VFM Detailed Asset Class Commentary

March 2020



Domestic Equity

Never let a crisis go to waste!

At the start of 2020 we envisage a tough environment for domestic growth considering the Eskom load shedding experience in December 2019, capping domestic growth, coupled with the ever-present threat of a Moody’s downgrade. Well, the first quarter turned out worse that most could have expected. The Coronavirus pandemic, whilst presenting a fairly low mortality rate, has had devasting impact on economic activity with many economies in “shut down” mode for a few weeks and global travel grinding to a virtual halt.

The sell-off in JSE shares has been indiscriminate across almost all sectors with very few being spared, the overall SWIX index delivering a painful -23.3% over the quarter and -20.8% for the one-year performance. Domestic equities have suffered a few years of low single digit returns but the recent market sell-off has pushed the 5-year annualised SWIX return to -1.9% p.a. Consider these are nominal returns against the backdrop of realised longer term real returns for SA equities in the range of 5-7 p.a.

So, what now?

It is fair to say that we see many opportunities in local markets, especially in the financial sector. Whilst many of our banks are being priced at sub 5 PEs, we draw confidence from the SARB’s proactive capital management approach coupled with SA banks closed liquidity framework. Without doubt, the earnings of all SA focused businesses will be under pressure when activity levels grind to a halt but is this the permanent state of our environment? We would argue no and that at some point in the not too distant future we will return to somewhat normal activity levels, therefore, we need to position now for that eventuality.

The pandemic environment is however devastating to companies with high debt levels and we are experiencing this with shares such as Sasol and MTN. Whilst normal operating environments would have allowed these companies to muddle along and finance their debts and shareholders’ dividends, suddenly they find themselves trapped in a debt spiral.  Sasol has rapidly declined into an almost certain capital raise of at least $2bn, our base estimate is that it would be close to $3-$4bn considering that the proposed asset sale may not materialise in the near term.

We may be down, but the economy is not out for the count. We still have solid businesses operating in trying times. What the pandemic environment has proven is that the SA supply chains for basic commodities are still strong and operational. Maybe we will emerge out of this environment re-imaging our textile supply chains and onshoring jobs to protect us against future excessive reliance. We certainly do not believe that everything is lost for the domestic economy and have been judiciously adding domestic exposure in our equity funds.

The challenge in the next while is to look through the dire earnings reports that will emerge and buy business that can restore and build stronger platforms 12-18 months into the future.


Global Equity

March was, simply put, a very difficult month for global equities as markets simultaneously adjusted to a range of liquidity, solvency, and growth risks. Aside from the health risks associated with COVID-19 and the impact this virus will have on global growth, equity markets have had to adjust to a range of liquidity risks emanating from the interbank and secondary credit markets. After seizing up in October last year, the US interbank market experienced another bout of liquidity shortage in mid-February which, in our view, initiated the decline in equity prices. This coincided with downward revisions in growth estimates of both economic and company forecasts. But markets have taken note of the unprecedented level of central bank and fiscal stimulus announced over the past six weeks. Will the combination be enough? The honest answer is that no one knows, but markets seem to have taken some solace in the short term. With US company Cellex having developed an anti-body test that is simple and yields rapid results, employers will be able to make informed choices as to how to phase their workforce back into production towards the latter part of April. If all goes well (i.e. there are no lockdowns until June) some semblance of normality should return to markets. For now, the “evidence” of this stabilization can be seen in the dollar index (stopped rising), gold (stopped rising), US 10-year treasury yields (stopped falling) and equity markets bouncing off their recent lows. A number of the stocks held in our portfolio have fared well during this period leading credence to their quality and earnings power as embodied in the mandate and objective set out above.


Fixed Income

COVID Calamity

For reasons too obvious to mention, this was a poor quarter for both bonds and inflation-linked bonds. So, poor that it was worth dusting off the record books. March 2020 produced the 2nd worst ever month for bonds (-9.75%). The worst month was August 1998, with a loss of 14.43%. Interestingly, the very next month, September 1998, was the best single month for bonds AND the next month again, October 1998, was the second-best ever month. ILBs have been in issue in South Africa since only March 2000, but with a loss of 7.06% this March, the 20th anniversary produced the worst month on record. For the quarter, bonds lost 8.72% and ILBs lost 6.61%.

Of some comfort – possibly! – to our clients, both our active bond and active ILB GIPS Composites outperformed their benchmarks in this diabolical quarter. Our bond track record is now twelve-and-a-half years old and has produced outperformance of the All Bond Index in 91% of all rolling quarters. For ILBs that percentage drops to 74%.

So much for what’s behind us. Equipped with a plethora of evidence showing how futile forecasts are, we eschew forecasts in managing clients’ funds, taking the view that to use these would fall foul of our serious fiduciary duties. A portfolio manager can seek alpha from either private or privileged information or from a differentiated interpretation of public information. We do not possess the former and even if we did, acting on it might be illegal and would certainly be unethical. That leaves us to rely on our processes of inference and occasionally to draw on the teachings of behavioural finance, especially when markets are dysfunctional as they are now.

This behoves us to take stock of where we are, to make unemotive assessments of valuation and to avoid herd-trades. Even with the sharp deterioration in the world’s assessment of SA’s creditworthiness (as was briefly the case in 2008), forward inflation rates implied from prevailing bond yields render bonds very attractive; the more so due to the certain impact on inflation courtesy of the plummeting oil price. In fact, the extreme diversion between the prices of precious metals and of oil bodes well for SA’s trade and current accounts but as always, during times of extraordinary stress, good news is ignored and vice-versa.

The currently available “bang for buck” or more academically, the term premium for SA bonds, is at an all-time high, meaning that for every year of extra term an investor is willing to take, he or she receives a greater amount of marginal yield than ever before. We are harnessing that yield, even though the path to this situation has been painful.

As always, we can never assure clients of any level of absolute or relative performance, but we can assure you of tireless effort, application of sound investment tools and avoidance of fragile and panicked trading.


Property

The day the yields disappeared – Listed Property, the quarter that was.

The SA property sector, already on the ropes, was dealt yet another telling blow as SA and global equity markets were left reeling as fears over the impact o-19 intensified. Locally the sector was hardest hit of all asset classes. The SAPY was down roughly 35% in March and around 50% down year-to-date, and REITs with high-teen dividend yields, low single digit PEs and PB ratios below 1.0x have become par for the course.

Recently, REITs had to deal with weaker top line revenue growth and an ever-increasing cost base which outstrips revenue growth. Reduced escalation rates, increasing vacancies and negative rental reversions have taken their toll on revenue growth while increasing costs, especially administered costs, have served to reduce net property incomes. As result, the historically high payout ratios of SA REITs has come under pressure. Offshore diversification efforts have resulted in roughly 40% of the SAPYs income generated outside of SA. High online retail penetration rates and CVAs have resulted in counterparties with UK retail exposure taking pain thereby somewhat undoing the diversification efforts employed by local REITs.

The weak backdrop noted above was exacerbated by the emergence of COVID-19, which has led to a whole new set of challenges for landlords. Retail focussed REITs are now having to deal with large national retailers threatening to withhold rents. The industry has however published relief measures in support of tenants in April 2020. In a bid to preserve cashflows we have seen several REITs either cancelling or postponing dividend payments and withdrawing distribution guidance. REIT legislation requires them to pay out at least 75% of distributable earnings, limiting the ability of REITs to withhold distributions in support of cash flows. To this end, the SA REIT Association has requested softening of regulations from National Treasury.

Historically, yields and growing distribution profiles of REITs made for an attractive investment proposition. The sector’s return is generally driven my income rather than capital growth, highlighting the importance of sustainable cash flows. High yields, however, should not be viewed in isolation and should be accompanied by strong balance sheets and good liquidity to provide some assurance that those yields will materialise.

Against this backdrop, what do you pay for a property counter with low or no yield?  Optically the counters look attractive but fundamental dividend paying ability remains fluid and until we have some degree of clarity around rental trajectories, we remain cautious of the sector overall.