on capital than most developed market banks which gives our banks a greater ability to absorb increased bad debts. Based on our work, we believe bad debts would have to be three to four times higher than those during the great financial crises of 2009 before wiping out their excess capital buffers.
Turning to consumer stocks, we think Woolworths is trading at a large discount to fair value and has several potential self-help initiatives that can add value independently of the economy over the medium term. In 2015, the market valued Woolworths at over R100bn. Today that number is just R32bn. Over that period the food business has grown profits strongly and is now the biggest contributor to the bottom line. Despite some challenges, the clothing division is still profitable and relevant, and management are aiming to get the division back to its previous levels of profitability. The David Jones business in Australia has struggled as department stores have come under pressure globally, but this is well known and based on our numbers the market is attributing a large negative value to the business.
Cognisant of the risks
In summary, the levels of disparity in global equity markets are extreme by historical standards. Unfortunately, this knowledge does not tell when it is going to change. We are excited by the positioning of the portfolio but are aware of the extraordinary times we as investors and ordinary people find ourselves in. This means that thinking about and managing risk is as important as thinking about returns.