This article was originally published as commentary in the Equity Fund factsheet.
The economic outlook deteriorated during the second quarter, exacerbated by the British referendum. Although the market’s perception of near-term headwinds may be correct, it also creates opportunities for investors like us, who have long time horizons, to buy well-capitalised financial services companies on attractive multiples of sustainable free cash flow. The Allan Gray Equity Fund used this opportunity to buy a basket of financial services companies at what we believe are attractive prices.
During the second quarter, the Fund also added to its position in Naspers, which now makes up 6% of the portfolio.
A closer look at Naspers
At 50 times core headline earnings, Naspers is not cheap on the face of it. However, our analysis reveals good value for money. Naspers can be considered as the sum of two major parts, the investment in Hong Kong listed Tencent, which has a market value of R2 500 per Naspers share, and all the remaining businesses, including Mail.ru, e-commerce ventures and pay TV. We think the remaining businesses are worth about R800 per share. If a holding company discount is not considered, the Naspers share price of R2 200 implies that investors are buying Tencent at a 44% discount to the listed valuation. This is approximately 19 times Tencent’s latest annualised quarterly non-GAAP earnings.
There are a number of reasons why 19x earnings is an attractive multiple for Tencent:
- It has a dominant competitive position in online games and Chinese social media, a growing and highly profitable industry
- The company is in a growth phase, with earnings growing at 40% to 50% per year
- Tencent’s cash and associates can be conservatively valued at 20% of its market capitalisation and do not currently contribute to earnings
- Various new growth initiatives show early promise (e.g. online video, payments and banking)
- Free cash flow has historically exceeded earnings by about 10%
When considering the attractive implied price of Tencent one needs to remember that the holding company discount may persist for some time. Investor sentiment could remain negative towards the company and its current loss-making e-commerce ventures while some shareholders might prefer to own Tencent directly.
Additional risks relate to the fact that many internet business models are relatively new and hence the economics could change drastically as technology and innovation march ahead. Thus far, Tencent and Naspers have successfully navigated this space and have developed new products and revenue streams to offset those that have fallen out of favour with consumers.
The long-term capital allocation track record of Naspers gives us confidence that the underlying value should reflect in earnings and their share price in time. We are cognisant of the risks as well as the potential rewards when investing in Naspers and have sized the Fund’s position accordingly.