Additionally, while linked but not limited to the health of the Chinese economy, commodities prices have been feeling the brunt of slowing global growth. Despite the obvious demand side weakness there remains significant supply constraints that will support prices moving forward and making commodity stocks look attractive.

We offer some insights and takeaways after a busy month of third-quarter earnings reports across the US, UK and Europe.

Finally, we discuss why we shifted out of Truworths to take a position in Richemont. Without any delay, let’s get into it.

International Section

By the numbers

October giveth what September taketh away. We saw a significant rebound in October, with the S&P 500 up 7.3%, driven by Q3 earnings that came in better than expected and chatter about the US Fed slowing down rate hikes. The equity markets, in particular, are looking oversold, providing fertile grounds for a strong bounce. Significant moves came from the energy space and the travel and leisure sectors, with cruise line operators and energy service providers up more than 30% for the month. However, it was not all roses, with the technology sector selling off hard, driven by a confluence of issues, including a slowing consumer demand, declining ad spending, and rising expenses. Meta bore the brunt of the sell-off, falling 31.3% in October on the back of slowing revenue growth from its two leading franchises, Facebook and YouTube. META continues to see expenses blow out with its investment into the metaverse. In China, there was much disappointment: during the Communist Party’s National Conference, President Xi failed to mention any economic stimulus plans to support its flailing economy, sending Chinese listed shares in Hong Kong down significantly, with the biggest moves seen among the tech bellwethers. In the UK, we saw Liz Truss step down as Prime Minister, locking in the shortest term in office (44 days). UK assets took comfort in the steadier, more prudent hands of her replacement, Rishi Sunak. UK government bonds strengthened, the pound recovered somewhat against the dollar, and economically sensitive sectors outperformed.

Where is fair value?

In June, we wrote a piece looking at what outlook was being priced in by the market. The conclusion was that the S&P 500 was trading at fair value (with a forward PE of 18.5x) if earnings remained flat YoY for the next 12 months. However, some downside risk did exist if S&P 500 earnings declined closer to the typical 20% we see in a recession.

Since June, the S&P 500 has fallen 8%, and the Fed has raised rates by 300bps to a range of 3.75-4.00%. A further tightening of 50 to 75 bps is expected into year-end. We are now in the middle of the third-quarter earnings reports which give us a good chance to observe how the interest hiking cycle is impacting company operations.

Half of the S&P 500 companies have already reported earnings, with seven out of ten surprising on the upside, with an average Q3 earnings growth of 2.2%. This represents a slowdown from previous quarters, but is hardly a recession-like 20% decline. Scratching below the surface reveals an insight into underlying details. A significant driver of earnings growth this quarter has come from the energy sector, which has seen earnings growth surge 134.1%. If we exclude energy companies from the earnings growth calculation, the remaining S&P 500 companies saw earnings decline 5.1% YoY, indicating that inflation and rising interest rates are pinching. Going forward, analysts expect the ex-energy earnings decline rate to decrease, with growth returning in the first and second quarters of 2023.

Looking forward to 2023 year-end earnings, while expectations have come down from the June expectations of $250/share to the current $235/share, 2023 earnings are still showing growth versus 2022 – hardly the stuff recessions are made of.

If 2023 EPS expectations turn out to be accurate, the S&P 500 is trading on a forward PE of ~16x earnings. This shows significant value given that the 5-year average PE is 18.5x earnings.

Here is where it gets fun. Assume Wall Street analysts are too optimistic and are not extrapolating the current slowdown we currently see in Q3 earnings.

Historically, a normal recession causes earnings to fall 20% from the peak. We also know that the S&P 500 typically bottoms out at 18-18.5x earnings.

Let’s do the math. Assuming Q2 EPS of $56.87 represents peak earnings, annualising this number gets you to $227/share- still 3.5% below the current 2023 estimate. Assuming a recessionary decline of 20% from peak earnings, this gets you to $182/share [$227 *(1-20%)]. Putting $182 on a multiple of 18.5x gets you to a fair value of 3,367 for the S&P 500, which is 10.5% below current levels, although not far from the level touched by the S&P 500 in mid-October.

Re-engineering the equation, if we divide the current S&P 500 value by 18.5, we get to an implied 2023 EPS of $207/share, representing a 10% decline from peak earnings. Thus, it is fair to suggest that the market is currently pricing in a 50% probability of a typical recession, which seems fair.

Ultimately, much of the recession risk is already priced into equity markets. And while markets will no doubt continue to experience bouts of volatility, we anticipate that once rising interest rates take effect and we enter “the beginning of the end” in the rate hike cycle, equity market participants will look forward to eventual economic recovery. Whether anyone can time the market perfectly is questionable, but we believe the upside potential looks very attractive from a current market valuation point of view.

Chinese conundrum

In addition, there were no changes to the Zero-Covid policy. In response, Chinese equities fell, with tech names feeling the brunt of the sell-off. Big tech companies are a barometer for what’s happening in China, so whenever there’s news, whether good or bad, you see the reaction in their share price – leading to volatility in the market.

Investor pessimism in China is high. The continued weakness in property values, the Zero-Covid policy, and the recent crackdown on big tech has left scars on consumer sentiment.

The property market plays a significant role in the overall Chinese economy, as a large portion of Chinese net wealth is attached to the sector. With consumer sentiment directly linked to property prices, the state of Chinese property impacts consumer sentiment and, therefore, consumer spending. Unfortunately, we have yet to see any positive intervention that has succeeded in supporting the property market. Despite monetary policy easing and loans becoming more accommodative, the demand is not there; consequently, retail sales are still underwater.

More recently, there has been a bounce in Chinese share prices following positive news that China may ease its Zero-Covid policy. With negative global investor sentiment toward Chinese equities and rock-bottom valuations, any positive news quickly translates into large share price movements.

Adding fuel to the fire, several US analysts labelled Chinese tech as “uninvestable” and downgraded several companies. These downgrades were later reversed, citing positive regulatory announcements that should abate the significant uncertainties.

Tech valuation: dirt cheap

Revisiting an article from a previous Wood for the Trees, Peeling Back the Onion, we look at both Alibaba and Tencent’s intrinsic value of their underlying operations. Stripping out their large investment portfolios, the core business remains. At this level, the current value remains attractive. It is imperative to pay attention to valuations and not get entangled in the noise.

Starting with Alibaba. It is currently trading at US$65.21, with its investment portfolio contributing a market value of US$25.01 (38.4%). Excluding the investment portfolio’s value, the underlying business value comes to US$40.20 and represents the value the market is currently attributing to its underlying business. At these levels, the market values the core business at a multiple of 5.57x earnings.

(Values as of November 4, 2022)

Looking at Tencent, we see a similar story. Tencent is currently trading at HK$238.60, with its investment portfolio contributing a market value of HK$87.23 (36.6%). Excluding the investment portfolio’s value, the share price comes to HK$151.36. At these levels, the market values the core business at a multiple of 11.98x earnings.

(Values as of November 4, 2022)

These two world-class companies are trading at extremely low multiples. With investors so eager to buy the sell-off, as soon as China announces a gradual reopening, the tide will turn, and the payoff is potentially enormous.

To navigate the seas ahead, we want to own companies that benefit from growth initiatives in the focal areas that anchor ‘China’s core priorities.

One of the core priorities is being self-sufficient and developing high-quality technology. China’s Ministry of Industry and Information Technology recently released its first action plan for the digital economy under the country’s five-year plan. The report references Tencent and cites it as a company that is rapidly pursuing virtual reality opportunities.

The other core priority is shared prosperity. China’s current slowdown is a consequence of the deep distortions in the country’s income distribution. The politburo aims to rebalance the economy and wealth accumulation. It wants to expand the middle class, and consequently, Alibaba will stand to benefit as a company exposed to middle-class growth and spending, as well as the pickup in sales from pent-up demand.

While the road to recovery is still hampered by broader macro issues, we remain confident in the growth potential of both Alibaba and Tencent. Undoubtedly, investing in China comes with risk, and in the case of Alibaba and Tencent, we believe a significant amount of risk has already been priced in. When the tide starts to turn, the valuations for both these companies could move significantly higher.

Earnings, earnings, and even more earnings

It has been a busy couple of weeks as companies report earnings for the turbulent third quarter. No company has been immune from the market headwinds of a stronger dollar, higher interest rates, supply chain disruptions, or slowing consumer spending in the face of inflation. However, some have fared better than others.

Financials

Banks are major beneficiaries in a rising interest rate environment as they earn more interest on the cash held by their clients. On the other hand, other market-sensitive businesses like investment banks are going to weaken due to a decline in capital market activity. Additionally, they provide colour on the health of the consumer. Are people spending or saving? How are deposit balances and credit card loans behaving? Are consumers paying late or defaulting? Investment banks, on the other hand, tend to underperform on the back of a decline in capital market activity.

In response to the questions above, JP Morgan’s CFO stated: “The short answer to that question is just no. We just don’t see anything that you could realistically describe as a crack in any of our actual credit performance.” Executives at the other banks echoed this message. Bank of America’s CEO reiterated that “consumers continue to spend at strong levels” with average deposit levels that “remain at multiples of the pre-pandemic levels.”

As expected, higher interest rates have slowed saving/deposit growth, but credit card loans, card volumes, and commercial loan growth all look better than feared. Provisions for loan losses and delinquencies are rising as loan balances increase but are still at or below pre-pandemic levels. Even though there are many uncertainties in the market from the big banks’ perspective, consumers continue to spend with solid balance sheets, job openings are plentiful, and businesses remain healthy.

Tech

Shifting attention to the bellwether companies that underpin the global economy: Meta (formerly Facebook), Alphabet (parent company of Google), Microsoft, and Apple.

Meta’s share price took a knock after reporting earnings where it topped revenue estimates but missed on profits and reduced its revenue guidance. However, investors took a dim view of Meta’s soaring expenses ($96-$101 billion) for its investment in the metaverse, especially in a weakening economic environment.

Concerns have also surfaced in the advertising space, partly due to privacy changes and the potential cut in ad-spend revenue as companies look to limit spending given the weakening economic backdrop. Both Meta and Alphabet rely on ad-spend for revenue growth, and this was notable in ‘Alphabet’s slowing sales growth. In contrast, enterprise IT spend seems to be holding up better than expected, with Microsoft gaining market share. Microsoft remains the clear enterprise platform leader and, yet again, produced solid quarterly results driven by strong underlying performance and execution.

While the growth of Microsoft’s divisions continues to impress, macro headwinds led to softer PC demand. Weakness in demand for consumer electronics continues to be a focal point this earnings season as we face inflation fears and lap a tough comparable from a year ago when sales surged as the pandemic forced companies toward a work-from-home environment. But Apple didn’t fall victim to this. It is clear from the recent numbers that demand for Apple products remains strong. Apple reported impressive earnings last week, with record revenues of more than $90 billion, and continues to show why the company is in a league of its own. It appears to be more macro-resilient compared to its tech peers despite the uncertainties and increasing currency headwinds.

For both Microsoft and Apple, even though they issued weaker-than-expected guidance, we believe they can innovate through recession fears and come out the other side financially stronger. As macro trends start affecting consumer spending, you can see the relative outperformance in some of these big names, especially among the companies with strong cash reserves and who aren’t trading at nose-bleed levels.

Retail and entertainment

For Visa, the continuation of spending trends and the post-pandemic travel boom is still in full swing. It continues to be a double-digit sales and earnings compounder with impressive free cash flow. The company increased its quarterly dividend and announced a new $12 billion share buyback program; American Express mirrored these strong results. Regarding the consumer’s health, the CEO noted on the call that they are “not seeing any changes in consumer spending behaviour at all.” When asked what the upcoming holiday season looks like, “from a travel perspective, it looks really, really strong because people are booking three months out…we don’t see anything really changing over the next three months.”

Consumer goods

Unilever and Nestle provided insight into the consumer’s health, pushing pricing with a marginal drop in volumes. In this most recent quarter, Unilever raised pricing by 12.5% while volumes declined only 1.6%. Notably, these companies benefit from the strong dollar; they are seeing an all-time low consumer sentiment out of Europe and continue to experience muted sales in China.

The third quarter gave us insight into consumer strength, the effect of a stronger dollar, and the free cash flow position of businesses. Headwinds such as diverging demand dynamics, inflation, and evaporating liquidity have set some companies back by a significant degree but have also revealed the companies with strong underlying performance. We remain cautious given the market volatility but will position ourselves accordingly to take advantage of opportunities as they present themselves.

Local Section

By the numbers

Local markets were up almost 5% this month despite Naspers and Prosus falling 16%. Both names retreated in conjunction with weakness in the underlying share price of Tencent, which fell foul to the increasingly negative sentiment toward China’s ability to stimulate its economy. Despite Naspers and Prosus detracting from what could have been an even better month, we saw financials up 12.7% and SA property up 9.5%. Both are sectors that we have been vocal about where low valuations are not reflecting the solid operating fundamentals, so it’s good to see other investors beginning to take note. Standard Bank and ABSA were up 19.20% and 13%, respectively, in October. We also saw the rand hedge names on the list of top performers: British American Tobacco, Anheuser, Aspen, and Impala, all topping 10% for the month.

Commodities: looking through demand softness

The commodities complex is a complicated network of interrelated factors that, when taken together, influence the price. Worsening global growth prospects, including recession fears and the slow pace of a recovery in China, are currently suppressing commodity demand. While on the supply side of the equation, supply disruptions triggered by the Russia-Ukraine conflict, ongoing La Nina weather patterns, and muted investments into new supply have contributed to a volatile commodities market where prices have whipsawed over the last 12 months.

We believe that these supply shocks have yet to be appropriately appreciated by the market, which is currently myopically focused on demand weakness. When global economic activity picks up, we expect demand weakness to ease at a faster pace than at which supply challenges will be resolved. This will drive commodity prices higher and be supportive of valuations as a result.

PGM market balanced for now

In the PGM market, post-Covid supply bottlenecks have curtailed the recovery of global vehicle production, weighing on vehicle supply and PGM demand. Subsequently, slowing economic growth has led to the vehicle production outlook for 2022 and beyond being revised downwards.

On the supply side, South African platinum miners, which account for 70% of global supply, reported weak production figures on the back of intensified load shedding, production delays from plant maintenance, and planned closures. Although Russian supply has been sanctioned, we have yet to see an actual impact on the supply in the market, hence risks to global PGM supply remain.

Coal has been a major beneficiary of the energy crisis

Coal has been a clear winner in the European energy crisis. The onset of the war and the subsequent gas supply concerns led to a scramble to secure enough supply for the upcoming winter season. As a result, gas prices soared, and the demand for a substitute saw coal prices move higher.

However, the closure of coal plants due to clean energy policies in developed markets has resulted in the coal supply coming in short of the strong demand. In addition, other major coal-producing countries have been facing challenges, putting additional pressure on supply. The La Nina season continued to rain out production in Australia, while the Transnet strike in South Africa temporarily shut down ports and coal movement. Additionally, the Indonesian government pressurised local producers to limit coal exports in an attempt to secure domestic supply.

Oil production remains constrained

Although the crude oil price has retracted from the peak levels seen earlier this year, it remains relatively high. This is despite the weak global economic growth causing demand weakness and the increased supply from the US release of strategic reserves.

Going forward, we expect the pickup in economic activity driven by a recovery in China and the stabilisation of global economies to lead to an increase in demand. The lack of reserve releases and insufficient investment in new production will constrain supply, thus supporting higher prices.

Base metal demand dependent on China recovery

Given the slowdown in global construction, base metal prices remain weak. As China is a key player, an improvement in their economic growth is essential for a price recovery. The Chinese government is anticipated to provide stimulus in the form of infrastructure projects to jumpstart the economy. Should this come to fruition, we expect to see improved demand for base metals.

Valuations not reflecting reality

Despite the supply-demand challenges noted above, commodity-related stocks, excluding coal miners, have underperformed their commodity basket prices across the board. This overreaction means that commodity names are attractively priced at current levels, providing a degree of downside protection.

Current valuations based on consensus expectations remain attractive, with most commodity stocks trading at significant discounts to their 5-year average valuations.

Commodity names remain very cash-generative, with most offering healthy dividends. With dividend yields above 10%, the total-return prospects for commodity names over the next 12 months look very enticing.

A challenging environment provides opportunity

Sentiment towards the commodity names remains tied to a global economic recovery, with any stimulus policy from China seen as a significant catalyst for the sector. Yet, at current pricing, valuations are attractive and dividend yields are high. We believe that demand weakness will be remedied before supply constraints are resolved, which will support basket pricing in the future. Given that share prices have underperformed the corresponding basket pricing, we feel it provides a degree of protection from significant downside risk into the coming months. We remain buyers and holders of commodities on appropriate portfolios.

You can’t change the direction of the wind, but you can adjust your sails

We have historically held an overweight position in the retail space. The Covid recovery play and the previously ignored consumer strength are some of the driving factors behind this. However, there are concerns that SA apparel retailers may have reached peak earnings.

The SA consumer has consistently surprised the market. Month after month, we continue to see evidence supporting the notion that the SA consumer is faring well despite rising inflation and interest rates.

Results season for the SA retailers reaffirmed this, with knock-out results from all the major retailers. We have covered this in detail, but the highlights are that retailers posted total sales growth for the first half of 2022 at an average of 10%, or 7% like-for-like on the apparel side, while food retailers saw 8%. Price inflation was managed appropriately, with apparel increasing pricing by 4.4%, on average, and food coming in short of CPI (8% at the time). Credit books remain healthy, and the strong performance is expected to continue into the year’s second half.

*Like-for-like excluding store movements

The consumer is strong, but caution is necessary

The strong results pushed the sector higher, with many analysts adjusting earnings expectations upward for the coming year. Fast-forward a few months, and while earnings expectations remain intact, sentiment towards the future strength of the SA consumer is starting to slip. We have yet to see any significant cracks, but as inflation climbs and higher interest rates bite, we are concerned that the average South African will start buying less and focus more on purchasing the necessities.

Given that consensus is pricing in double-digit earnings growth for FY23 and FY24, we are concerned that even a slight underperformance relative to expectations may result in significant pricing pressure amongst apparel retailers. While the current metrics remain strong and we maintain a degree of exposure, we have reduced our overall exposure to apparel retailers by selling out of our Truwoths position.

Why Truworths?

When compared to the other apparel names, Truworths relies on organic growth as opposed to growth via acquisitions. In addition, it has a large credit book. This may have been a catalyst for growth when credit taps were opened in the wake of the pandemic, but it leaves them overly exposed to potential consumer weakness in a rising interest rate environment. Further, Truworths has considerable exposure to the UK (15%) which is concerning given that the UK economy is under significant strain and is forecast to sink into recession.

If the UK starts to weaken and that 15% of its operations underperform, the SA operations will need to pick up the slack. Subsequently, should the SA consumer start waning, Truworths will find itself in a tricky spot relative to its peers.

For this reason, we have sold out our Truworths position, reducing our exposure to apparel. Inclusive of dividends, we have exited the position essentially flat and, given the potential headwinds, feel caution is appropriate.

Richemont: a quality safe haven

While it is anticipated that the SA consumer will start feeling the pinch, the global luxury sector via Richemont offers a safe haven that is somewhat detached from the general economic weakness.

Covid put a significant strain on earnings due to a lack of international travel and worldwide lockdowns. Its Asian operations, in particular, were one of the biggest detractors of performance. As consumer demand returned, so did earnings. Richemont staged a stellar recovery into 2021 but saw a substantial pullback going into the start of 2022, as the Chinese Zero-Covid policy and concerns around global economic growth pulled the handbrake on the market’s expectations for the company’s performance.

Current valuation looks attractive

The market has taken a more cautious view of Richemont, choosing to attach a much lower PE ratio than where it had previously priced. Consensus has EPS for FY23 of R11.00/share, giving Richemont a forward PE of 16.8x – 24% below its historical average PE of 22x.

Using its historical average of 22x against last night’s closing price (1 Nov 2022) of R184.38 implies the market is pricing in earnings of R7.00/share, not the consensus of R11.00. This is almost 40% below consensus expectations, which suggests that a lot of pessimism, including concerns surrounding a slowdown in China, is already priced in.

Given the current global climate where economic growth concerns are front of mind, a PE valuation lower than historical levels is not unsurprising. However, a discount of this magnitude does appear extreme. Taking a position at this undemanding level provides a level of protection against a significant downside.

Luxury doesn’t come cheap

The lower price elasticity of demand for luxury goods companies increases their ability to push through price inflation onto consumers. Price increases published in the luxury sphere for the third quarter of this year have shown these companies aggressively pushing through higher prices.

Gross margins on luxury goods are high, and as a result, the inflationary impact on the cost of goods sold tends to have little impact on the overall result. In addition, Richemont’s clientele is less impacted by the economic climate, so demand tends to remain consistent even when the average consumer starts feeling constrained.

Portfolio changes

Richemont flags as attractive given its current undemanding PE, its ability to push through price increases in a high inflationary environment, and its resilient customer base. Earnings expectations for 1H23 are for a low double-digit increase in organic growth and sales, with a similar performance expected from its largest revenue contributors, the jewellery maisons. The potential relaxation of Covid restrictions in China will support the stock in the coming months.

Given the current global economic uncertainty and market volatility, we are taking a more cautious approach over the coming months, hence our reduction in SA apparel exposure through the sale of Truworths. We have taken a position in Richemont with the proceeds, which provides us with a more defensive position at an attractive valuation discount.

Closing comments

Thanks for reading through this monthly update. It’s not easy out there at the moment, and it is in times like these that everyone’s resolve is tested. Staying the course and understanding what has already been priced in is probably the most important information we can leave you with this month. If history is anything to go by, then the best medicine for short-term market volatility is an appropriately adjusted long-term view and ensuring one owns shares in quality companies – which we have already taken care of for you. If you would like to discuss anything regarding your portfolio composition, please do not hesitate to reach out to your respective portfolio manager.