By Clyde Rossouw, Co-Head of Quality
"We own Paypal and Visa, two well-established businesses that are growing very rapidly."
The global economy has picked up momentum and growth has become more synchronised, with the US and UK taking the first tentative steps towards monetary policy ‘normalisation’. On the domestic front, Cyril Ramaphosa is now the president of the ANC, and, according to the positive reaction from our local equity market, all will soon be right with South Africa. However, the outlook remains far from certain.
There are a number of risks that could derail the fragile global recovery, ranging from fiscal and monetary policy error to escalating geopolitical tensions, protectionism and ever-increasing debt levels. And what about the prospects for South Africa? The outcome of the ANC elective conference does not dismantle the system of patronage that has weighed on our country’s economic prospects. We have a split top 6 in the ANC, and this risks policy paralysis and slow reform. What our markets and economy require is the resumption of capital expenditure/investment in South Africa to drive GDP growth. Euphoria alone is insufficient to move the needle on growth.
Global and local markets are moving higher, driven by technology
Despite this uncertain backdrop, markets seem to be running hard. ‘The most hated bull market in history’ approaches its tenth year, with the S&P 500 having delivered over 350% total cumulative returns since its post-crisis lows. Similarly, the FTSE/JSE All Share Index delivered 21% over the past year, half of which came from the largest share, and the only technology share in the market, Naspers.
We don’t own Naspers in both the Investec Opportunity and Cautious Managed funds. Our zero exposure has been a key question for a number of our clients, given that Naspers has been the significant driver of equity returns. Naspers’s dominance in our market reminds us of some of the previous market structures we’ve seen at the turn of the century. Those investors who were involved in the financial markets in 1999/2000, will remember the contribution that Dimension Data made to the SA stock market performance. Investors may also recall the substantial – over 80% – contribution that Anglo American and BHP Billiton made to the SA market at the top of the commodity cycle over 2006-2008. The SA market is very narrow, and is often driven by one or two holdings, as illustrated in Figure 1.
Figure 1: Stock market concentration raises risk
Source: Investec Asset Management, 31 12.17, JSE and Bloomberg. *The Dimension Data peak price weight refers to the weight on the peak intra-day price. The Top40 weight refers to the peak price weight (month-end). **The 12-month return (and contribution to return) is calculated starting 12 months prior to the peak price. *** Returns/contributions to returns exclude dividends
The diversification benefits of adding global quality
The consumer staples, healthcare and technology sectors provide a fertile hunting ground for quality companies, primarily due to their ability to create barriers to entry. In South Africa, there is a dearth of technology and healthcare businesses, whereas these opportunities are in abundance across global markets.
As investors are exposed to a narrow and concentrated opportunity set in South Africa, we believe that adding a quality offshore component to a SA portfolio provides complementary exposures. This forms an integral part of diversification. Aside from the complementary exposure benefit, we are finding superior quality businesses offshore that have proven their ability to deliver high-quality profits, sustainable growth in earnings and cash flows, and high returns on invested capital (ROIC).
Figure 2: Sustaining high levels of profitability (ROIC)
Past performance should not be taken as a guide to the future, losses may be made. Source: Investec Asset Management and FactSet, 31.12.17. Investec Global Franchise Fund re-weighted excluding cash and equivalents, since inception. The ROIC is different from the actual fund performance and past performance is not a guide to the future.
Defining a quality tech business
We recognise the dynamic role that many technology businesses are playing in shaping the world. To this end, our Investec Global Franchise Fund, and the offshore vehicles of the Investec Opportunity and Cautious Managed funds, provide exposure to an array of higher growth technology opportunities. This diversity of technology holdings ensures we avoid a single stock, single geography/jurisdiction approach where we are too exposed to regulatory risk in a particular market.
We are not thematic investors. When we add any share to the portfolio, it has to meet certain quality criteria. The valuation needs to make sense; the company should have clear and strong secular drivers for growth, (not seasonal or cyclical), and importantly, generate cash. What the company decides to do with this cash is also of upmost importance. Capital allocation decisions should be value accretive. This is how we evaluate any business for inclusion in our portfolios. So which technology companies have a position in our portfolios?
- We have exposure to NetEase, the second largest manufacturer of games in online China, which is further globalising its footprint. It has a market cap that is a tenth of that of Tencent, but its revenue growth for the overall business has been around 30%. Most importantly for us, we can value the business on a free cash-flow yield basis as the business generates cash, and it currently trades on a valuation that is approximately half of that of Tencent.
- We own Paypal and Visa, two well-established businesses that are growing very rapidly. They have strong network effects and we can also value them in terms of their free cash-flow yields. The payments space is one of the areas that Tencent is trying to grow, via Tenpay and Alipay, but they are still fledgling at this stage.
- In terms of exposure to e-commerce opportunities, Priceline is a key holding for us. The travel industry is fragmented and we see great growth opportunities for a market leader that dominates in that space.
- We have exposure to internet security, an area we are excited about as there are clear secular drivers of returns. Cyber attacks are on the rise, and corporates are going to be forced to spend more to ensure their networks are sound and are able to withstand these attacks. Checkpoint Software Technologies has a large array of products and solutions that address the security needs of network clients.
- And lastly, in the software space we own Intuit, which provides a number of accounting solutions.
Holding Naspers means having a concentrated exposure to Tencent, the Chinese internet company that operates within a state-dominated economy. China is growing very strongly, which has benefited Tencent materially over the past few years. We believe that Tencent is a quality business, operating in an industry with strong secular and structural growth drivers. However, the valuation is extremely rich at this point in the cycle, providing us with an insufficient margin of safety should valuations normalise. So why do we currently not hold Naspers, a supposed discounted entry point to Tencent? Largely, we believe our process has captured and replicated various opportunities that Tencent and the Naspers ‘rump’ offers, whilst most importantly, retaining control over our capital allocation decisions. Our diversified technology holdings therefore reflect an investment in innovative companies that are well placed to successfully navigate an ever-changing landscape.
Looking forward to 2018
In our view, a focus on structural rather than cyclical growth will be key this year. We are not thematic investors, so we do not try to anticipate which sectors will outperform this year. Rather, we expect the market to reward companies that prove their ability to deliver sustainable growth in earnings and cash flows, and punish companies across the market whose earnings disappoint.
In South Africa, a number of political uncertainties are behind us, and there appears to be some value emerging in the domestic equity market. We continue to look for opportunities in that space, remaining cognisant of valuation risks.
Ultimately, we will continue to focus on bottom-up asset selection rather than analyse political fundamentals and the fortunes of exogenous factors such as commodity prices, interest rates, or the economy to sustain growth. As always, we advocate a balance of exposures, ensuring there are multiple return drivers in the portfolio, as well as shock absorbers to protect against known and unknown events.
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