Much of November’s market moves were shaped by Omicron. At this stage, not enough is known about its characteristics, but what we do know anecdotally is that it appears much more transmissible. This was enough to upset the collective equity apple cart, with more than a third of October’s stellar gains given back in November as the MSCI All Country World Index drew down around 2,5% in the month. Whether Omicron is equally as deadly as it is clearly contagious remains to be seen. Evidence in our country remains promising so far, with spiking infection rates not nearly matched by proportionate increases in hospitalisations. This is an encouraging first sign.
Regardless of all the unknowns, what is clearly evident is that the emergence of this variant has shaped behaviour, if not sustainably into 2022, certainly for the short term, and this was enough to dent sentiment. Coupled with higher inflation levels being reported in the US and a key Fed meeting taking place in the middle of December, this was enough to sour sentiment.
This month, in our last update for 2021, in addition to our whip around local and global markets in our ‘By the numbers’ sections, we look at a couple of interesting data points from South Africa, touch on weakness in Alibaba, and make a few global comments as we peer into 2022. When we closed off 2020, we commented that if a few shoes were to drop in our favour, SA markets could well be off to the races… and off to the races they have been this year, with stellar capital returns in 2021.
We hope you will enjoy this month’s read.
By the Numbers
First look at 2022
The recovery into a post-Covid world remains uncertain, but one prominent feature of the normalisation of accommodative policy is clear: higher inflation and rising interest rates.
Following a robust macroeconomic recovery in 2021, global growth is anticipated to wane in 2022 as the monetary boost to GDP growth fades. Financial conditions remain easy versus historical levels, but persistent supply constraints, labour shortages, and logistical bottlenecks impede the recovery. Concerns are for higher inflation for longer.
Inflation expectations have certainly risen, but primarily for shorter time horizons at this point. As the support from easy monetary policy ebbs, less money circulating should mean higher interest rates and a possible decline in the relative value of risk assets. Still, the effects depend on the pace and magnitude of the policy shift.
The question remains whether the US Fed can successfully normalise rates and tame inflation without choking off growth. The yield curve – the difference between 10-year Treasury yields and shorter-term 2-year yields – offers us some hints as to what the market expects over the period. We are currently seeing the yield spread narrowing, driven by the shorter end (2-year) pricing in more rate hikes in the near term while the longer end (10-year) remains at 1.50%.
The fact that the 10-year yield remains significantly below the current inflation rate, resulting in negative real yields, suggests that the Fed will not be successful at balancing the economy. This means that the risk of choking off growth is a real possibility, resulting in them having to try stimulate the economy again in the medium term with easier policy.
With supply shortages likely to stick around until next year, and service-sector prices trending higher, high inflation will likely linger into next year. Goods inflation, which has been the primary contributor to this year’s hot inflationary environment, shows little signs of easing too. The question facing investors for 2022, is whether companies can maintain margins in the face of supernormal inflation and whether the US consumer will be able to stomach price increases without adjusting behaviour.
Alibaba – regulatory headwinds creating volatility, but underlying operations remain solid
In a counter move, Chinese policymakers began to pressure Chinese companies they deemed to hold “sensitive information of national security”. The authorities are insisting that firms deemed to hold “sensitive data” must supply it to the relevant national regulatory bodies, allowing them to determine whether it is in China’s national interest to share that data with the US, thus impacting Chinese companies and the ability to list in the US.
The simultaneous regulatory crackdown in China on an array of public and private companies this year has complicated the investment case further, ushering in a new, uncertain environment for international investors. With the market keeping a close eye on China, any slight news break drives prices lower.
The situation reached a crescendo with the recent US listing of the Chinese ride-hailing company, Didi. What started with the Chinese government requesting information on stored customer data ended with them pressuring Didi to delist from the Nasdaq. While the Chinese regulatory framework has stressed that these new requirements pertain mainly to new listings, it has nevertheless put pressure on the existing US-listed Chinese tech giants.
Given the US’ call for more transparency and China’s reticence to share any potentially sensitive information with the US government, a problematic situation is arising for existing US-listed Chinese companies. Rather than face the risk of being forcefully removed from the US market or meeting the ire of Chinese regulators, many may feel the best alternative will be to move their primary listing to the Hong Kong stock exchange.
With this in mind, one of our holdings, Alibaba, has been caught in the crosshairs. The potential risk of a delisting has caused significant weakness in the share price as US investors, who are prevented from owning Hong Kong-listed entities, chose to sell down their positions rather than being forcefully liquidated on a US delisting.
We believe that the sell-off in Alibaba stock is presently divorced from its current operating fundamentals, driven chiefly by technical factors and delisting concerns. NVest Securities has no such restriction from owning stocks listed in Hong Kong.
We remain confident in the growth potential of Alibaba with its entrenched position in the Chinese way of life. While there are current headwinds, these do not detract from the evident scale, dominance and cash-generative nature of the business. The current regulatory environment has created a share price that has completely dislocated from operating fundamentals, creating an opportunity for long-term shareholders to benefit as the environment normalises.
Regulatory headwinds and US-delisting concerns have driven Alibaba’s valuation down to an adjusted forward P/E ratio of 9x, when taking into account its investment holdings – this is less than half of its normal range.
Assuming modest 15-18% revenue growth for the next four years and constant free cash flow margins, we value Alibaba’s eCommerce business at $210/share.
Alibaba’s cloud computing business also offers tremendous upside, which in our opinion, is currently not reflected in the valuation. The cloud market in China is growing at between 30-50%, with Alibaba being the dominant player with a 40% market share. In the last quarter, Alibaba’s cloud business generated $3bln in revenue and recently started generating profits. Using Amazon’s cloud business, AWS, as a template, and making some conservative assumptions, we believe Alibaba’s cloud business could be worth between $90-$123/share as a stand-alone business.
On top of Alibaba’s operating businesses is an investment portfolio of listed and unlisted holdings worth $45/share.
Adding all these parts together, we calculate a sum of the parts valuation above $350/share.
By the Numbers
SA recovery underway
Despite macro-economic conditions presenting a rather sombre view, recent management updates across most sectors suggest a recovering operating environment that belies current valuations seen in the market.
Banking – improving profitability as default rates remain within normal levels
Despite management teams remaining cautious due to the uncertainties of the impact of the fourth Covid wave, they all noted the operating environment has improved:
- Increasing loans and advances, driven by strong retail banking. Corporate loans and advances remained subdued at 2-3% as originations are offset mainly by repayments, and utilisation of current facilities remains muted.
- Credit impairments are trending lower, with credit loss ratios settling within the through-the-cycle ranges. Within most banks, these ranges are at about 75 to 100bps.
- ECL (Expected Credit Loss) provisions remain elevated. Management remains reluctant to normalise them in line with the lower level of impairments given the uncertainties from the lingering impacts of the civil unrest and a potential fourth Covid wave. We still view the banks as being over-provisioned, with the potential for provision releases to boost earnings.
- Improving net interest margins due to an improved loan mix and a general rising interest rate environment.
- Non-interest revenue growth remained in the mid-single digits driven by transaction revenue (commission
and fees) which has recovered on the back of increased banking activities, while trading income is normalising from 2020 highs. On the negative side, life claims are rising due to the impacts from the fourth Covid wave.
- Cost-management continues to be a key focus, with management teams doing a great job at keeping costs at or below revenue growth, providing a positive impact on margins.
- ROE levels have recovered and, for the most part, are approaching pre-Covid levels, with management teams in line to achieve their medium-term targets. Most banks are currently delivering ROEs above their cost of capital.
- Dividend payments have also resumed, and we expect dividend growth to improve in line with earnings.
We remain very positive on SA banks as we see a divergence between what the market is currently pricing into valuations and the current operating fundamentals within the banks. In our opinion, the market is not appreciating the banks’ current profitability.
Property sector – management doing a great job despite tough operating conditions
The property sector has outperformed YTD, returning ~ 26% compared to the ALSI at ~23%. This sector has recovered well, with the following key themes noted:
- The biggest recovery was seen in the retail sector, driven by lower vacancies, increased trading densities, increased footfall, increased leasing activities, and improved rental collections. In most cases, footfall and trading densities have recovered to 2019 levels. As per the chart below, taken from the Vukile interim results presentation, footfall and sales are now above pre-Covid levels.
- Balance sheets are stronger as property companies have done a commendable job reducing debt. This has resulted in more sustainable capital structures, with loan-to-value ratios trending down.
- The property sector remained successful in disposing of non-core assets. Contrary to the significant discount to net asset value the property shares are trading at, on average, disposal of assets is occurring at, or close to, book value versus a discount to NAV of between 30-50%. For example, Vukile disposed of R798m worth of property in 1H22 at book value, while Growthpoint sold property worth R440.6m at a profit of R118.4m to book, with all sold above book value. Management teams across the sector have successfully driven disposals in a tough environment.
- As per sector requirements, all companies have now reinstated distributions.
- Weakness in the office sector persists, with vacancies remaining high, driven by excess supply and negative rental renewal growth. Leasing activity is subdued, while tenant downsizing and consolidations, coupled with shorter-term leases, continue to pressure the office sector.
Overall, the more retail-focused property companies recorded the most robust recoveries. Property shares continue to trade at significant discounts to net asset values, and while operating conditions remain challenging, management teams are doing an exceptional job. We believe the property sector is mispriced and offers outsized returns.
Retail sector – expectations are low, and downside remains limited
The retail sector has faced many challenges, reflected byslightly weaker sales and earnings numbers being expected by the market. These include supply disruptions, fuel prices increases, and the impacts of the civil unrest.
Despite these challenges, the retail sector remained resilient and remains attractive from a valuation perspective. The key highlights from recent updates:
- Pricing remains a key focus as companies try manage price inflation pressures while simultaneously driving volumes. In the face of general market inflation, retail management teams must walk a tight line between passing inflation through to consumers and maintaining sales volumes. Shoprite’s price inflation remains relatively low and targets the 3-4% range next year. Shoprite management has noted they are focused on maintaining current gross margins at existing levels (24-25%) and will reinvest any incremental margin rands into promotions. Truworths, on the other hand, is having to price more attractively to maintain volumes, experiencing 2.2% price deflation in the first quarter. However, Truworths management is forecasting limited promotional activities as they have aligned inventory correctly going into the festive season.
- On the operating cost side, the retailers are well placed as they benefit from a lower interest expense, having paid down debt and enjoy declining rental expenses as they continue to negotiate a reduction in leases.
- For credit retailers, we continue to see improvement in the quality of their credit books. In Truworths’ case, there has been a decrease in overdue accounts and an improvement in bad debts. The percentage of active accounts able to purchase are at very high levels. Therefore, when sentiment improves, there is potential for credit sales growth to accelerate. Similar to the banks, Truworths’ bad debt provisions are currently disproportionately high compared to the current bad debt expense. Failing a deterioration in the current operating environment, we expect these to be released back into the income statement with the potential to drive significant earnings growth in the future.
- Supply disruptions have been a concern amongst SA retailers. Those that source their products locally saw limited supply disruptions compared to those sourcing globally. All retailers reported supply chain disruptions to varying degrees. Truworths noted that supply chain disruptions were limited as they source ~70% of their products locally. Shoprite also stated that the impacts of the supply disruptions were minimal. Woolworths reported varying degrees of impact across their businesses, with their SA businesses seeing a limited impact, while the Australian businesses were hit hard by disruptions. On the other hand, Pepkor, which sources more products offshore, noted they had experienced supply chain disruptions which impacted the group through increased costs and delays in product inflows.
- Retailers continued to generate a substantial amount of free cash flow, which has been returned to shareholders in the form of dividends and share buybacks. Companies are taking advantage of low share prices to buy back shares, with Truworths reported to have bought back 19.3m shares (4.3% of issued shares) at an average price of R39.87 per share, and Shoprite reported to have bought back R500m worth of shares. Both companies continue to make purchases. Given the current health of free cash flow generation, with most retailers in net cash positions, we expect to see this trend continue.
Feedback from the retailers in their most recent updates indicate that they have navigated the challenges seen over the past few months (which are not anticipated to cause further harm into year-end), while inventories are well placed and ready for the peak season. We continue to believe that the SA consumer is financially better positioned than what is currently reflected in the valuations of SA retailers. We expect stocks to react positively to better than expected numbers with limited downside in current share prices. We remain optimistic about the retail sector.
We hope you have enjoyed this month’s read, and we want to take this final opportunity to wish you a safe and peaceful break with family and friends as we draw the curtain on 2021. A year with so many unexpected twists and turns, but one in which equity returns, both locally and globally, proved far more resilient than many would have thought possible.
We’ll be in touch in early February as we take a more detailed aim at 2022.
All the very best,