SIM Top Choice Equity comment - Mar 16 - Fund Manager Comment02 Jun 2016
Market review
This quarter saw a sharp rebound of the JSE, with a total return of 6% for the Swix, led by a snapback of beaten-up resources stocks, which were up 18%! This has been a global phenomenon led by emerging market bonds (up 11%). SA government bonds were up almost 12% in dollars, followed by a partial recovery of emerging market currencies and equities. Once again we see the phenomenon whereby extreme risk aversion is followed by a normalisation in prices, but in order to benefit from this one needs to remain stoic when the chips are down and focus on valuation first and foremost. In this commentary we examine the fundamental drivers of this rebound, which are:
- A recovery in commodity prices, especially the gold price, which is up 16%, and the Brent oil price, which is up 4% this quarter but up 31% from the January lows!
- A more dovish tone by Janet Yellen and further central bank intervention, especially on the part of the Chinese and European central banks;
- Resilient institutional flows in most emerging markets (offsetting outflows from retail investors).
Investors who were bearish equities and within this asset class, resources stocks, had to cover shorts and bid prices higher in a desperate attempt not to miss out on this rally, causing extreme levels of volatility. Explaining the level of intraday volatility to our clients has become a futile exercise with the market overshooting on any piece of news flow - a typical indicator of the heightened levels of uncertainty. We witnessed the iron ore price spike 20% in one day and oil, a commodity with immense liquidity and traded globally, spiking 11% intraday in February. The recovery of prices has seen a number of stocks double this quarter.
The resources rally can be attributed to the fact that the US dollar appears to have topped out after rallying for close to five years, which means that commodity prices have started to recover from their lows. In addition, it looks as if there was a surge of demand for iron ore (up 60% since the December lows before pulling back) and other key industrial metals ahead of the Chinese New Year. As for oil, the gradual reduction of shale production provided some support despite the inability of Opec to agree on supply cuts. But globally, we still face many headwinds:
- Global industrial production remains under pressure with emerging market economies at seven-year lows and activity remaining below trend. China first quarter growth in production has been weak and GDP growth is at 25-year lows.
- Most commodity markets are in surplus with the oil market still requiring supply discipline to balance wavering demand with US stock piles at the highest level since 1930, leading to the price hitting 12-year lows in February.
- Despite setting a 6.5%-7% GDP growth target for 2016, hard landing risks remain for China.
South Africa faces some further specific issues, namely stagflation and a potential credit downgrade with policy makers scrambling to re-establish credibility after the December cabinet reshuffle. This has undermined consumer confidence, which is at 15-year lows and the current account deficit at 5% of GDP is taking longer than expected to respond to the weak rand. South Africans are also bracing themselves for the impact of the crippling drought, which will require close to 0.5% of GDP in maize imports and will catapult food inflation into the double digits. The key issue now remains when Moody's, which has South Africa's sovereign rating two notches above junk, will downgrade us by one notch in line with the other rating agencies. The current economic and political uncertainty has certainly fuelled some capital allocation decisions from corporate South Africa. We have seen a continuous trickle of offshore expansions, focused mainly on developed markets.
What did we do last quarter?
The equity market rebounded close to 6% this quarter, recouping its December losses to post an annual performance back in the black at just below 3%. Year to date the fund is in the first quartile in what is a very competitive category and it has beaten the index in the past year. The fund reduced some selected positions after they had sharp rallies. For instance, we curtailed our large position in Old Mutual after it rallied 20% on the announcement that the group would be broken up by the new CEO to unlock value. We also took profits in Anglo American plc, which was one of the strong performers this quarter, up close to 70% as the market got more confident that it would be able to de-gear its balance sheet by disposing of marginal assets.
We also introduced Standard Bank to the fund after it fell by over 20% in 2015 and de-rated from a premium rating to trading at a price to book of 1.3x. The earnings of the bank is recovering after suffering losses from Chinese metal exposure. We exited from Barclays Africa, which now needs to find a new parent company after Barclays plc signaled their intention to reduce their stake by some 40% over the coming years, causing an overhang in the stock.
What added to, and detracted from, performance
The fund benefitted from the 59% rally in Northam, our preferred platinum stock. Northam has, in our opinion, the most resilient balance sheet of the Platinum majors after raising capital by selling a portion of the company in a BEE deal. The management has also been very opportunistic in acquiring adjacent ground and plant to their existing Booysendal mine at very attractive prices, capitalizing on the commodity downturn. This tends to be the exception rather than the rule in the resources sector where typically management pursues growth in an upturn and seeks to dispose of assets at the bottom of the cycle.
The fund also saw its second largest holding, Steinhoff International, rise 23% during the quarter after the company listed on the Frankfurt Stock Exchange. The company has continued on its acquisitive streak, first withdrawing at the last minute from bidding for UK catalogue retailer Home Retail and then making a $1 billion cash bid for French household goods retailer Darty to thwart a competing bid. It is clear that the strategy of the group is to gain scale in a country like France where Conforama, its subsidiary, is already dominant in the furniture market by adding to its retail footprint and improving its electricals purchasing synergies.
On the downside, the fund was impacted by an 8% decline in the price of Mondi. There was much uncertainty as to the ability of the company to pass on the raw material price increases and its exposure to the Russian market was not helped by the collapse of the Russian ruble and a potential price fixing investigation. We remain comfortable with one of the best management teams in the sector, especially with the valuation having pulled back with the stock now on a forward PE of 10x and a prospective dividend yield of 4%.
Our strategy
The fund reflects the best views of SIM's equity unit trust portfolio managers and holds approximately 20 stocks. It is not benchmark cognisant and owns no offshore stocks. We believe that this portfolio provides the best of both worlds in terms of representing our investment ideas aggressively, while providing adequate diversification. The fund's largest holdings are companies that are leaders in their respective sectors but whose valuations are below our estimate of fair value. The fund consists of companies trading at a lower forward PE than the market, lower priceto- book ratios and higher dividend yields.
With the JSE Swix now back to 11700 after a 15% rebound from the lows of 10000 in January, valuations are now once again above our estimates of fair value. Some pockets of upside remain, especially in Financial Services, with the index still down 4% over the past year but resources stocks have re-rated considerably, exemplified by the 67% recovery in Anglo American's share price. The current rebound is perilous. While it is possible for the market to grind higher, we have grown more cautious with risk aversion dissipating and stocks once again breaching our estimates of fair value in a world where central banks try to appease financial market volatility and where liquidity assisted growth has become the new global paradigm.