THE ELEPHANTS IN THE ROOM THE QUESTIONS YOU SHOULD BE ASKING WHEN INVESTING IN SA EQUITIES
JONATHAN LARCOMBE | ANALYST
ABOUT THE AUTHOR Jonathan is a senior member of Old Mutual Equities, the fundamental equity manager of the Old Mutual Investment Group. He has 18 years of investment experience.
I am sure many of you have heard of the 80/20 rule, which suggests Applying the 80/20 rule to investing, we find that 33 stocks, or 20% that 20% of the cause accounts for 80% of the effect. Accordingly, of stocks by number on the FTSE/JSE All Share Index (ALSI), account focus on the 20% that matters for an 80% effect. For instance, the top for a remarkable 80% of the index weighting. In fact, just seven 20% of earners in many countries pay around 80% of income taxes. stocks account for 50% of some JSE indices – that is, 4% of stocks In some sports, roughly 20% of training techniques have 80% of the accounting for 50% of the ALSI weight. Thus, focus on the 4% that impact – hence the saying: “Train smart, not hard.” matters for a 50% effect.
JSE ELEPHANTS, BUT MICE COMPARED WITH THE US S&P 500 INDEX WEIGHTING OF TOP 10 US AND SOUTH AFRICAN COMPANIES
M US P E PE NTM PE PE
US US M
AN PP LE MTN AN O D AN D OO A SASOL AN LAM ITON LL ITON S NA SPERS ALPHA ET AMAZON AN HASE FIRSTR FA E MI ROSOFT RI HEMONT ON ON MO IL HP I HP E DARD AN DARD AN OF AMERI A ST AN GLO AMERI P MORG RITISH AM AM RITISH TO A ER SHIRE HATHAWA ER SHIRE OHNSON OHNSON
Source: FactSet, as at 31 October 2018 While the “elephants” dominate on the JSE, they are “mice” when stocks. Another point from the article was the importance of using compared with the US S&P 500 Index. However, the combined an appropriate benchmark, which affords better measurement and index weight of the top 10 companies on the S&P 500 Index is only alignment with investors. around 20% of the total, versus 55% for ALSI. This again emphasises the importance of getting the big calls right in the SA market. An THE MAGNIFICENT SEVEN attractive feature of the ALSI top 10 is the relative rating using a price- The chart below indicates how disparate relative to the ALSI the earnings (PE) multiple. The majority of the SA “elephants” are rated performance of the top seven companies currently comprising lower (“cheaper”) than the US top 10 companies. 50% of the market has been over the past 20 years. Furthermore, stockpicking within sectors was key – with BHP Billiton outperforming In my previous Fundamentals article, How relevant is “active share” Anglo American and FirstRand ahead of Standard Bank (more so in assessing SA fund managers?, I touched on the concentration of over the 10-year period). Graphically, it is evident how critical it was a few shares making up the bulk of the stock exchange weight and to get one's call and position of Naspers correct. highlighted the need to get stockpicking of these few shares right. As an aside, by investing in a general index tracker, you are effectively In the following pages, I will provide a high-level overview of each of blindly taking an active decision to own the full weight of these seven these companies and some of the key current considerations for each.
LONG-TERM PERFORMANCE OF THE TOP SEVEN STOCKS ON THE FTSE/JSE ALL SHARE INDEX
FIGURE IN RA ET INDI ATES WEIGHTING IN ALSI TOTALLING
N R HP S F R FTSE SE A S I ALSI S A A
Source: FactSet, as at 31 October 2018
KEY TAKEOUTS
• SEVEN STOCKS ACCOUNT FOR 50% OF THE ALSI
• GETTING THE BIG CALLS RIGHT HAS A HUGE IMPACT ON RELATIVE PERFORMANCE
• ASKING THE RIGHT QUESTIONS AID SECTOR AND STOCK SELECTION
11 NASPERS COMPANY DESCRIPTION Naspers provides video entertainment in sub-Saharan Africa. In addition, it has stakes in Tencent, Mail.Ru, MakeMyTrip and Delivery Hero. Naspers's unlisted assets are within the classifieds, payments and food delivery sectors, with a notable footprint in India and Brazil. The bulk of its value resides in its investment in Tencent. Tencent has established itself as the dominant internet company in China and offers consumers an array of everyday functions.
SEGMENTAL GEOGRAPHIC TYPE
E A IVAS S S A S V E E M R A A L A T O O
Source: Naspers, presentation June 2018
KEY CONSIDERATIONS Tencent: Naspers: • Will Tencent maintain its dominant gaming position in China? • Will Naspers dominate all geographies in the winner-takes-all • Will it significantly build out an advertising model on WeChat and classifieds business? continue to grow its payments business? • Will it successfully unbundle the pay-TV business and demonstrate the • How significant will monetisation be? value in the e-commerce business? • What will be the impact of unfavourable regulatory changes? • How will it adapt to new and disruptive technology? • What are the risks of large international tech companies successfully • With rapid growth and concomitant investing at the core of entering and competing in China? e-commerce, will this investment spend eventually generate returns? • What course of action will Naspers follow to narrow the conglomerate discount – that is, the discount at which it trades to the sum of the parts of its shareholdings in both listed and unlisted assets?
MANAGING ASSETS AND ALLOCATION OF CAPITAL FOR GROWTH AND FINANCIAL RETURNS
Public Profitable
Play to win Value Operate for appreciation return & cash Proven Scale to full potential & profitability
Committed investment
Potential
Experiment & expand
5+ years away 3-5 years away from full potential Cash generative
Source: Naspers, presentation June 2018 As an aside, in 2011 Naspers constituted approximately 3.8% of at this time, we consulted with our clients to suggest an appropri- the FTSE/JSE Shareholder Weighted All Share Index (SWIX). With ate benchmark that had a downweighted Naspers weighting with our positive investment case and view on value, we held approxi- more diversified constituents. This allowed us to remain holding mately 6% of our portfolios in Naspers at that time. Since then it a positive bet in Naspers, but at an appropriate risk level. Not has remained one of our core holdings. As a result of the positive all clients chose to adjust the benchmark, but understood the risk rise in the share price, it had grown to 20% of the SWIX by July Naspers brought to their risk-adjusted returns. 2017. Although we still had a positive view on Naspers, holding 22% of clients’ funds, particularly retirement portfolios, in a single stock was inappropriate for the level of risk it brings. As a result,
ANGLO AMERICAN AND BHP BILLITON COMPANY DESCRIPTIONS Anglo American is a diversified mining company with key BHP Billiton is a global resources company. It is a producer of operations in base metals, coal, iron ore (held through an 80% various commodities, including iron ore, metallurgical coal, copper interest in listed Kumba Iron Ore) and platinum group metals and uranium. Its petroleum segment is engaged in the exploration, (PGMs), held through a 78% interest in the listed Anglo American development and production of oil and gas. The company extracts Platinum. While its head office is in the UK, its operations are and processes minerals, oil and gas from its production operations spread across the globe, with exposure to South Africa, Australia located primarily in Australia and the Americas. and South America.
ANGLO AMERICAN REVENUE BY PRODUCT ANGLO AMERICAN CAPITAL EMPLOYED BY GEOGRAPHY N M O 7 A 4 PGM T 1 14 25 P 19 D M D 17 22
S A N I 2 9 14 1 Source: Company Reports, 2018 presentation
BHP REVENUE SPLIT BHP LOCATION OF ASSETS R P P 1 1 N S A 25
A I N A 2 1 12
20 Source: Company Reports, 2018 Annual Report KEY CONSIDERATIONS COMMODITY PRICES: Mining companies are mostly price takers • Anglo American’s ill-judged acquisition of the Minas Rio iron for their commodities in a market driven by global macroeconomic ore deposit in Brazil at the top of the cycle (2008), which fundamentals. One consideration would be the ultimate impact of is still being ramped up. As a result, its major greenfield current trade wars on prices. development of one of the world’s largest untapped copper orebodies in Quellaveco, Peru is being closely watched. DEMAND: A key driver of commodity consumption is global • BHP has its own major brown- and greenfield projects economic growth. A sustained slowdown, particularly in China, underway, namely Mad Dog 2 (deep water oil), South Flank would severely impact demand. (iron ore), SGO (copper) and Jansen (potash).
EXCHANGE RATES/COSTS: Commodities are typically sold in INDUSTRY-SPECIFIC ISSUES: Investors need to constantly factor in US dollars, while production costs at operations are generally new forms or rates of taxation and royalties, increased government denominated in the local currency. Where on the cost curve do regulation and changes in costs, like freight rates. Skills, electricity these companies sit for each commodity mined? and water shortages may also affect production and mining
ORE BODY: Assumptions are made on the quantity and quality of inflation more than anticipated.
the mined ore body – production forecasts may be affected if the Based on cash flow returns on investments (CFROI), as per the actual ore mined differs from these assumptions, new reserves are charts on the following page, it is evident how miners are cyclical. not discovered or existing reserves are not expanded. The mining boom of mid-2000, driven by Chinese industrialisation,
SAFETY: Mining remains inherently dangerous. Staff injuries or saw miners profit. Unfortunately for Anglo American, with its large SA exposure, and state policy uncertainty at the time, it missed deaths may suspend operations. In addition, unionised employees this boom. Typical of booms, miners go on a capital spending pose the risk of production interruptions following labour unrest. spree and oversupply the market, which ultimately results in TECHNOLOGY: Changing technology may see demand for a prices dropping – as can be seen in the asset growth charts. We commodities shift. For instance: have passed this phase, supply has been cut and prices have • Electric vehicles have no need for a catalytic system that normalised. contains PGMs. Whether comparing BHP Billiton to Anglo American or to its other • Man-made diamonds continue to gain market share. peers, the quality of this business is evident. Its "best-in-class" tag is OPERATIONS: Companies investing to grow need to do so at earned, as demonstrated by its higher margin, cash generation and optimal returns on capital employed. There is the risk that these having the highest CFROIs in the industry. The questions investors capex-heavy projects come in over budget and/or are late, and need to ask regarding Anglo American is whether it will continue to therefore miss timing the cycle. Examples of these major projects trade at a discount to its peers in terms of valuation? Will positive are: South African developments be the catalyst for a rerating?
14 BHP BILLITON CFROI BHP BILLITON ASSET GROWTH BHP BILLITON EBITDA
FROI D R
Asset Gro t
Economic Return CFROI
A uste Operatin Mar ins
ANGLO AMERICAN CFROI ANGLO AMERICAN ASSET GROWTH ANGLO AMERICAN EBITDA
FROI D R
Asset Gro t Economic Return CFROI A uste Operatin Mar ins
Source: Holt Lens STANDARD BANK AND FIRSTRAND COMPANY DESCRIPTIONS Standard Bank is the largest South African banking group FirstRand was created in 1998 through the merger of the ranked by assets and earnings. It listed on the JSE in 1970 and financial services interests of Anglo American and RMB Holdings. has been in existence for more than 150 years. It has a strong It has an owner-manager culture with a decentralised structure of market position in corporate and investment banking, and in franchises: FNB (retail and corporate), WesBank (asset finance retail banking. It has a controlling stake in Liberty Holdings, a and unsecured lending), RMB (corporate and investment banking), listed insurer. Operating in 20 African countries, it has a vision to Ashburton (asset management) and Aldermore (UK mortgages and build the leading African financial services organisation. Having SME lending). It has a strong market position in South Africa and embarked on an unsuccessful expansion into emerging markets is looking to grow its share of insurance, while also diversifying before the global financial crisis, it has now refocused its strategy geographically into the rest of Africa and the UK. on Africa. Its international partner, Industrial and Commercial Bank of China (ICBC), acquired a 20% stake in Standard Bank in 2008.
STANDARD BANK BUSINESS SEGMENT SALES STANDARD BANK GEOGRAPHIC SEGMENT SALES
A R I 27 2
S P 2 5 S A L G 71 19
Source: Company Reports, 2018
FIRSTRAND BUSINESS SEGMENT SALES FIRSTRAND GEOGRAPHIC SEGMENT SALES
O RM U 5 9 FN A 7 O A 11
W 15 FN 54
RM I S A 1 0
Source: Company Reports, 2018
The charts on the following page compare historic economic returns, asset growth and return on assets. One can see how FirstRand has achieved higher economic returns using an asset growth rate similar to Standard Bank, but with better quality growth demonstrated by the best-in-class return on assets – and all done at a lower leverage rate. For this reason, and considering the quality of its franchises, it deserves its premium rating. KEY CONSIDERATIONS MACROECONOMIC ENVIRONMENT: REFORMS: Will political and economic reforms in South Africa With South Africa in a low growth trap, what is the impact on: meet or exceed expectations, as these impact investor sentiment • The banks’ asset growth? Where do they find profitable towards the financial sector? growth and what growth expectations are reflected in share TECHNOLOGY AND DISRUPTORS: The banking industry is prices? becoming a digital rather than a physical system. How will the • Returns on equity (ROEs) targets guided? Will they be traditional big four banks manage competitors (like Capitec and achieved over the medium term? Discovery Bank) and disruptors (Fintech)? • Non-performing loans? Is the provisioning conservative COMPETITION: The risk of intense price competition between the enough? banks, which eventually erodes returns to levels that are below • Property market valuations? A negative correction in prices expectations. would materially impact the banks’ loan books and their CAPEX: Banks incur significant capex on various IT systems. Often provisions for bad debts. the material revenue and cost-benefits from the implementation of • Vehicle sales? WesBank, for example, is a key profit unit these systems do not materialise. Additionally, will capex on IT within FirstRand. remain elevated in the fight against disruptors? Outlook for key African countries and other offshore regions where INTEREST RATES: Expectations for inflation and the concomitant these companies are present: interest rate profile and bond yields play an important role in • Will the opportunity to capture the unbanked in under valuing banks. penetrated markets in Africa materialise? REGULATION: South Africa has a world class regulatory • With a large dependency on raw material sales, how will any environment. Local banks came through the global financial crisis commodity downturn impact lending growth? relatively unscathed and this provides investor comfort in our • The poor deal-making outcomes of past ventures outside of banking system. South Africa raise questions on current and future deals. Banks PRICE: How much is being priced into the share prices in terms of need to grow, but will these investments make an adequate sustainable long-term returns on equity (ROEs), particularly for their return on invested capital? African operations?
STANDARD BANK CFROE STANDARD BANK ASSET GROWTH STANDARD BANK RETURN ON ASSETS
FROI D R
ROE CF ROE
ets Ass ets et Ass et Gro t c mi c Return co no Return on on Return E
A uste Total
FIRSTRAND CFROE FIRSTRAND ASSET GROWTH FIRSTRAND RETURN ON ASSETS
FROI D R
ROE CF ROE
Ass ets et Ass et Gro t c mi c Return Return on on Return co no E A uste Total
Source: Holt Lens RICHEMONT COMPANY DESCRIPTION The Rembrandt Group was established by Dr Anton Rupert in the • Richemont is most exposed to the Chinese and Middle East 1940s. Richemont was created in 1988 in the spin-off of the consumers, whether at home or travelling abroad. Will the international assets owned by Rembrandt Group (now known demographic growth of the high net worth individuals in China as Remgro). The group engages in the design, manufacture and and emerging markets lead to an increase in demand for distribution of luxury goods. The group operates in four business branded products? areas: • Richemont has undergone a major management reshuffle, with • Jewellery maisons (Cartier and Van Cleef & Arpels) both movements within the group and some departures. What • Specialist watchmakers (A. Lange & Söhne, Baume & Mercier, are the longer-term implications of these changes? IWC Schaffhausen, Jaeger-LeCoultre, Officine Panerai, Piaget, Roger Dubuis and Vacheron Constantin) • Online distributors (Watchfinder.co.uk and Yoox Net-A-Porter) • Other brands, including Alfred Dunhill, Azzedine Alaïa, Chloé, Montblanc and Peter Millar.
KEY CONSIDERATIONS • Changes in demand are linked to uncontrollable events that impact consumer confidence. For instance, any serious geopolitical shock, pandemic, natural disaster or terrorist strike that impedes travel – as many luxury goods are acquired when travelling abroad. • Do the grey-market platforms (unofficial sellers) cause major disruptions to luxury goods companies, especially with the growth of online retail? • Does Richemont maintain its brand relevance in a fast- changing consumer world?
SALES BY BRAND SALES BY PRODUCT SALES BY REGION
O Middle East and Africa 7 L 4 M 7 Japan 9 O 9 Asia Pacific V A 41 40 1 Americas 4 1
W S Europe 40 25 27
Source: HSBC Estimates SASOL COMPANY DESCRIPTION Sasol is an international integrated chemicals and energy electricity. It manufactures around 40% of South Africa's fuel needs. company. It was established in 1950 with the aim to commer- Sasol operates a fuel retail network in South Africa and is involved cialise coal-to-liquids technology in South Africa. It develops and in gas-to-liquids ventures in Qatar and Nigeria. It also has a commercialises technologies, and builds and operates related substantial diversified chemicals portfolio and is about to start up a facilities. Its core business is adding value to low-cost coal and major US$11 billion integrated chemicals project in the US. It has gas feedstock through proprietary technologies to produce a range major facilities in South Africa, the US and Europe. of products, including liquid fuels, chemicals and low-carbon
EBIT BY GEOGRAPHY EBIT BY PRODUCT M 19 R 27 1 SA 4
E E 0 50
Source: Company data, 2018 Investor presentation
KEY CONSIDERATIONS • Sasol’s share price is highly correlated to the rand oil price. RAND OIL AND SASOL SHARE PRICE With the majority of the underlying businesses having their R R commodity price correlating to the US dollar oil price, it is ZAR S fair to assume that group income is linked to the changes in R R R R
oil price. Forecasting both the oil price and the USD/ZAR S areprice
exchange rate involves significant volatility and uncertainty (for R R
instance, geopolitical supply risks, global growth rates, growth R R AR oil price of the global middle class, shale gas supplies and marginal R R costs of production). R R • After many years of building the expensive Lake Charles R R Chemicals Project (LCCP) in the US, will Sasol execute as promised? Will it enter a period of strong organic growth and O O O O achieve the forecasted project returns? O O O O O O O • With management forecasting the ethane cracker Source: FactSet, as at 31 October 2018 (converting gas to other by-products) to add up to 20% of earnings in 2022, will Sasol successfully diversify from a purely rand/oil play? • Currently, the feedstock price (ethane) is high, while by- KEY SENSITIVITIES IMPACTING PROFITABILITY product prices are low. • Will de-gearing its leveraged balance sheet commence in the O R 0 coming years – through a combination of expected capex reduction and increased free cash flow − while, at same time, having sufficient liquidity to execute growth projects and R US R 0 maintain its commitment to its dividend policy? • Other contingent risks to consider are fines for anti-competitive behaviour, SARS litigation (potentially in excess of R16 billion), R 50 carbon taxes (Sasol is one of SA’s largest carbon emitters), air quality regulations, large project risks, and impairments risk R from adverse commodity and foreign exchange movements. US To potentially complicate matters further, Sasol operates across US
numerous jurisdictions. Source: Company presentation 2018
To show just how sensitive Sasol is to external factors, in • Africa is growing rapidly and so are its energy needs. Will FY2018 its EBIT (earnings before interest and taxes) was Sasol be able to capitalise on the continent’s natural resources? R17.7 billion. A US$1 change in the oil price or a 10c African countries must continue creating a favourable change in ZAR/USD is around 5% of EBIT (this assumption environment for growth and foreign direct investment. excludes any hedging done by the company).
One can see from the brief synopsis of these “elephants in the room” how questions need analysis, consideration and, ultimately, a conclusion. At Old Mutual Equities, we have a diverse group of analysts from different backgrounds, who specialise in understanding each of the abovementioned industries and companies, among many more. Both getting and positioning these big calls right in our client portfolios will have an important impact on their relative performance.