Everybody exhale… After holding their breath for 6 months in the face of the consistent selling of risk assets so far this year, investors collectively breathed out in July as this month marked the first meaningful bounce in risk assets from market lows this year. While the moves higher on the local front were not stellar (but to be fair the drop in value this year has been less than half of global equities), offshore they were much more significant. The US market posting +9% in July, with global equities a respectable +6% following in its wake.
What’s changed you might ask? We try to address this question with much of this month’s content. It’s a lengthy read, particularly on the offshore side of things, so we won’t waste much more of your time with this introduction. Please do use the hyperlink enabled navigation block below to quickly get to any topics you may find of interest in this month’s newsletter.
Let’s get to it, we hope you find the information meaningful.
International section
By the Numbers
Big tech
Positivity amid uncertainty
It’s been a busy few weeks as dozens of our holdings reported their quarterly earnings. A combination of economic uncertainty, declining GDP growth and speculation around decreasing consumer spending have trickled down to negatively impact sentiment on company earnings and advertising spend. This quarter’s earnings revealed how some companies have performed better than others.
We’re taking a look at Alphabet, Meta, Microsoft, Apple and Intel to see whether or not uncertainty is reflected in big tech share prices. These companies are among the world’s largest advertisers or tech product providers, and generally provide an excellent read on the health of the consumer. Interestingly, we saw somewhat diverging results from the tech giants.
Amid these fears of a digital-advertisement slowdown and weakening economy, Alphabet posted good results with revenues that were better than feared after the poor results from Twitter and Snapchat. This was driven by the strong resilience of Google Search advertising on the back of strong travel demand. However, management did point out a pullback in spend by some advertisers on YouTube, but this points to some soft pockets across certain industries and geographies rather than broad-based weakness. Cloud revenue remains a strong driver of growth evidenced by the sustained demand for digital transformation. Given Alphabet’s immense resources and successful track record, our bullishness has increased after this successful quarter.
On the other hand, Meta (Facebook) painted a different picture when it comes to broad-based advertising – they are seeing a slowdown in ad demand due to the economic uncertainty. This quarter they reported their first decline in revenue after reporting their first decline in users 3 months ago. Full-year forecasts also showed that current quarter revenues would fall short of expectations as marketing departments shrink their budgets. The economic slowdown coupled with the inability to offer targeted advertising due to Apple’s privacy update has magnified the revenue deceleration. That said, we remain optimistic for Meta over the long-term despite these headwinds – it is only a matter of time before they overcome these challenges, restore ad revenue growth, and continue to drive attractive returns for shareholders.
Coming back to digital transformation. Intel is a big player in this area and shocked analysts after it slashed its revenue and earnings outlook, blaming consumer weakness in PCs, lower data centre revenue, and excessive inventory. Revenues were down 22%, and this negative sentiment cascaded into the rest of the industry. But unfortunately for Intel, a lot of this weakness is due to their own execution issues and doesn’t represent the conditions for the entire industry.
We remain positive on Cloud, High-Performance Computing and Data centres and see this as a favourable secular trend with immense growth potential. The amount of data being processed is growing exponentially and companies’ IT spend will continue to grow. This leads us to Microsoft, who reported solid results and surprisingly upbeat guidance despite the difficult environment. On its earnings call, management said that it expects double-digit sales growth and operating income, with margins roughly flat. This is an encouraging sign given the general sentiment of slowing IT spend. Microsoft has multiple revenue drivers and is involved in each layer of IT. They are at the centre of favourable secular trends within the Productivity & Business Processes and Intelligent Cloud space. This is why we’re fans of their long-term story.
Last, but certainly far from least, Apple was up nicely for the month after reporting better-than-expected revenue and earnings. Product revenue came in above estimates, with iPhone sales leading the way and eliminating concerns over cut production in China, while its services revenue came in slightly below expectations. Management noted that sales should accelerate in the current quarter despite economic headwinds and incremental US dollar strength. Apple stands to benefit with the continuation of 5G adoption, as well as the record number of people switching over from Android. And as the Chinese economy improves, consumer spending on high-end smartphones, tablets, and laptops will continue to grow. Based on their deep-rooted market position, supply chain execution, higher mix of recurring services revenue and the potential for earnings upside as we get deeper into the 5G cycle, we remain believers of the investment case.
It’s the second derivative that matters
In math’s parlance “Second Derivative” refers to the change of the change or put another way the acceleration or deceleration of growth. Global equity markets are forward looking and often any initial sign that suggests the current trajectory is changing causes markets to recalibrate and react one way or another accordingly.
At its January meeting, with labour market conditions approaching what the Fed deemed maximum employment levels and inflation running above its 2% long term target rate, the FOMC committee changed its narrative from its December comments “ With inflation having exceeded 2 percent for some time, the Committee expects it will be appropriate to maintain this target range until labour market conditions have reached levels consistent with the Committee’s assessments of maximum employment” to “With inflation well above 2 percent and a strong labour market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate”.
With this, a 30-month streak where interest rates had either been cut or held at near zero had come to an end. Global Markets quickly recalibrated to incorporate the trajectory of a rate hiking cycle that it thought would be required to get inflation under control. This impacted market valuations on two fronts. Firstly, via the discount rate resulting in future profits now worth less when discounted back to present value and secondly, increasing the cost of borrowing would slow down the economy thus resulting in less profits in the future. Subsequently the S&P 500, and most risk assets, sold off more than 20% in the six months through June.
Over the next four meetings the FED accelerated the pace of the hiking cycle at unprecedented levels, 25 bps in March, 50 bps in May, 75 bps in June and 75 bps in July. This unsettled risk markets causing fund managers to reduce their exposure to equities and move funds into the protection of cash, as is evident from the latest BofA Fund Manager Survey.
Given all this cash on the side lines and with the majority of fund managers generally underweight equities, the obvious question on everyone’s mind was – when will the market bottom and when to get back into equities?
This is clearly a very complicated question with many moving parts and scenarios. But like all journey’s one must start somewhere. That first step came last week at the FOMC meeting when Chairmen Powell alluded to the fact that future rate hikes would be less than the 75 bps hike in July. Additionally, the market reduced its expectations for the terminal rate to 325-350 bps down from 375-400 bps. This marked a change in the second derivative. Investors were quick to react, causing equity markets to rally. The market is now 14.5% off its lows for the S&P 500 and almost 20% for the Nasdaq, however both remain 14% and 20% off their highs respectively.
The main factors that will drive equity markets and investor risk appetite moving forward are going to be dictated by the path to inflation normalization and the impact on economic growth getting there.
Inflation about to peak
US Inflation continues to hit levels not seen in 30 years, with the last reading in June coming in ahead of expectations at 9.1%.
While many of the CPI components are now trending above 5%, Gasoline and Natural Gas prices have been significant contributors to sky high US CPI figures, with US Retail gas prices up almost 60% in the most recent June CPI reading accounting for 25% of the Y/Y inflation move.
Looking forward US gas prices have come down substantially from their highs in June (-16%) but still remain substantially above last year’s level (31%) so will still add to Y/Y inflation, but its contribution is diminishing. The same can be said for most raw materials, from crude oil to wheat, where prices have peaked and are beginning to roll over.
Any recession could be mild and brief
Connotations of the word “Recession” are generally very negative evoking scenes of mass unemployment and bankruptcies. However, it doesn’t have to be that way. In fact, most people probably won’t even realise if we did experience a “recession”.
Recently 2Q US GDP came in a -0.9% Q/Q annualized following the -1.6% reading from the 1Q. A recession can technically be defined as two consecutive quarters of negative GDP growth. So according to this definition the US is already in recession and yet we haven’t seen a massive deterioration of corporate profits and retrenchments. Why could this time be different? The fact is consumers and businesses are much better placed with more buffers to take a short-term slowdown in the economy without kicking off a dangerous default spiral leading to large write offs and business failures.
Doug Kass of Seabreaze Partners recently published a report making a compelling case that any recession would be mild and brief. He makes the following very astute points:
- The absence, in large part, of the sort of leveraged positions and segments of the economy that have characterised previous deep economic down cycles
- Unlike previous economic downturns, especially the global financial crisis, our banking system is far less levered and has sizeable cushions of liquidity and capital
- There is over $2 trillion of excess consumer savings
- There is a cushion of sizeable unrealised/embedded gains in the nation’s housing stock and large unrealised gains in the U.S. stock market
- The U.S. has a very strong industrial/corporate base that has generally improved their balance sheets by rolling over into inexpensive debt over the last five years and have maintained high profit margins
- We have a robust and tight labour market, with solid wage increases in the last several years. Importantly, in the last 60 years the U.S. has never had a recession without a preceding spike in initial jobless claims
- The job vacancy rate is at an all-time high
- The U.S. unemployment rate is 3.6%, the lowest level since the start of the pandemic and only 0.1% above the 50-year low reached just before the pandemic in February 2020
- Some important components of inflation are moderating
- To the many market participants who are focused on prospective consumer weakness due to the fall in mortgage activity and the marked decline in stocks, I offer the following chart, which demonstrates that consumers’ balance sheets remain strong and underleveraged
Consumer staples – Investors too pessimistic
Consumables such as Food and Beverages companies are not overstocked at this point, and we are seeing stable demand and better elasticities that are driving optimism and upside to organic sales growth. While input costs have been a challenge, key commodities are off recent highs and could provide some relief in raw materials, packaging, and freight going forward.
To counter increasing costs, companies have been able to push pricing through to the consumer with marginal impact on volumes. Worth noting, is the stronger US dollar that is also creating a headwind for multinationals and is expected to continue in the coming quarter. Looking forward, the pricing window is still open should costs ascend higher, and companies aim to defend margins.
Let’s take a deeper dive into some of the results and remarks from this quarter’s earnings season:
Each quarter better than the last. Unilever beat expectations and managed their way through the worst inflation headwinds in over 25 years. Q2 underlying sales were up 8.8%, with pricing contributing 11.2 percentage points (pp) and volumes down 2.1 pp. For the first half of the year, gross margin fell by 210 bps.
Pricing has stepped up sequentially and is a priority for the company; noting on the analyst earnings call, “We are pricing ahead of the market, and we’re prepared to tolerate low single-digit volume declines in order to land that price.” Thereby supporting margins.
Underlying sales guidance was raised to “above” the 4.5-6.5% range, with margin guidance now firmed to 16%. The softer margin guidance is due to management preserving the ability to step-up investment in brands, and we view this as a positive, as it recognizes the need to invest in the brand, and it also allows for an upside surprise.
The strength and quality of the top line reaffirms the attractiveness of Unilever compared to peers, as it currently trades at a >30% discount on a PE basis to Nestle and is closing the gap!
Cautiously optimistic. Nestle echoed the theme with a pricing beat leading to top line guidance upgrades but was less aggressive in pricing. Q2 implied sales were up 8.7%, with pricing contributing 7.7 pp and volumes up 0.9 pp. For the first half of the year, gross margin fell by 280 bps.
Full-year sales guidance was raised from “around 5%” to 7-8%, while margins were guided lower to around 17% which is the bottom end of the previous range. The company is still experiencing supply constraints and marketing expenses were down as a result. The CEO mentioned on the analyst earnings call, “that you should not promote what you can’t sell.” Proving that excess inventory is not a problem.
Nestle remains a smooth sailing ship, and in the words of Nestle’s CFO, “if we enter into a recession with further economic and financial constraints for consumers, we are probably in an industry which will be hit last.”
Heineken mirrored the strong results with organic sales up 24.3%, price/mix contributing 15.6 pp and volume up 7.7 pp. These companies are defensive beneficiaries as they find themselves in a positive pricing environment as well as benefitting from strong demand as restaurant & travel continues to recover. This recovery in travel was also seen in Visa’s results, who confirmed strong pent-up demand for consumer travel has led to volumes surging past pre-pandemic levels.
We see Diageo well positioned to respond to consumer trends and navigate a tougher external environment given their better portfolio, stronger brand health and sharp execution. Furthermore, these shares are not expensive for a quality compounder.
In summary, trends suggest that consumers are willing to pay-up and stomach higher prices as they find themselves in a stronger financial position than at the beginning of the pandemic. Even though savings rates are decreasing, their total savings remain high, and they are receiving a higher income as wages continue to rise. We are closely monitoring the fluid situation and as long as consumer spending remains relatively resilient and inflation rates begin to trend lower, we’re keeping a more optimistic view on 2023.
Local section
By the Numbers
SA market commentary
The Pandemic Hangover
The hangover created by increased monetary support during the pandemic has led to global inflationary concerns requiring decisive action by global central banks to cool prices. Controlling inflation is a balancing act, interest rate increases are effective but used with too much force can stall a country’s economic growth, leading to a recession. Global equity markets currently find themselves on edge, reacting to the slightest changes in inflation rates, GDP growth, interest rates and employment figures. As a developing market, when global sentiment is uncertain, the SA equity market has to hold on for the ride.
The YTD performance of the local bourse shows the ALSI and Top 40 still firmly in the red, down over 7%, resources down over 12%, industrials over 11% weaker and listed property down around 8% with the only outlier being the financials, gaining around 3.5% YTD.
However, when compared to the MSCI All World index, the relative performance is far worse than that of the JSE. The MSCI World has returned -15.6%, more than double the JSE’s -7.2%. Looking at the larger underlying exchanges, it is evident that weakness prevailed across the board, with the US in particular the worst performer.
South Africa’s performance was stronger relative the rest of the globe for a number of reasons including; our equity market starting at a lower valuation, higher commodity prices providing support as well as factors such as inflation and rising interest rates not impacting us as severely as the rest of the world.
Local indicators, are cracks starting to show?
SA has fared relatively well up to this point, but have we begun to see cracks indicating the tide is starting to turn? According to our locals’ indicators, No. SA data continues to show resilience on the part of the SA consumer and economic data consequently maintaining its integrity despite the global pressures.
Tax receipts remain robust, with 1Q FY22/23 showing company income tax +14% Y/Y and personal income tax +11% Y/Y. Conservative analyst estimates extrapolating similar collections throughout the rest of the tax year are indicating the potential for tax overruns in the tens of billions of rands for FY22/23.
SA’s terms of trade remain in positive territory despite commodity prices having come off their highs. The positive trade balance is anticipated to remain in positive territory throughout 2022.
Increasing inflation and a higher cost of debt if persistent will put pressure on the average South African household in time. However, at present we fail to see any cracks. Household debt levels and service cost remain manageable and the SA consumer’s resilience remains evident as seen in the latest updates from SA Inc.
July saw a flurry of trading updates from the retail sector and although they were not exactly comparable due to period differences, the individual results showed strong performance, some in the double digits and almost all coming in above market expectations.
The ability of retailers to push through pricing increases while at the same time holding on to volume growth indicates a retail environment that remains in good health. The latest updates showed almost all of the major apparel retailers had the ability to push through mid-single digit increases and still deliver strong top line growth.
The updates received a positive reception from the market, indicating that market sentiment remains too negative and is pricing far worse expectations for earnings growth.
On the back of the positive retail sales prints, SA banks rallied as the strength of the consumer filtered through into expectations for bank earnings. Banks ended July amongst the strongest performers on the local bourse.
Early August saw Absa release updated 1H22 guidance, indicating an upgrade to earlier HEPS guidance (>20%) to an increase of between 27%-32% or R12.52-R13.20 per share, a clear beat as consensus is currently R11.41 per share. Similarly Standard released an update indicating a HEPS increase of between +27%-32%, this too coming in ahead of consensus expectations.
As seen with the retailers, negative sentiment has pressured bank valuations and as a result the earnings updates were well received by the market. In our opinion they remain attractively priced at current levels.
Earnings Expectations Versus Market Valuation
Despite the backdrop of rising inflation and global concerns around economic growth, earnings growth forecasts remain strong, in the high teens for FY22 for the local market. However, negative market sentiment has pressured valuations lower forcing the ALSI 12 month forward PE to a level not seen since the global financial crisis.
In our opinion, the caution being exercised by the market has resulted in the mispricing of the local bourse. All indicators are pointing to conditions stronger than the SA market would have you believe. We feel this strength will feed through into earnings, leaving us in cheap territory. Most sectors are offering attractive entry points and we will continue to take advantage of this mispricing across our portfolios.
Knockout sales updates from SA retailers
The South African consumer is facing many challenges, not all unique to the SA economy, which have had a negative impact on sentiment. The increased inflationary pressure resulting from higher fuel prices, rising interest rates, intensified load shedding and the non-payment of the Covid-19 social relief, amongst other things. All these combined served as headwinds to disposable income and posed a risk to consumer spending in future.
Food sales remain resilient
The food retailers reported first half results with sales growth coming in at an average of 8%, a slight acceleration on the previous reported period of 7.6%. Internal price inflation continued to be well managed, coming in below the current CPI food inflation of over 8%. This speaks to the continued efforts by management to help soften the blow on consumers.
This weak sentiment has been evident in the poor consumer and business confidence and has also translated into conservative earnings expectations for the South African retailers. This analyst cautiousness became evident when the SA retailers released sales updates that came in ahead of market expectations.
Shoprite was best in class, reporting exceptional results in a tough trading environment. The sales for the core South African business grew by 8.9%, and 6.3% on like-for-like basis over the second half of the financial year. Although this was lower than the first half sales growth of 11.3% and 10.7% like-for-like. Management continues to execute well on strategy and take market share from peers.
Woolworths underperformed, recording total sales growth of 4.6% and 3.4% on a like-for-like basis in the second half of the financial year. This was a weak result compared to Shoprite and Pick n Pay, but it was an improvement from the result produced in the first half of the financial year with sales growth of 3.8% and 2.8% on a like-for-like basis. Management will likely have to refine their strategy and execute diligently to be able to recover market share from the peers.
Clothing sales accelerate despite pressure on consumer
The apparel retailers showed no significant signs of weakness in consumer spending as total sales growth for the first half of 2022 came in at an average 10% and 7%. This is higher than the previous reported period of 7% and 6% on a like-for-like basis. Price inflation was also well managed, coming in at an average of 4.4% over the same period.
While the food business lagged, the Woolworths fashion business delivered strong results and grew sales by 6.5% (9.9% like-for-like), keeping in line with peers. This was a record performance given that the average growth reported in previous reporting periods has been circa 2%, going back to 2016.
A strong performance from Country Road saw sales growth of 9% (11.3% like-for-like) despite an 8% reduction in trading space. While David Jones grew sales by 4.3%, after the easing of the lockdown restrictions over the same period.
This recovery is welcomed progress given that management struggled to execute and grow sales in this business for the longest time.
Truworths surprised with sales growth of 9.7% (12.8% like-for-like) for their Africa segment, showing a significant improvement from the 1.8% sales growth reported in the first half of the year.
The London business, Office, also saw improved trading conditions, recording sales growth of 24.1% in Rand terms for the second half of their financial year from 3.9% growth in the first half, all while reducing trading space by 4.4%.
The credit book is in a healthy position as reflected by the improvement in overdue balances and a healthy level of active accounts able to purchase. For the period ended June 2022, gross trade receivables increased by 9.4% to R5.9 billion compared to June 2021 and this provides an opportunity for management to further drive sales growth going forward.
The Foschini Group reported robust performance, with first quarter sales growth of 11.2% (7.1% like-for-like) for their Africa business, albeit slower than previous reported quarter growth of 16.1% (11.5% like-for-like). The business continued to benefit from the strong localized, quick response clothing supply chain and sourcing model, which shielded the business from continued international supply chain disruptions.
TFG London continued the strong performance as the economy saw a resumption in working from the office, delivering growth of 39.9% (GBP) compared to the same quarter in the previous financial year. TFG Australia exceeded expectations with retail turnover growth of 15.7% compared to 11.5% in previous quarter (AUD) off a very high base.
Management’s acquisition strategy and solid execution has proven to be a success given the successful integration of Jet stores. Tapestry Home Brands is also expected to be integrated into the group effective 1st August 2022.
The performance seen in the first half is expected to continue into the second half of 2022 as TFG Africa, MRP and PPH reported strong trading and increasing momentum for the first three weeks of July, with sales growth of 27.3%, 18.4% and 20.3%, respectively.
Despite continued pressures on the SA consumer, sales trends remain resilient and significantly above the more suppressed expectations currently being priced into valuations.
Closing Comments
But, as we have said consistently, there are always likely to be opportunities that present themselves during times of volatility, with the latest examples highlighted in this newsletter being cases in point. Benjamin Graham (the father of value investing) is quoted as saying that the market is like a voting machine in the short term, tallying up which stocks are popular, and which are not. But in the long term, it is like a weighing machine assessing the substance of a company. While not as eloquently put, our investment process and philosophy follow a similar thought process. We attempt to assess the extent to which short-term news flow is shaping current share prices, particularly where we believe current commentary is irrelevant to the long-term earnings outcome of the company under consideration. Where the team believes the disconnects are too significant, either a buy or sell decision is triggered. As the war rages on and investors become increasingly hawkish on monetary policy, we believe further opportunities will present themselves for the prudent allocation of capital.