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Wood for the Trees | March 2022
15 March 2022
With central bank policy decisions front and centre this year, we felt it appropriate to use our opening graphic to clarify some of the terminology likely to be used by market commentators. Unfortunately, for the bulls, we’ll be looking at the left-hand side of the graphic this year to explain the decisions likely to be taken by most first-world central banks. Hawkish sentiment goes along with with higher interest rates to combat what we could easily now clarify as rampant inflation in the US. However, as is always the case, one needs to be careful not to paint every situation with the same brush. Inflation is being driven by many different factors, including some positive ones (think low unemployment levels and higher private net asset values as two such examples). As a result, while central bank policy decisions are likely to introduce headwinds for some equities (in particular those trading at hard-to-justify valuations), not all equities are the same. Some, such as banks, tend to do very well in a steadily rising interest rate environment. Their operating cost base remains stable, with a healthy increase in net interest margin providing a strong earnings kicker over time. It’s principally why we buy shares in agile companies that can adjust to changing monetary and economic conditions over time. There are always opportunities to pick up mispriced assets; it just requires a good combination of discipline and patience.

This month, Liam looks at the likely key drivers of investor sentiment in the first half of the year, the Q1 earnings season and the path of interest rates, and discusses a new stock on our radar, TSMC. Locally, Mandy and the team flash through locally listed retail and property, concluding with a piece on what has driven Naspers and Prosus lower in 2022.

Enjoy the read.

International section

By the Numbers

After a difficult start to the year, with January and February recording a cumulative loss of 7.5% for the MSCI All Country World Index, March provided some respite, with the S&P500 leading the way. The S&P 500 added 3.5% in March, closely followed by the Nasdaq with a similar return. A little bit of weakness for the dollar – around 1,5% – but that wasn’t enough to help the broader emerging market complex post positive returns. The Hang Seng impairments continue as the market remains caught in two powerful downdrafts – the impact of regulation on technology shares, and China’s perceived association with the Russians. The numbers could have been much worse than the negative 3.5% return for the month; at one point, the index was down 19% at the Ides of March (not just a bad day for Julius Ceasar, it would seem).

Not entirely surprising to see companies with commodity exposure featuring on the upside of the equation, as numerous commodities spiked as a result of the Russian/Ukraine war. JD.com, one of the Chinese tech companies we mentioned earlier, languished at the bottom of the table as the Nasdaq’s worst performer for the month after dropping 19%. Interesting to see Tesla jumping more than 20% in March. Musk is clearly of the view that if something has worked well, why not simply do it again. A second stock split on the cards was just what the retail punter needed to help drive Musk’s wealth to spectacular levels. I don’t know why I didn’t think of that. I mean, it’s all about how many shares I have, right? Two is greater than one – it’s simple maths. You know that old saying… ‘Fool me once, shame on you, fool my twice, shame on me!’

Q1 earnings season promises to be enlightening

As we head into the 1st quarter earnings season in the U.S., all eyes will be on how companies have dealt with inflation and the increasing cost impact on margins and earnings growth.

For most of 2021, equity market performance was driven by earnings growth as PE multiples contracted from record-high levels. Earnings growth was sufficient to deliver a >30% performance in the S&P 500 in 2021, as year-end earnings growth finished up 48%. With earnings growth expectations for 2022 being questioned, we have seen an impact on the market’s performance.

The world has become a more complex place with the Russia/Ukraine conflict pushing an already stubborn inflation rate even higher. This is happening at the same time as the Fed and other central banks are beginning to tighten very accommodative monetary policies.

1st quarter earnings growth and forward guidance will be critical in shaping the performance dynamics as we move forward. Currently, expectations are for Q1 earnings growth to be in the region of 4.7% – down from 5.7% as of 31 December – as we are seeing more companies provide negative guidance moving closer to reporting season.

On the other hand, revenue growth is proving to be much more resilient with 1st quarter revenue growth expectations of 10.7%, suggesting some margin pressure. Profit margins are expected to drop to 12.1% from 12.8% in Q1-21, and 12.4% in Q4-21 yet remain above long-term average margins of 11%. The winners this quarter will be those companies that can hold onto margins and push pricing through to the consumer.

For the remainder of 2022, expectations are for earnings to be in the region of $227.80, representing growth of 9.3%. If the typical 5% earnings beat materialises, that will mean a more typical 15% earnings growth rate. The S&P 500 is currently trading at a slightly above-average multiple of 19x; given rising interest rates and more normal earnings growth expectations, it’s hard to make a case for multiple expansion. It is a stock pickers market, which should divide up the winners and losers. We will focus on companies with strong pricing power and superior growth dynamics.

The interest rate hiking cycle has begun

The U.S. Fed narrative has done a complete about-turn in the last six months. Initially, Chairman Powell stuck to his guns, suggesting inflation was “transitory” and driven by a short-term demand/supply mismatch exacerbated by supply chain bottlenecks due to Covid related shutdowns, which would pass as the operating environment normalised.
Unfortunately, transitionary inflation seems more longer-term in nature as prices of all categories have ramped up along with wages.

The Fed narrative has become more hawkish as they try to play catch-up and get inflation under control without damaging economic growth. The Fed raised rates for the first time at their March meeting, taking the effective Fed Fund rate range up to 25-50bps, with the Dot Plot suggesting we will exit the year with rates around 2%. This represents five to six more 25bps rate hikes this year (six more meetings in 2022). The market suggests the Fed needs to be more aggressive and exit the year with rates closer to 2.75%, meaning that the Fed will have to up its game and raise rates 50bps per meeting over the next three meetings to get ahead of the curve.

On top of rate hikes, the Fed is also about to embark on Quantitative Tightening (QT) as it begins to reduce its enormous balance sheet. In the recent Fed minutes, Fed governors alluded to the fact that they will reduce assets by $95bln per month starting at the May meeting, suggesting a $1tln per year run on their $9tln balance sheet.

There is a large amount of scepticism as to whether the Fed has the skill to tighten monetary policy – bringing inflation under control – while at the same time maintaining a healthy economy. Most recessions have resulted from the Fed increasing rates too aggressively and choking off economic growth. The potential for this happening is currently represented by the 10-year/2-year U.S. yield spread, which is close to inverting, suggesting a recession may be imminent.

Economic indicators are currently pointing to a U.S. economy that is still on a healthy footing: the job market remains robust, with job openings far exceeding new hires and the property market remaining buoyant.

This tug-of-war is currently dominating the markets, the outcome of which will have a broad impact on risk assets across the globe.

Investing for the future

Taiwan Semiconductor Manufacturing Company (NYSE: TSM)
April 6, 2022

As the new digital world penetrates our traditional way of life, the importance of automation and digitalisation has never been more pertinent. With this in mind, we focus on opportunities that are likely to scale as technologies converge and transform industries, and we believe semiconductors are the building blocks in this theme.

Semiconductors are foundational to the global economy, with Taiwan Semiconductor Manufacturing Company (TSM) deep-rooted in this industry. TSM is one of the clearest examples of a “Pick-And-Shovel Play”, as it is the underlying technology that makes up the backbone of this growing industry.

TSM is a semiconductor manufacturer that produces the actual end product (semiconductor chip) for other companies such as Nvidia, Apple, and many others, and is referred to as a foundry. It is seen as a more diversified semiconductor player, as its success is not tied to demand growth from a single company; instead, it benefits from a broad semiconductor growth for the industry as a whole.

TSM is driven primarily by strong demand for its advanced technology in key areas such as 5G, High-Performance Computing (HPC), Internet-of-Things (IoT), and the automotive industry. It is connected to the cloud, artificial intelligence, telecommunications, autonomous driving, and the metaverse. In other words, TSM is involved in all areas of secular technological growth and innovation.

TSM’s outlook is encouraging: higher revenues and stronger margins should allow TSM to generate compelling earnings quarter over quarter. The company occupies a leading position with >50% share in the foundry market and >80% share in leading processes. Generally, a monopoly in the most cutting-edge technology comes with pricing power.

And that is why, from a growth perspective, TSM is exceptionally well-positioned. TSM, due to being in business with many different companies around the world, will benefit from broad-based chip demand growth in 2022 and beyond. Its success is not tied to individual product lines in the way that other semiconductor players may be. As the ongoing global chip shortage continues, TSM is in a strong negotiating position relative to the companies with whom it trades. Therefore, demanding higher prices shouldn’t be an issue for the company. This explains why the company is forecasting a margin expansion of 53-55% this year – pushing through price increases in a tight market should allow them to offset higher input costs.

TSM has budgeted over $100 billion towards CapEx spend for the next three years. It plans to increase its lead and dominance further by increasing its fab capacity and chip output which should go a long way to increasing growth and returns over the next decade.

In the United States, the Biden administration has authorised the “Facilitating American-Built Semiconductors (FABS) Act”, which could include potentially $52 billion in funding for the U.S. semiconductor industry. This also includes new policies designed to strengthen the U.S. relationship with Taiwan, benefitting TSM and their factory currently being built in Arizona. This aims to provide tax-based incentives for constructing, expanding, or modernising semiconductor fabrication plants to bridge the gap between the U.S. and Asia.

There are concerns that global demand for consumer electronics, like smartphones, PCs and TVs is starting to slow down. However, other sectors, including automotive, High-Performance Computing and Internet-of-Things, are picking up the slack. The TSM chairman has also noted that they cannot meet demand with their current capacity. We expect the demand for chips to remain strong, supporting pricing for decades to come as chips remain a critical component of secular drivers in cloud, AI, 5G and EV adoption.

From a valuation perspective, TSM is attractive. Due to rate hike worries and escalating global tensions, the semiconductor industry has experienced a significant sell-off in recent weeks. TSM shares have declined to just above $100, down 30% from recent highs. This has made TSM’s forward PE multiple drop to around 17.5x. A company with an excellent market position (that is benefiting from strong macro tailwinds and has delivered high-teen growth in recent quarters) seems quite attractive at a high-teens earnings multiple, especially as its relative growth looks more attractive in a slowing growth environment.

Across the industry, there has been a substantial uptick in the overall PE multiples. This should continue for the next five years due to the emergence of 5G technology, widespread adoption of electric vehicles, Internet-of-Things (IoT), and Data Centers.

We are confident about the opportunities for semiconductor stocks as the structural importance of semiconductors in the rapidly digitising global economy cannot be overstated. Specifically, TSM has a compelling future outlook and is trading at a bargain. The recent sell-off presents an attractive buying opportunity given TSM’s solid fundamentals, favourable prospects, and attractive risk/reward profile.

Local section

By the Numbers

In March, the JSE delivered another good result to cap off a solid quarter, outperforming most global indices in USD terms for the period. While commodities have done a lot of lifting this year, March was the month for cyclical domestics, with the bank index rocketing 13%. Interestingly, a bit of a mixed bag from commodities this time, with platinum miners in particular, taking some pain. A combination of negative sentiment, driven by disruption to the auto sector (impact of the Russian/Ukraine war), and a lacklustre reporting period for the sector (disappointing production – lower output numbers at a higher-than-expected cost, combined with underwhelming dividend payout ratios) put significant downward pressure on stocks. The chief protagonist here, Impala Platinum, was down 23% in March. That’s a big move from a big mining company. Keeping with the negative sentiment, Naspers and Prosus also struggled in March, and have done so all of this year. Our team has written a piece on them this month so we won’t rehash that here again. Still, it’s challenging to maintain a premium rating in the face of materially-slowing growth prospects, combined with significant regulatory uncertainty. As many readers know, we have been banging the drum on the evidence, which seems to have supported the view that the South African consumer is holding up better than most would have expected in the face of Covid. It is good to see conviction playing out in stock price movements, with banks and retailers having an exceptional March.

The Foschini Group, a stock that we recently added to our portfolios, led the sector higher in March with an 18% return. While not included in our indices, it’s important to take note of the ZAR this year. It moved from around R16 to the dollar down to R14.50 – a remarkable story indeed. Not only this, but for the first time in many years, we have seen foreigners as net buyers of South African equities. Long may it last!

Cyclical sector valuations – Retail & Property

Retail Sector

The South African economy has been showing signs of a post-pandemic recovery. However, this is threatened by ongoing supply chain issues, the Ukraine crisis, stubbornly high unemployment, rising fuel costs, increasing inflation, and interest rate hikes, to name but a few. Despite these challenges, management teams of SA retail companies have done a great job in driving sales growth, improving margins, and managing cost inflation. Highlights from recent results updates include the following:


  • Companies recorded strong sales growth in the last quarter of 2021, driven by Black Friday promotions and festive shopping. This momentum carried through into the new year, with January sales supported by strong back-to-school promotions. The growth in sales varied across the retailers, with The Foschini Group (TFG) and Mr Price (MRP) capturing the highest growth amongst clothing retailers, with Shoprite (SHP) the highest in the food category. Massmart struggled, with sales down over 6%.
  • Inflation remains a focal point for the global market, and pricing was key for the retailers. Management teams successfully walked a tight rope of passing inflation to consumers while at the same time managing volumes, evidenced by margin expansions. Internal price inflation was well-managed across the food and clothing retailers. Shoprite’s price inflation remained relatively low and is targeted to be 3.9% for FY22. On a group level, Woolworths (WHL) also managed to keep price inflation low at 3.7%, while on the other hand, Truworths (TRU) chose to keep pricing attractive, noting a 2% price deflation for the 1H22.
  • We also saw improved operating margins from various cost management initiatives, including declining rental expenses, as management continued to negotiate a reduction in leases.
  • Balance sheet positions continue to strengthen, with improved net debt levels and strong free cash flow generation. Free cash flow was returned to shareholders in the form of dividends and share buybacks. Companies continued to take advantage of the low share prices, with TRU buying back 14.5m shares (representing 3.8% of shares outstanding) at an average price of R53.26 per share. Similarly, Shoprite reported having repurchased R339m worth of shares in the 1H22 financial year.
  • We continued to see the quality of the credit books of credit retailers improve. The TRU credit book continues to be in a healthy state, with all key metrics indicating it is well-positioned to support sales growth. TRU management reported increased application levels, declining overdue accounts and net bad debt levels, and a reduced doubtful debt allowance. Similarly, TFG reported normalised average approval rates and an increase in the credit book. However, both retailers noted that overall credit remained purposely restricted by stringent acceptance criteria in line with prevailing economic conditions. We expect to see growth in the credit books with improving conditions as management starts to relax the credit risk criteria.

We continue to believe that valuations are not fully reflecting the improved operating environment in SA.

    Property Sector

    Recent updates from property companies highlighted a somewhat improving but challenging operating environment, with the following key themes noted:


    • Retail portfolios continue to improve, driven by lower vacancies, improving trading densities, increased footfall, increased leasing activities from national retailers and improved rental collections. Most companies noted that they had seen increased basket sizes as turnovers have recovered faster than foot count, which is still below pre-Covid levels. This is evidenced in the chart below from the Vukile FY22 pre-close presentation.
    • Industrial portfolios remain defensive as vacancies continued to trend lower. This is driven by a relatively strong demand for industrial properties, evidenced by the improved renewal success rates and increased letting activities.
    • However, weakness was noted in the office portfolios as vacancies remained high, driven by weak renewal success rates resulting from tenant downsizing (to reduce costs) coupled with an oversupply in the sector.
    • Balance sheets are stronger as companies continue to pay down debt resulting in more sustainable capital structures with loan-to-value ratios trending downward.
    • Property companies continue to dispose of non-core assets. On average, non-core assets were disposed of at or above book value. Management teams were successful in driving disposals in a challenging operating environment.

    Property shares continue to trade at significant discounts to net asset value despite the relatively improved conditions. We continue to believe the property sector is mispriced and offers outsized returns.

    Overall, valuations remain subdued and do not accurately reflect the improved operating environment. We remain optimistic about this cyclical sector.

    Prosus and Naspers – A challenging start to 2022

    2021 was a challenging year for the likes of Prosus (PRX) and Naspers (NPN), down -18.5% and -18.1%, respectively. This year is presenting its own set of challenges where wild daily swings have become the norm and the overall downward trend has the market uncomfortable. As the largest underlying holding, Tencent is the driver behind the price performance. Understanding what is driving the share price of Tencent is key in deciphering the inherent value in PRX and NPN.

    Tencent – Regulations Drag on Earnings

    Over the last year, a barrage of Chinese regulations was introduced, including anti-trust laws, data regulations, limits on game time for minors, and months-long game licensing halts. This impacted almost every internet sphere including eCommerce, online gaming, and education. Tencent co-founder, Pony Ma, and President, Martin Lau, supported the move to a more controlled internet environment where, in their opinion, more regulation would lead to healthier, sustainable growth over the long term.

    Over the short term, however, the regulatory impact and a slowing Chinese economy has dampened earnings, with Tencent posting its lowest revenue growth on record (+8%) along with a 25% decline in earnings. Domestic gaming revenue saw a soft 1% increase in Q4, down from the 5% increase in Q3, and signs of stress started to show in online advertising, which posted a 13% decline in ad revenue for Q4.

    The impact on earnings was not specific to Tencent, with similar earnings pressure being felt by their biggest rival, Alibaba, as they too battled with the regulatory onslaught and a slowing economic environment.

    Is the discount warranted?

    The large discount between underlying net asset value (NAV) and market valuation has become an infamous trait of Naspers and Prosus. Breaking this discount down into the sum of the parts identifies how significant this discount has become and begs the question of whether it is warranted. Prosus, as of 31 March 2022, was trading at an NAV of R1,800 per share. This is calculated using live pricing for its listed assets and December valuations (provided by Prosus) for the unlisted assets. To be prudent and account for any significant value changes, if the value of the unlisted assets is halved, the underlying NAV adjusts down to R1,600 per share. Lastly, if unlisted assets are left out entirely, the underlying NAV sits at R1,400 per share for the listed assets.

    As of 31 March, Prosus closed at R795.76 per share. This represents a discount of 50% relative to underlying NAV, including unlisted investments (at a 50% discount) and a discount of 43% when only valuing the listed investments. While a discount to underlying value is fair for a holding company, a discount of this size is extreme. Historically, while the discount excluding unlisted assets averaged around 20%, the market is now pricing in more than double that discount.

    Tencent leading the pack

    Tencent makes up around 80% of the underlying NAV of Prosus. Comparing price performance, Prosus (and Naspers) track Tencent to a large degree. In the past few months, the negative days have hit NPN and PRX harder, leading to a widening gap in the discount being priced in.

    Tencent’s Outlook

    While recent performance has been tricky, on a positive note the second half of 2022 is anticipated to bring some life back into Tencent. The crackdown on the technology sector is largely over, and while Tencent does anticipate new regulations to be imposed over time, they are expected to be incrementally far less onerous than the regulations imposed over the past few years.

    The Chinese economic environment is the next factor determining earnings expectations. With Chinese Vice Premier Liu He confirming Beijing would roll out support for the economy and keep markets stable, Tencent stands to benefit. The news of more accommodative policies was well received by the market and is anticipated to feed into results later this year.

    Tencent has historically traded on an average forward PE of around 30x. At its low point in March, this valuation dropped close to 15x, recovering to around 21.6x at current pricing. Excluding their associates (other investments), which focus primarily on Tencent’s core operating numbers, this forward PE drops to around 16.7x at current pricing. From our perspective, these levels price attractively, verging on cheap, despite expectations for more subdued growth levels.

    Tencent is not without its challenges, but earnings potential remains, albeit at a slower rate than seen in the past. With an improving operating environment and the market currently pricing in a worst-case scenario, we believe Tencent stands to benefit. With Tencent as a driver in the second half of 2022 and based on its depressed price point and the margin of safety the discount to underlying NAV creates, we feel comfortable adding to our Prosus exposure (where appropriate).

    Closing Comments

    There is much for investors to digest in 2022, with clearly the most significant short-term risk being escalations in the war between Russia and Ukraine. As things stand, it seems possible that a mediated outcome of some sort is the most likely scenario, and on that basis, further contagion from a risk asset perspective is expected to be muted, with the focus remaining on interest rate decisions and rates of inflation. These of themselves are not immaterial to future pricing.

    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.