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Wood for the Trees | August 2021
15 August 2021
The last month of winter in the southern hemisphere proved to be a profitable month for risk assets as the All Country World Index pushed higher by more than 2%. There was a strong trend to most sectors barring commodities, which took a breather, particularly in the second half of the month. In addition to this, August was somewhat of a watershed month for Chinese government intervention.

Having played second fiddle to Donald Trump for all of his presidential term (at least from a social media perspective), President Xi Jinping boldly stepped into the void in August with the Chinese government flexing its muscles in a whole host of industries. The magazine cover that we are headlining this month summarises it beautifully. Do what you like, provided it is in line with the party narrative and supports our intentions of common prosperity for all (P.S. also, make sure you don’t make too much money while you’re at it). While our opening salvo here is slightly tongue in cheek, it has left the investment community with a very tricky conundrum. Has the Chinese market become uninvestable given the uncertainty around the future regulatory environment? At this stage, it is too soon to conclusively answer that question in our view. However, what we can see is that valuations on traditional metrics look increasingly attractive, and should the current regulatory overhaul prove to be less penal than currently priced, there is significant upside to be had. That being said, should one choose to dip one’s toes into stormy seas, it remains important to manage risk with appropriate position sizes (i.e. smaller than usual) when considering the commitment of fresh capital in this environment.

This month, we have a look at two companies currently impacted by this regulatory environment (being Naspers – through Tencent – and Alibaba), and then close off the local side of things by looking at the balance sheets of Truworths and SA’s big four banks to see what treasures they may have in store for us.

International section

By the Numbers

A +2% gain for the MSCI All Country World Index in August (which includes EM equities) continued the good momentum in global equities in 2021. A strong month for most world equities, barring those with a heavy commodity bias, which took a bit of pressure in August as COVID variant concerns dented expectations for future demand for oil. Against this backdrop, it is not surprising that the FTSE 100 struggled to post a positive return given the heavy contribution both Royal Dutch Shell and BP have in the index. US leadership back to the fore, with the S&P 500 leading world composite indices higher and the specialist Nasdaq-100 going one step better, up 4% in August. A lot of commentary dominated by the FED in August, as the minutes of their last meeting were released to the market, together with a verbal update from Powell. Perhaps most interesting was his deliberate intention to decouple the end of quantitative easing (large scale bond buying – which injects liquidity and puts a lid on market rates) from the start of lifting interest rates. We believe this to be an important signal to the market as the FED is likely to terminate the bond buying programme quite some time before intending to raise interest rates. That being the case, it will be important to manage the yield curve expectations of market participants to try to prevent aggressive front running of policy moves. Macy’s hitting it out the park in August, with their 2Q trading update 10% ahead of their 2019 pre-COVID quarter. This was a strong comparative which caught analysts by surprise and led to a raft of earnings and target price upgrades in the month, with Macy’s eventually settling 31.7% higher in August.

A quick look at the S&P 500

Despite a myriad of headlines highlighting the risks of central bank tapering, structural inflation, supply chain blockages, pandemic stimulus cheques ending, Delta resurgence etc., the S&P 500 keeps powering ahead. YTD, the S&P 500 is up 18.70% and remains just off all-time highs.

The general market continues to be driven by earnings growth, as forward price to earnings has lingered around 21x for much of the year. The recently completed 2Q earnings season demonstrated the extent of the conservatism embedded in the earnings estimates as 2Q earnings growth finished significantly above estimates as we ended the quarter (86% vs 56%).

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”.

The question that needs answering is how long these upside surprises to earnings can go on.

FactSet’s summary of Wall Street analysts’ aggregate S&P 500 earnings for 2021 (bottom line in the graph below) and 2022 (top line):

As you can see, the 2021 (bottom) line has flattened out in the last two weeks. As of September 3rd, analysts’ estimates bubbled up to $201.48/share for the S&P 500. As of Friday (the 10th), that aggregate estimate was essentially unchanged at $201.53 (up only 0.02%). On the plus side, 2022 estimates are still rising: last week, they were $219.47/share; this week, they are $219.83/share (+0.2 pct).

How concerned should we be about this flatlining of 2021 estimates? Over the next few weeks, we think it will certainly cause incremental US equity volatility because it only reinforces the slowdown narrative we’re seeing in the economic data. Once we get into earnings season in October, however, companies should still be able to beat estimates handily.

This FactSet chart below explains that longer-term optimism. S&P 500 earnings were $52.80/share in Q2 2021, but analysts’ expectations for Q3 and Q4 are lower ($49.23/share and $51.23/share, respectively). Even if the US economy doesn’t grow as quickly in the second half of 2021 as in the first, we find it very hard to believe that corporate earnings power is set to decline.

Peeling back the onion

Current regulatory headwinds are putting pressure on the stock prices of many Chinese tech giants by depressing valuations and causing a distraction from the evident scale, dominance, and cash-generative nature of these businesses. Despite this backdrop, we remain confident in the growth potential of both Tencent and Alibaba, which we currently own in portfolios. When considering valuations, it is important to assess the core-earnings power of firms like Tencent and Alibaba, which also have large investment portfolios. To achieve this, we stripped out these large investment portfolios and revealed the intrinsic valuation of the underlying operations. At this level, current value remains attractive.


Tencent has an extensive portfolio of internet-enabled businesses, including social media, music streaming, e-commerce, online games, cloud computing, fintech, and payment systems. Tencent is currently trading at HK$481.20, with their investment portfolio contributing a market value of HK$136.05/shr (29%).

Subtracting the market value of the investment portfolio brings down the share price to HK$345.15; this represents the value the market is currently attributing to its underlying business. At these levels, the market is valuing the core business at a multiple of 17.2x earnings for a revenue stream that is growing by north of 20%. Clearly, the regulatory headline risks are pressuring the multiple at present, but we expect this risk to pass, and the value embedded in Tencent’s underlying business will yet again shine through.

Using a back-of-the-envelope calculation, we assume a continued 15% revenue growth for the next five years and maintain a current 25% free cash flow margin. We then apply a 20x multiple to that FCF and discount it back to get a value of HK$424.18/shr for the underlying revenue. Layering the value of the investment portfolio on top brings you to a forward valuation of HK$626.18/shr, or a 30% upside from current levels.


Alibaba, “China’s Amazon”, is a dominant e-commerce marketplace retailer with a market share of approximately 60%. The company’s web portals also provide electronic payment services, shopping search engines, and cloud-computing services. Even with the hindrance of recent regulations, the degree to which this will harm their immense earnings power is reasonably low.

Alibaba is currently trading at US$162.29, with its investment portfolio contributing a market value of US$46.64 (28.7%).

Subtracting the market value of the investment portfolio brings down the share price to US$118.58. This shows that the market is valuing the core business at a multiple of 11.9x earnings for a revenue stream growing at approximately 20% (we accept, of course, that earnings may include some consolidation on investments – but this exercise aims to be illustrative rather than exact).

Using a similar forward valuation as Tencent, we assume a 20% revenue growth and 20% FCF margin. This equates to a present value of US$283.52/shr for its underlying business. Adding the value of the investment portfolio gets us to an estimated total value per share for Alibaba of US$330.16/shr, representing 100% upside from the current share price.

The point of this note is to demonstrate that these businesses have multiple dimensions, and market value is delivered on several fronts. It is important to realise what the underlying business is being valued at to make an educated decision on what is currently being discounted into the share price. In the case of Tencent and Alibaba, we believe a significant amount of risk is already priced in, and if this current headline risk proves transitory, valuations for both could be significantly higher.

Alibaba cloud

Heading for the Clouds
9 September 2021

Chinese firms have been rushing to embrace the goal of “common prosperity”, and despite the regulatory noise coming out of China, Alibaba continues to be a strong driving force in cloud computing and digital transformation.

We believe that Alibaba Cloud is currently underappreciated and worth substantially more than the market is currently discounting.

The cloud market in China is still in the early stages of development and is estimated to be five years behind the US. The Chinese cloud market remains in its infancy, with the current market size only one-tenth the size of that in the US, with Alibaba having approximately 40% of the market share in China.

Using Amazon’s cloud computing service (AWS) as a guide to calculate the potential value of Alibaba’s cloud computing segment, we estimate that Alibaba Cloud is worth about $50-$62 as a stand-alone entity, representing an incremental 30-36% upside into the current Alibaba share price.

In Alibaba’s most recent earnings report, cloud computing revenue grew 29% year-over-year. Whereas in the past five years, AWS has grown revenues by 35% annually. If we take a conservative growth rate of 20-25% over the next five years, Alibaba Cloud FY26 revenue would reach $22-$27 billion. Being in the early stages, the Chinese market should theoretically grow faster, so a growth rate of 30%+ is easily attainable, which would contribute $33 billion to revenue. If they can achieve a conservative 20% EBIT margin (AWS 28% EBIT margin), Alibaba Cloud could be worth approximately $170 billion on its own in FY26 using an EV/EBIT multiple of 26x.

This is approximately 20-40% of the current Alibaba market cap of $464 billion. These estimates are summarised in the table below:

If we look at the value on a per-share basis, Alibaba Cloud could contribute as much as $42.06-$87.86 to the current share price of $170.71 (upside of 20-50%). We believe the intrinsic value of Alibaba’s main e-commerce segment is worth much more than the current market value, essentially suggesting that you are getting a $170 billion cloud business for free!
We maintain our bullish outlook for the company – especially at its current price. As Warren Buffett puts it: “Buy at the sound of cannons and sell at the sound of violins.” Alibaba is having its fair share of cannons right now, and we are confident in our holding as it continues to drive prosperity in the digital era.

Local section

By the Numbers

The month of August proved fruitful for South African investors, with the FTSE/JSE Equally Weighted Top 40 Index delivering a return in excess of 3% for the month. Fortunes were made and lost in the detail though, with significant variance between the best and worst performing sectors. Fighting for the wooden spoon was the Resource sector, Platinum counters in particular, all of which underperformed the general mining sector. Heavyweights like Impala and Amplats posting double-digit declines as sentiment was impacted by global vehicle manufacturers aggressively cutting production on chip shortages during the month. Toyota in particular being the most vocal, confirming a 40% cut as a result. It’s not all doom and gloom mind you. Chip shortages don’t mean softening demand, which would be far more of a concern in the investment case were that to be the case. Another poor month for Naspers as well, down 12%, as investors navigated their way through the corporate action which concluded in August. It didn’t help that the Chinese regulator really stepped up its interventionist policies in the month, aggressively engaging with companies that they consider to be strategically important to the Chinese nation. Tencent never managed to escape the eye of the storm as young gamers had their wings clipped, impacting future revenue flows from this channel, marginally impairing the Tencent investment case. But a great month to be a bank in South Africa. Financials having a stellar August, up 15% in the month. Most of the large banks reported during the month, with numbers materially better than expected, particularly on the loan impairment side. Their credit books look much healthier than forecast at the start of the pandemic, and while growth is unlikely to set the house on fire, earnings look reasonably secure from here with a nice tailwind of provision releases pushing numbers green over the next few quarters.


Strong balance sheet an opportunity for earnings tailwinds

Truworths delivered a strong set of results for FY21 despite the challenges faced from a tough operating environment. While retail sales only inched up 0.5% to R17bn, this masked the mix between strong SA sales that were up 6%, and a tough UK environment where sales were down 17%. From an operating perspective, Truworths did an exceptional job, increasing gross margin to 51% and driving operating margins up 350bps to 18.5%. This excellent execution drove profits up 30% YoY. Management continues to drive world-class profitability, with ROE increasing to 32%.

Despite these good results, the share price reacted negatively to comments that sales for the first nine weeks of FY22 were down 5.3%, relative to Woolies which reported sales up 17.7% for the first seven weeks of FY22. Peeling back the impact on sales of looted stores and adjusting for the estimated impact of civil unrest, sales would have been up 2.2%. Management also cited their reluctance to discount aggressively for the muted sales number; they remain optimistic for FY22.

Our view remains bullish as the company continues to optimise and improve balance sheet quality.

  • Cash is king. The group ended the year in a net cash position of R577m. Truworths generated R3.7bn in free cash flow in a pandemic impacted year, equating to a 15% FCF yield. Truworths returned R1.8bn to shareholders in the form of dividends and share buybacks, and repaid R1.7bn in borrowings. We expect Truworths to continue to generate significant free cash flow going forward, and with no further debt to repay, Truworths will have the capacity to significantly ramp up shareholder returns.
  • Debt – a thing of the past. The group managed to reduce its debt to R500m from R2.1bn in FY20, essentially making it debt-free. As a result, finance cost savings could add up to 8cps (~1.4%) to earnings.
  • Compounding effect of share buybacks. The group bought back shares worth R768m during the year, representing ~4.3% of the issued shares. With the expected surplus cash for FY22, there is an opportunity for further buybacks, which will reduce shares outstanding and provide a further tailwind for EPS growth.
  • Credit book the key to sales growth. The credit book is key to unlocking sales growth in the coming financial year. Management noted that increased application volumes have resulted in a more diverse pool of applicants. Current levels of risk-approved applications and opened accounts are far below 2019 levels and 10-year historical levels. The normalising risk environment provides room for management to ease risk criteria, resulting in higher approvals and potentially increasing sales growth by an incremental low – mid single-digit.

Applications and Risk Approved vs Opened Percentage

Furthermore, the expected credit loss provision decreased to 23.4% (2020: 30.2%) of gross trade receivables. The unwind resulted in a significant increase in earnings in the current year. We expect this to return to more normalised levels of 20%, leading to further releases of the credit provision and a significant increase in earnings. Management was confident about the health of the credit book and its ability to grow it to further drive sales.

With Truworths currently trading at a single-digit price-to-earnings ratio, we continue to see this high-quality company – with multiple levers to provide returns to shareholders – and offering significant value.

Bank credit books

Loan loss releases and credit risk normalisation provide an earnings tailwind

We continue to believe current prices offer an attractive entry point into SA banks that have well-capitalised balance sheets, and which can potentially deliver mid-teen earnings growth even without a pick-up in loan growth. If we do get a pick-up in loan growth beyond the current 3% level, shareholder returns could then really be off to the races.

Given the forward-looking nature of expected credit loss provisioning in terms of IFRS, a combination of the deteriorated macroeconomic outlook due to covid pandemic and customer risk profiles built into credit impairment models, we saw a sharp increase in credit loss provisions in 2020. As the economic fallout from the 2020 lockdown did not materialise as initially guesstimated, there is now the potential for credit loss normalisation and loan loss provision releases.

We have performed an assessment to see what the impact might be of credit loss ratios and loan loss provisions returning to normalised levels over a 3-year period on incremental earnings growth moving forward.

The table below shows the impact of releasing these provisions and normalising CLRs to earnings going forward:

  • Excess provision was calculated based on current provision levels less 2019 provisions, which we consider representing a more normal level in the current environment. The assumption was that the entire excess provision would be released in one period and on an after-tax basis. The excess provision would result in an upside in earnings of 99% for FSR, 62% for ABG, 38% for SBK, and 43% for NED.
  • If CLR returns to normalised levels, that will result in a 60.4% pick-up in earnings for FSR, 53% for ABG, 30.4% for SBK, and 31.9% for NED.
  • The total incremental EPS impact based on provisions as a % of gross loans and credit loss ratio normalising over a 3-year period are as follows:
    • FSR will have incremental EPS of 212 cents: 84.9% growth from 2019 earnings. This equates to a 3-year CAGR of 22.73%
    • ABG will have incremental earnings of 1307 cents per share: 67.9% upside on 2019 earnings and an 18.85% 3-year CAGR.
    • SBK’s incremental earnings amount to 674 cents per share: 37.9% increase on 2019 earnings and an 11.31% 3-year CAGR.
    • NED will have incremental earnings of 1414 cents per share: 54.3% upside on earnings and a 15.55% 3-year CAGR.

We view our expectations as being conservative as we return to pre-pandemic levels over a 3-year period. As per our recent SA consumer report, we see the SA consumer in good health with solid income growth, increasing disposable income, better than average savings rates, and higher net wealth compared to pre-pandemic levels. All this places the consumer in a good position to service debt and qualify for loans.

The recent performance of the SA bank stocks suggests that investor expectations are very low. This is reflected in bank valuations which, up until August, were trading at levels of close to a 50% discount to historical valuations. Given the tailwind provided from an accounting perspective as the economic outcome from the pandemic was less dramatic than forecasted, EPS can grow comfortably in the mid-teens for the next three years without any assumptions for an increase in loan growth.

At current levels, the risk/return profiles for SA banks are skewed asymmetrically to the upside. We remain overweight SA banks.

Closing Comments

We hope you have enjoyed the update this month. In a low rate environment, risk assets continue to be the order of the day, but it is pleasing to see that even in the sometimes indiscriminate price action that we can see, there remain good quality companies at reasonable prices which continue to offer good homes for the allocation of capital in the long term.