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Wood for the Trees | May 2022
15 May 2022

The lead graphic for this month was just going to be the four letters highlighted in colour above. I thought it was pretty self-explanatory until I started googling what these four letters could also stand for. It’s a rabbit hole, don’t go there. But one of the tamer suggestions was ‘What the freaking heck’. As I chuckled to myself while compiling this newsletter, it occurred to me that for many investors, this is just what they may be thinking in response to the aggressive drops in the market so far this year, particularly offshore.
It hasn’t been easy, which is why we wrote a piece in the middle of the month to give an indication of how prices are moving relative to earnings. In summary, the piece noted that today’s lower prices only matter to those that need liquidity, but for the rest, a company’s earnings profile over time will help underpin its intrinsic value. Interestingly, at this point the earnings lines look in much better shape than current market prices would have you believe, particularly for the shares that we own in your portfolios. We find it helpful to think of shares not as prices, but rather as part ownership of a productive asset. Regardless of short-term price moves, a productive asset produces something of value that the economy needs or wants. If the case for the company’s product or service holds and the company is competitive, earnings will be generated, dividends will be paid, and this storm too shall pass. It helps us to look past the noise.
This month, we take a high-level look at what outcome the offshore market is pricing in at current levels to see whether the implied appears reasonable. We also relook at our local market outlook set out at the beginning of this year to see how things have developed. We whizz through some detail on Disney and the Foschini Group as well.
We hope you enjoy this month’s read.

International section

By the Numbers

After a torrid January to April period, many had hoped that May would bring a much-needed bounce in equity markets following precipitous declines year to date. Unfortunately, that was not to be, with May coming in barely positive – around the 1% mark for most global indices, barring the Nasdaq, which is still carrying the wooden spoon at -2%. Officially in bear market territory, the index closed May with a return of -22% YTD. There was much to digest in May for investors, with the FED implementing its first 50 bps rate hike in a number of decades, while flagging that more are to come in future meetings. We also had surging oil prices following fresh Russian sanctions and crashing cryptos, as it turned out that some ‘stable’ coins were, in fact, not so stable. Given rampant oil prices resulting from Russian sanctions and the dominance of energy companies in its composition, it’s not surprising to see the FTSE leading the first world indices that we follow this year. For the first time in a number of years, the US is the laggard. Much like the FTSE100, 3 of the top 5 performers for the month were energy companies. Under Armour sits at the bottom of the table as they personify everything that currently worries the market. Higher costs which can’t be passed on to consumers, coupled with global supply chain challenges resulting from the war and Chinese lockdowns, meant that they posted a small loss for the 4th quarter on revenue of over USD1 billion. Not pretty; the stock shed 30% for the month and has lost half its value this year. No surprise then to see the sudden departure of the CEO, who had only been in the job since 2020. On a different note, don’t feel like you’ve missed out on the FTSE 100’s top performer in May, Flutter (Irish based sports betting company), when you look at the charts below? It needed that bounce to help lift it from a very poor year-to-date performance. Even after the big jump, the stock is still down 16% in 2022.

What is the market currently pricing in?

Stock markets can be scary at times, especially given the current volatile conditions and cacophony of negative headlines. In times like these, it is always good to try to come to terms with what the market is currently pricing in. This exercise provides a perspective for potential moves under certain scenarios. Being armed with this knowledge places an investor in a better position to make reasonable decisions going forward.

We have just about completed the first-quarter earnings reporting season in the U.S. For the most part, earnings have been impressive. 77% of companies reported earnings that beat expectations, in line with the 5-year average. Earnings growth came in at 9.2% – a full 4.6% ahead of expectations. Revenue growth for the quarter was impressive at 13.6% – the 4th highest reading since FactSet began tracking revenue growth. Currently, there does not seem to be anything wrong with the level of economic activity despite some inflation-driven margin pressure.

Looking forward, earnings expectations for FY22 and FY23 are $229/share and $251.50/share respectively, representing 10% and 9.6% Y/Y growth.

Is recession priced in?

Is the S&P 500 currently trading at fair value? Only if you believe that earnings expectations will turn out to be true.

Many market commentators are calling for a recession as they doubt whether the Fed has the ability to successfully engineer a soft landing while it increases interest rates to get a handle on inflation. Time will tell if the Fed is successful, but for research purposes, let’s assume that the U.S. economy falls into recession over the next 12 months. How would corporate earnings be impacted?

Starting with current S&P 500 earnings power, which we know is $54 – $55/share per quarter (that is what the index’s companies generated in Q4 2021 and Q1 2022). This works out to $218/share for the full year, and represents peak earnings if we are heading into a recession. Recessions hit earnings, of course, but by varying amounts. Standard recessions (1990, 2000, 2020) can cause an average earnings decline of 26% from peak to trough.

Let’s assume we get a garden-variety economic contraction, where S&P earnings go from $218/share to $161/share based on the average 26% drop of the 1990, 2000, and 2020 recessions. Here are the current valuations for the S&P 500 (at 4,100) based on a sliding scale of potential earnings:

  • $218/share (0% recession odds): 18.8x
  • $204/share (25% recession odds): 20.1x
  • $190/share (50% recession odds): 21.5x
  • $175/share (75% recession odds): 23.4x
  • $161/share (100% recession odds): 25.47x

To make sense of these PE ratios, we need to know where the S&P 500 index has bottomed in prior recessions on a trough PE basis.

  • October 1990: 15.3x
  • October 2002: 20.0x
  • March 2009: 17.1x
  • March 2020: 18.3x

Taking the average of the last three observations gives you a multiple of 18.5x. Obviously, 18.5x is a troubling result as it implies that even after a 13.5% YTD decline, the S&P 500 – at 4,100 – is still not putting any odds on a recession.

Ultimately, the S&P 500 needs to go to 3,525 ($190/share EPS trough, 18.5x multiple) just to discount the 50:50 odds of a recession, which is a decline of 14%. If we get a typical economic downturn, the S&P 500 should trade around 3,000 (2,979 to be exact, at 18.5x and $161/share) – down 27% from current levels.

This is not our base case but rather an exercise to assess where the S&P 500 “could” trade if recession fears continue to grow. If the Fed successfully engineers a soft landing, a recession is not inevitable. If the Russia-Ukraine war ends, oil prices will decrease and lessen recession risks and inflation pressures. This will allow the Fed to stop tightening, and for earnings growth to drive markets higher.

Looking at it from a slightly different angle: if the Fed successfully engineers a soft landing, history tells us that the S&P 500 typically falls 11% – 33% during the tightening cycle. Given the current 13.5% market drawdown, we may have experienced the worst…

We remain cautiously optimistic.The valuations of many top-quality companies with strong operating prospects, beyond any short-term bump in the economy, have dipped into attractive levels. The U.S. consumer is comfortably positioned with adequate savings levels and low indebtedness, providing a buffer against any temporary slowdown should it materialise. Likewise, U.S. corporates remain well capitalised and in a healthy financial condition. We intend to use this volatile period to build opportunistic positions.

Disney Q2 update

Disney reported a good set of results for the recent quarter ending March. Revenues increased 30%, with Operating Income up 50%.

The standout highlights for the quarter were:

  • Disney Parks, Experiences and Products revenues increased >100%, delivering operating income of $1.7bln vs a previous loss of $406mln. Operating margins in the Parks business have returned to a healthy 26%. All metrics continue to be stellar, indicating a strong desire of consumers to get out and about.
  • Management noted that attendance continues to show strong growth with all U.S. parks now open. Internationally, Paris has opened, but Hong Kong and Shanghai remain closed.
  • Direct-to-consumer (DTC) revenues increased 23% to $4.9bln.
  • Disney+ subscribers increased by 7.9mln during the quarter (beat expectations of 5mln net adds) – bringing total Disney+ subscribers to 137.7mln. Given that Netflix recently saw a significant subscriber loss, it bodes well for Disney. Management reiterated its target of reaching 230-260mln Disney+ subs by 2024, breaking even in the DTC business in the same year.
  • Pricing per sub across the range of DTC products remains strong.

We believe trends in the business are moving in the right direction, and remain confident in the execution ability of the Disney management team.
Despite the solid set of results and good guidance, the market is showing a few concerns for some of the cost increases vs a year earlier for the next quarter:

  • $350mln in the Parks segment due to Hong Kong and Shanghai remaining closed
  • $150-$200mln decline in content revenues
  • $900mln in DTC content costs

In our opinion, none of these issues is material and will likely be temporary.
We are buyers of Disney at these levels. We believe the market is significantly discounting the stock using just the Parks and Media businesses, excluding DTC. In addition, you are technically getting the DTC business for free, which on a stand-alone basis could be worth between $45-$87/share.

DIS is currently trading at 13x FY22 Parks & Media EPS of $7.55. Before the launch of DTC, DIS traded at 18x the Parks & Media business. Therefore, applying an 18x multiple to $7.55 gets you to $135/share. DTC is for free…
As Disney moves toward FY24, they should be 100% up-and-running across all Park’s segments, meaning that EPS will move towards our $8.78/share estimates. Additionally, DTC is guided to breakeven that year.

We have used this short-term macro noise to add to our positions in DIS.

Local section

By the Numbers

Much like its offshore counterpart, the JSE managed to eke out a small gain in May, with the Equally-Weighted Top 40 going green with a 0.5% gain. Individual sector performances showed strong correlations this month, with most large sub-sectors returning similar numbers, barring the Banks Index, which jumped almost 6% in May. We got some reprieve from the rand this month, strengthening 2.5% against the dollar. While it is always tricky to really work out why the rand moves as it does in the short term, stellar mining earnings, higher corporate tax receipts and a surprise Government Bond rating upgrade by S&P didn’t hurt our cause (the ratings agency raised our outlook from stable to positive). There was no significant economic newsflow on the local front to write home about this month, but it was nice to see the NPA arresting a few more suspects involved in various forms of corruption. Looking at notable stock-specific movements this month, it was good to see a bit of leadership from Naspers and Prosus after what has been an awful year for both counters. Without the Chinese narrative improving, it’s difficult to see this one shooting the lights out just yet, notwithstanding its relative cheapness. Goldfields and Massmart were probably the most newsworthy on the downside. Almost all of Goldfields’ loss for the month occurred on the 30th when they announced a transaction to buy Yamana Gold in an all-share deal (Yamana is a USD6 billion Canada-based gold major). Shareholders voted with their sell buttons, apparently worried about the dilution implied by an all-share deal. Massmart released a 19-week trading update in May, which was not well received by the market, with group revenue negative for the same period the prior year.

Local outlook update

At the start of the year, our outlook for 2022 highlighted how market valuations suggested an environment under significantly greater stress than reality. Five months on, the market has felt the pressures of the Ukrainian crisis, rising inflation, increasing interest rates and concerns of a recession. Let’s take a look at how things are holding up.

South Africa’s GDP expectations have been revised lower over the next 12 months, with longer-term expectations remaining essentially the same.

CPI in SA has seen some understandable adjustments given the current global environment. However, it remains largely unchanged; expectations for the FY2022 remain within the reserve bank’s 3-6% target range.

Surprisingly, South Africa has benefited from the global turmoil created by the war in Ukraine. Rising commodity prices have driven SA’s current account surplus, relieving the pressure on our fiscus and reducing SA’s reliance on debt. This has fed through to SA’s Gross Debt to GDP figure being revised downward. This has not been missed by the ratings agencies, with Moody’s in April updating SA’s outlook to “stable” from “negative” and S&P Global improving its outlook in May to “positive” from “stable”.

One of the most important indicators of the health of current economic activity that we watch is tax collections. Year-to-date figures show a resilient economy, with all transaction categories showing strong double-digit growth, and employee tax growth increasing by almost 10%.

Household balance sheets remain in a good state, with household debt and debt service costs as a % of disposable income declining, while public sector credit extension is steadily showing improvement – commercial credit, in particular, is starting to pick up the pace. We are now back at pre-Covid levels, suggesting a healthier consumer and increased confidence going forward.

Market valuation – pricing in a weak operating environment

Equity markets have zig-zagged throughout the year, with investors extremely sensitive to the smallest changes in the macro-environment. Local market valuations remain depressed relative to long term averages, with 2-year forward PE’s undemanding despite solid earnings growth expectations.

Retailers– sentiment remains low despite solid operating results

Retail sales have already seen an improvement over the past few months, with individual retailers posting results that indicate a robust retail environment. Results have shown strong sales growth and the ability to push through reasonable price increases, all while managing costs effectively and maintaining margin levels. Despite this, the market continues to undervalue the sector, with an across-the-board discount versus its historical average.

This is evidenced by the latest trading update released by The Foschini Group, in which they delivered solid sales growth of 23.7% for 4Q22 and 31.6% for the full year. TFG Africa posted another record quarter performance, up 16.1% for 4Q22 and 32.3% for FY22, thus indicating significant market share gains. Lastly, TFG Australia and TFG London recorded strong turnover performance.

Management guided HEPS for FY22 of between 955.4 and 1015.2 cents per share (with the mid-point at 985.3 cents per share), significantly ahead of consensus at 950 cents per share, providing an excellent example of how conservative market sentiment is.

Trading performance continues to be strong after the reporting period, with April sales up 17.1% in TFG Africa, which encourages us that valuations are too low.

Financials– priced for a deterioration in credit but evidence suggests otherwise

Financials have had a solid start to the year, with banks posting resilient results broadly in line with market expectations. The big four posted decent loan growth, stronger net interest income on the back of increasing interest rates, improving return on equity ratios, and credit loss ratios at the lower end of target ranges. Metrics remain resilient and are improving, yet the banks remain priced below their long-term averages on a P/BV level.

In their most recent trading update for the four months ended 30 April 2022, Nedbank confirmed that the operating environment remained broadly supportive for banks and their clients. Firmer economic activity, moderate credit growth, and slightly higher interest rates are the drivers behind this. They further noted that much of the momentum came from relatively robust consumer spending, underpinned by higher household incomes and enabled by limited Covid-19 related restrictions.

This is a positive statement and bodes well for the banks and the retail sector. Should this momentum continue into the year, we expect to see higher than expected earnings growth.

Naspers and prosus– too cheap, but more patience may be needed

Industrials remain dominated by the significant pullback in Naspers and Prosus. As discussed in our last note, we anticipate the second half of 2022 to bring some life back into Tencent’s earnings and hence NPN/PRX. The discount to underlying has grown too wide, around 45%, and is extreme in our opinion.

Valuations in the balance of the sector remain undemanding.

Commodities– awash with cash

Commodities have had a tricky start to the year, as recessionary concerns and lockdowns in China dampened investor expectations, and diversified conglomerates and PGM miners feeling the brunt of the uncertainty and resultant volatility. Despite this, balance sheets remain strong, and we expect higher dividend pay-outs to continue, supported by underlying commodity pricing. Most commodity names are providing double-digit yields.

Sasol staged its recovery with a stronger balance sheet and a more disciplined approach to capital expenditure. The higher oil price has supported it over the shorterterm, and despite this, long-term prospects remain positive.

Property – operations are recovering, valuations are not

Property continues to offer, on average, a 40% discount to underlying NAV, with dividends averaging around 9% across the sector. As results roll out, the sector shows a more robust environment than that being priced in by the market – as seen from the latest Redefine (RDF) and Octodec (OCT) results

RDF and OCT noted that although the operating environment remains challenging, they are seeing encouraging signs of recovery, which is evident in the operating performance.

Management teams have done a stellar job navigating the challenges and driving efficiencies. They have focused on debt reduction, resulting in lower loan-to-value metrics, and driven successful disposal programs. One such example is RDF, having realised property asset disposals of R5 billion, with a further R6.2 billion of property disposals at advanced negotiation stages. These disposals occurred at or above book value, reflecting the strong demand for these property assets.

Both companies reinstated interim dividends in the current year after not paying dividends in the prior interim period. This speaks to the companies’ improved liquidity and overall balance sheet quality. This is also a positive signal, indicating that management is confident with the recovery in the operating environment and the ability of the businesses to generate cash.

Despite the relatively improved conditions and stronger performance, property shares continue to trade at significant discounts to their NAVs. We continue to believe the property sector is mispriced and offers outsized returns.

SA Equities – continue to offer attractive return prospects

The negative market sentiment seen at the start of the year has continued. The market continues to price in far more negative conditions than those felt in reality. The result is undemanding valuations across several sectors despite strong earnings growth estimates. We have seen robust YTD results from several of our core holdings confirming this. As such, we will continue to position ourselves accordingly to benefit from any correction in the market.

TFG – Strong turnover performance drives earnings growth

The Foschini Group remains one of our top consumer retail picks. We believe expectations are too conservative, and the consumer is in a better shape than the market is giving them credit for. In our opinion, TFG is well placed to benefit from resilient retail growth, with negative sentiment resulting in too low valuations. Given the low expectations, we see the risk to the downside as limited.

In May, TFG released a trading statement noting that the company recorded solid performance across all operating territories. As seen below, group retail turnover grew 31.6% in 2022 from a soft base in the comparative period. Furthermore, group retail turnover performance remained strong throughout the 2022 financial year, with fourth-quarter turnover growing at 23.7%.

TFG Africa posted another record quarter turnover performance, indicating significant market share gains. TFG Australia recorded above-expected performance following the lifting of most of the lockdown restrictions in November 2021, with remaining border restrictions lifted in mid-March 2022. TFG London accelerated its improved performance trajectory in the 4Q22.

The operating environment remains resilient, with strong growth recorded in all operating territories post-year-end. Management noted that the trading performance in April continues to be robust, with TFG Africa sales up 17.1%.

Management guided that the HEPS for the full year (noted in the table below) to be between 955.4 to 1015.2 cents per share (midpoint of 985.3c per share), significantly ahead of market expectations at 950c per share, highlighting our point that market expectations are too conservative and need to be revised higher.

Overall, the result from TFG highlights a robust operating environment. However, in our opinion, this is not reflected in current market expectations, with earnings expectations too low and a Price:Earnings valuation below historical averages at 13x.

Closing Comments

There is much water still to flow under the bridge in 2022. Where will inflation level off? How high will the Fed raise rates? What impact will lower levels of liquidity have on price discovery? How high will oil prices go? When will the war end?

The answers to all these questions will directly impact risk appetite in the market and, consequently, share prices. While it can be difficult to stomach the volatility, particularly when foreign investments seem to have been one-way traffic for the last few years, the uncertainty brings with it fresh opportunities that must be weighed accordingly. While we don’t know the answer to all these questions just yet, we know that the market penalises heavily for uncertainty. If the penalty is too high (which, to us, it feels that it may be), this will unwind as the year unfolds and certainty returns