Coronation Financial comment - Sep 13 - Fund Manager Comment27 Nov 2013
Banks outperformed insurers during the third quarter of 2013, contributing to a 9.0% return for the fund against a 6.9% gain in the index. Over one year the outperformance against benchmark has been particularly strong, with the fund returning 29.7% against an index return of 22.4%. Over the more meaningful longer-term periods of 3 and 5 years, the fund has returned consistent outperformance with annualised returns of 18.8% (vs 18.2%) and 19.2% (vs 16.9%). Coronation's financial year end is September, and rather than comment on the most recent quarter's contributors and detractors as usual, it may be instructive to have a look back at the last 12 months to see what has worked and what hasn't in the portfolio. Over this period, the top performing share in our investable universe has been our own business, Coronation, which the fund has not owned. The next best five shares, all with total returns exceeding 45% were Capital and Counties (88%), Zeder Investments (68%), Hosken Consolidated Investments (52%), Discovery (49%), and Brait (47%). Each of these stocks has held a meaningful position in the portfolio during the last year, and at September each still represents between 3% and 5% of fund. There are two points to be made here:
- Of these, probably only one (Discovery) would be considered a traditional financial stock. While we are aware of the index benchmark, the fund is not managed in a manner that closely mirrors it. The fund has a relatively narrow universe in which to invest, particularly with the limited number of banks and insurers. We actively seek out and research additional opportunities where we see value and where permissible, will invest in these.
- We aim to keep the portfolio concentrated, and prefer it to consist of fewer, larger holdings. So where we see an attractive opportunity, we will build a meaningful position in that share. This pertains as much to the smaller non-traditional stocks as it does to the traditional banks and insurers.
As a result, much of the fund's outperformance over the last 12 months can be attributed to its holding in these shares. Offsetting some of this was negative contributions due to underweight positions in Old Mutual, Coronation and Sanlam, as well as the fund's holdings in African Bank and Nedbank. The fund's investment in life insurance companies is another example of our desire to concentrate views. These businesses have benefited from a strong rerating since 2009, aided by buoyant equity markets, multi-decade low interest rates (and hence discount rates) and attractive dividend yields. We have for a while been cautious on certain of these stocks on valuation grounds. In the past quarter some of this exuberance reversed, most notably in Discovery (a 4% holding in the fund which has benefited from a particularly strong rerating this year) but also in Liberty and Sanlam. As long as interest rates remain low (our sense is this is likely to last longer than not) and the path of global economic recovery remains uncertain, life companies are likely to benefit. We have, however, been selective in our approach to investing in these businesses, with our principal exposure being to MMI and Discovery. We find these companies attractive for their defensiveness and growth opportunities respectively. Investors will also note, however, that almost 7% of the fund is invested in RMI. This is essentially a holding vehicle for the same two businesses, as well as OUTsurance - the dominant South African direct short-term insurer that is making encouraging progress in the Australian market. A year ago we cautioned against lofty return expectations given the challenges that the sector was facing at the time. Yet the fund has generated nearly the same 30% return over the subsequent 12 months. We continue to be cautious - the interest rate cycle must ultimately turn, credit impairments are probably past their best, and the unsecured credit market faces challenging times, not least of which is tighter regulation. We believe the fund to be relatively defensively positioned, and continue to seek out 'non-traditional' investments that have the ability to add to performance.
Coronation Financial comment - Jun 13 - Fund Manager Comment04 Sep 2013
Following a very strong first quarter, financial shares declined during the second quarter with the financial index returning -1.6% compared to the fund return of 0.3%. We were pleased with the defensive performance of the fund during the period. This has aided in returning the fund to an outperformance of the index over one year (25.4% versus 22.1% for the index). Over more meaningful periods, the fund remains broadly in line with or ahead of the index: 3 years (20.5% p.a. versus 21.1%), 5 years (19.8% versus 18.0%) and 10 years (20.7% versus 18.9%). The quarter was dominated by concerns around the unsecured lending market after African Bank, the largest lender in this sector, surprised the market with a sharp decline in their interim profits to March. While there were some company specific issues impacting their numbers, it is clear that with lending slowing in the unsecured loan market, bad debts are on the rise. This is something that we have aluded to in our previous commentary, and the fund currently retains a very small position in African Bank. Added to this picture, we saw meaningful regulatory changes being proposed in an effort to ensure long-term sustainability of the industry. We believe that many of these proposals will be positive for the market and curb irresponsible lending. We are concerned that there are too many changes being proposed simultaneously without adequate impact assessment or consultation. This may well prove to be very disruptive, even for responsible lenders in the market. What are the implications for the banks generally and for African Bank in particular? Following the release of African Bank's results, the share price halved despite interim profits declining 26%. We do not believe that the franchise value of African Bank has halved on the back of what we see as a cyclical downturn to their profits and therefore see value in the share. The business clearly faces challenges going forward and we expect the environment to deteriorate further for both the bank and the furniture retailing divisions, but we believe that this is more than discounted in the current share price. The big four banks all have exposure to the unsecured lending markets, but given their diversified portfolios, should weather the downturn in unsecured lending much better. The following table (courtesy of CitiGroup) gives a sense of the contribution from unsecured loans to the lending books of the big banks. It's evident that personal loans remain a very small part of the lending books of the big banks. Given the higher yields earned in the unsecured lending space, the contribution to bank earnings is higher and closer to the 10% level on average, yet still small enough to be manageable. What gives us more comfort however is the proactive stance the banks have followed in terms of raising provisions in anticipation of the deterioration that we currently see in the sector. Bank earnings should prove to be more resilient as a result of this and we therefore remain comfortable with our bank holdings. The life sector remains richly valued in our view, despite the more recent sell-off. We have retained our large positions in Discovery and RMI where we feel the valuation is relatively less demanding and the company specific opportunities remain attractive long term. These positions were positive contributors to fund performance for the quarter. Other positive contributors included our holdings in Brait, Zeder, Peregrine, Capital & Counties and Intu Properties. We remain happy holders of these quality businesses at current valuations. The outlook for the South African consumer remains challenging. We are at a low point in the interest rate cycle and the next meaningful move in rates is likely to be up. We therefore expect the next three years to be tougher than the last three for both the banking and insurance sectors. We believe that this is a view shared by managers of these businesses and they are therefore implementing the appropriate strategies to ensure that their businesses weather this environment and grow beyond. We are however comfortable that the businesses we are invested in are valued at levels that more than take this tougher outlook into account while leaving us with some margin of safety.
Portfolio managers
Neill Young and Godwill Chahwahwa Client
Coronation Financial comment - Mar 13 - Fund Manager Comment29 May 2013
The first quarter of 2013 was another strong one for financial shares, with the index returning 5.9% and the fund 6.0%. The fund has started to close the gap on the benchmark index over one year (28.7% versus 29.7%), and over longer periods has continued to deliver strong returns: 3 years (17.3% p.a. versus 18.5% p.a. for the index), 5 years (16.9% p.a. versus 14.7% p.a.) and 10 years (22.6% p.a. versus 21.1% p.a.). The life insurance sub-sector continues to drive the performance of the financial index. Over 1 year, life insurance companies have returned 48%, with embedded values benefiting from strong equity markets and share prices rerating relative to the higher embedded values. After years of being unloved, investors have flocked to these shares due to their defensive nature - predictable cash flows, capital buffers and attractive dividend yields make for comfortable investing in uncertain times. We detailed in our previous commentary why we felt that life companies were (by and large) fully valued, and we continue to hold this view. The fund's performance has suffered as a result of low weightings in life insurance shares that have performed strongly during this period, particularly Old Mutual and Sanlam. The holdings in Discovery and MMI have offset this impact to some extent. The top contributors to performance for the quarter were in fact the fund's holdings in Discovery, Investec and Zeder. An underweight position in Old Mutual and overweight positions in Standard Bank and Nedbank detracted from performance. The reporting season for the banks highlighted the divergence in fortunes of the 'big four'. Both Nedbank and FirstRand continue to deliver strong results from their South African businesses. This has enabled them to bolster provisions for the tougher consumer environment and the inevitable turn in the interest rate cycle. Standard Bank too delivered good results from its domestic and Africa business, but continues to be plagued by the challenges in right-sizing the London-based plc. Absa continues to suffer from high levels of impairments and anaemic non-interest revenue growth. Provisioning levels look low relative to the other three, and we are concerned that earnings growth will continue to lag as this gap is closed. A tougher unsecured lending environment is becoming increasingly evident as the lower-end consumer feels the effects of creeping food and transport inflation and a reduced opportunity to consolidate debt, or to revolve it between providers. This holds some risk for all the banks, but we feel it can be accommodated in a diversified lending portfolio. We are less sanguine on the outlook for the mono-line businesses, and hence have only a small exposure to African Bank in the fund, where we feel valuation prices in much of the risk. There have been more changes to the portfolio in the quarter than investors would usually expect to see. The reporting season gave us fresh information with which to work, and it became increasingly apparent that the upside in some of the fund's holdings no longer justified the size of positions held. Those who follow the fund closely will notice that we have reduced our holdings in Standard Bank, Absa, Old Mutual and MMI. The proceeds from these disposals have been deployed in businesses that fall within the universe of the fund, but may be less obvious choices. We have increased the holdings in Brait, Hosken Consolidated Investments and RMI Holdings as well as Investec, and initiated a position in Reinet. These shares offer a greater margin of safety, and somewhat diversify the portfolio away from traditional banking and life insurance. Given some of our concerns on valuation, we believe this will stand the fund in good stead in the months and years to come.
Portfolio managers
Neill Young and Godwill Chahwahwa
Coronation Financial comment - Dec 12 - Fund Manager Comment18 Mar 2013
The fund had a very strong fourth quarter, returning 11.9% compared to 9.9% for the Financial Index. This was however, not enough to close the gap between the index and fund over one year, with the fund returning 35.9% and the index 38.1%. We encourage investors to measure us over meaningful periods of 3, 5 and 10 years as we feel this is more aligned with our long-term investment horizon, and cuts through the noise generated by more volatile returns over the short term. Over 3, 5 and 10 year periods, the fund (and index) has returned 19.3% (20.0%), 12.3% (10.3%) and 20.3% (18.7%) respectively. We are mindful that the three year number has fallen short of the index. We continue to review, question and challenge our views in the fund and believe that the portfolio is well positioned to deliver attractive returns over the long term. A mid-thirty percent return over one year is strong and when viewed in a longer-term context, we find that the last 10 years represent an exceptional period for financial stocks in South Africa. Over this period, the fund compounded returns at an average of just over 20% per annum, something we feel is unlikely to repeat over the next decade. In terms of valuations for financial stocks, 2002 was a depressed point and since then we have seen significant re-rating in the valuations of both banks and life insurers. The table below gives a sense of valuations for life insurance companies expressed in terms of discounts to their Embedded Value (EV) today compared with the average over the last 2, 5 and 10 years (a negative number implies a premium-to-EV rating). Clearly, on the basis of discounts to EV, the life sector no longer appears cheap. Companies in this sector have traded on average at meaningful discounts to EV over the last 10 years. With the exception of Old Mutual, all of the life companies shown above trade at varying premia to EV today. While not as extreme as the life sector, the banking sector is not looking particularly cheap either. The table below shows the consensus forward p/e for the big four banks combined. Clearly on a 6x forward multiple in 2002, banks offered a compelling investment opportunity compared to the current 11x.
So what is our view?
- Valuations of domestic financial stocks are fair for banks to high for life companies.
- We believe that off the current valuations, a more moderate return outlook from financials should form the base case for return expectations going forward.
- Instances of asset mispricing will continue to arise, and we continue to look to exploit these for the benefit of the fund.
- Where we can, we have defensively positioned our fund in stocks where we still see relatively limited downside risks, with a reasonable expectation for growth over the long term.
On the regulatory front, the financial sector is undergoing significant change in the form of Basel III for the banks and Solvency Assessment and Management regime (SAM) for the insurers. Many regulations being promulgated are designed to strengthen the financial system in the wake of the global financial crisis. However, we are starting to see some unintended consequences from overregulation and this is prompting a softening stance from the regulators. The banks, for example, have shown very little appetite to lend globally and in South Africa this has been felt in the area of mortgages. More recently however, it is encouraging that we have seen a meaningful softening in important bank regulations. A tangible example of this was the finalisation of the Liquidity Coverage Ratio (LCR) for banks by the Basel Committee in a much more diluted form compared to initial drafts. This bodes well for bank margins and ultimately lending appetite, but even more importantly signals some acknowledgement by regulators that the regulatory pendulum had swung too far. As we move into 2013, the domestic picture remains supportive of growth with interest rates expected to remain low throughout this year. However, the influence of a challenging global environment cannot be ignored in our market. Europe continues to battle the banking crisis, while the US debt ceiling issues continue to weigh. Against this background, we expect the domestic economy to show muted growth in the medium term and this should reflect in the earnings growth of financial stocks. This, coupled with the current level of valuations in general, underlies our caution around return expectations going forward.
Portfolio managers
Neill Young and Godwill Chahwahwa