The start of 2020 has been tumultuous as fears about the coronavirus have dominated the news and global markets. The resulting volatility has been compounded by the 30% collapse in the oil price. Radhesen Naidoo shares our thinking around what this may mean for long-term investors.
Over the week to 28 February 2020, the FTSE/JSE All Share Index fell by 11%. On 9 March, it fell by a further 6.2%, hitting a four-year low. The 9th of March also saw the S&P500 fall by 7.6%, delivering its worst daily performance since the global financial crisis in 2007/08. The US market, however, has experienced a bull run for over a decade, and high expectations leave plenty of scope for pain should greed curdle into fear. Globally, the sell-off has been indiscriminate, suggesting that price declines for many stocks may be disproportionate to the impact of the coronavirus outbreak on their long-term fundamentals. As bottom-up investors, this is what we spend our time analysing.
The virus’ outbreak has produced frightening headlines simply because viruses spread at an exponential rate. Given the current case number growth rate, it seems peak infections may occur within five months and subside quickly thereafter. We have no idea how things will unfold. In situations like this, our job is to remain disciplined and assess the impact on our funds and their underlying investments.
For investors in the Allan Gray and Orbis equity portfolios, periods of short-term volatility are inevitable and shocks to local and global shares are not unusual. Nonetheless, the outbreak and oil price collapse have come at a time when our performance has been under pressure. Over the last five years, South African equity returns have been weak compared to cash, and the poor local economic backdrop adds to the concern about what potentially lies ahead. We recognise that seeking comfort by switching or changing strategies may seem appealing, but there are opportunity costs for this type of investor behaviour.
As contrarian investors, we tend to find opportunities when the mood is depressed. As we have often said, the most important determinant of future returns is the price you pay for an asset. Looking at today’s starting valuations, the recent volatility has created very exciting buying opportunities and many shares are now trading at multi-year lows. We have not seen expected total returns of this magnitude since the early 2000s when domestic South African shares were extremely out of favour and the global financial crisis of 2007/08 - both of which proved to be exceptional opportunities to invest in equities. Businesses that can survive a year of no cash flow should hold up well, in our view, but this does not apply to companies with substantial financial leverage. Fortunately, most South African businesses do not have heavy debt loads, unlike many in the US, which have geared up to buy back shares in a low interest rate environment.
However, a key risk to acknowledge in our local portfolios is Sasol, which fell by 47% on 9 March. Sasol took on R145bn of debt to build a chemical plant in Louisiana. An oil price of US$35 puts the balance sheet under considerable strain. We believe Sasol is undervalued at R87.50 per share – but the debt makes the company a riskier investment proposition. Ironically, the outlook for the oil price is the best it has been in a long time. US oil production growth has plateaued in recent months and at these oil prices US production will slow sharply as the industry is cash flow negative at US$50, let alone US$35. US shale oil is not the only production source facing declines – the capital starvation of the past five years is beginning to bite in several jurisdictions. Our view is that the current Saudi/Russian strategy is the right one for a strong stable market in the long term. (Saudi Arabia and Russia seem to have decided not to defend a US$60 oil price and rather let low prices drive US shale oil producers into bankruptcy and therefore stem supply).
As a global investment manager, our offshore partner Orbis has a wider opportunity set and can explore ideas in areas perceived to be economically cyclical, such as the energy sector, which has been hit hard by recent events. The Orbis investment team is also exploring new opportunities in sectors that have been impacted by the outbreak, including aviation, hospitality and gaming.
The global economic impact of the coronavirus depends as much on reactions to the virus as it does on the spread of the virus itself. For example, the impact on automotive companies like Honda Motor, which Orbis owns on behalf of its clients, is negative. Half of Honda’s Chinese production is in Wuhan and most auto dealers are closed, which hurts profits. The share was down about 10% in the week to 28 February 2020. As long-term investors, we need to consider whether the long-term value of the business is permanently impaired by 10%. We don’t believe so as car sales in China will resume eventually and production will recommence. In addition, Honda’s auto business outside of China and its world-leading motorcycle business seem to have been forgotten in the noise of global markets.
For other companies, the financial impact may not be negative at all. Naspers, which has meaningful exposure to Tencent, and NetEase are two of the largest holdings in the Allan Gray and Orbis equity portfolios. These companies make and operate online games in China. Youdao, a NetEase subsidiary, also offers online education services. For many in regions locked down by the contagion, leaving the house for entertainment or education is out of the question, and Tencent and NetEase’s games and services provide a way for people to entertain themselves or study at home.
Looking across broader asset classes in our Balanced and Stable portfolios, South African bonds currently offer some of the most attractive real yields globally. The bond market appears to be pricing in a potential credit rating downgrade and we have taken advantage of this by increasing our duration over the past year. In contrast, the 10-year US treasury yield fell to an all-time low on 9 March, yielding less than 0.5% as the US Federal Reserve has cut rates. In the offshore component of the funds, we are optimistic about the shares Orbis finds attractive. We also hedge a portion of our offshore exposure, which helps to protect our funds during a market downturn, but this means we can still benefit from Orbis’ stock-picking capability. Lastly, rand weakness over the period has slightly offset the poor dollar performance of the offshore component.
Being a long-term investor has its challenges. It can be tough not to panic as events unfold, but patience can pay off. At times when others are fearful, a long-term perspective is not just a bulwark against emotional decision-making, but also a source of opportunity.