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Just how low can the rand go? Since it started weakening in mid-2011, it has fallen from R6.70 to the USD to R16.60, a depreciation of 146%. The decline only accelerated with the finance minister debacle in mid-December, just prior to which it was trading at R14.16.
This is not an entirely South African story, however. While the weak domestic policy environment has certainly constrained domestic economic activity, various global factors have contributed. These are chiefly the fall in commodity prices and strength in the US dollar as investors have rushed for the safe haven amid global uncertainty.
Rand Merchant Bank currency strategist John Cairns modelled the effects in a recent note to clients and estimates that domestic factors have contributed to 41% of the decline over that period. Clear negative factors in the domestic scenario have been persistent power shortages and the Marikana massacre.
The lesson is that while confidence in domestic policy is low, most of the rand’s value is determined by outside factors. So any rand outlook has to consider the prospects for global commodity prices and the strength of the US economy. Unfortunately, there is little reason for hope on either of those fronts. Oil prices have continued their dramatic decline, which has far outpaced that of the rand. From over $100 /barrel in June 2014 it had collapsed to just over $26/barrel at the beginning of January. There are many reasons for the weakness including growth in US production and weak international demand.
Oil price weakness is both an indicator of weak economic growth and a cause of it, depending on whether individual markets are producers or consumers. The result has been serious disruption to worldwide equity markets this January as investors have tried to recalibrate their expectations about corporate earnings. China led the carnage, with data suggesting that its industrial activity might be slowing faster than expected. That is compounded by growing concerns that its authorities might have lost their grip on economic policy. This has put pressure on global markets, particularly those such as SA whose growth model depends on Chinese demand for industrial and other commodities.
One consequence has been continued dollar strength as global investors steer clear of any risky assets in favour of the paltry returns offered by US bonds. The one bit of silver lining is that US economic activity is showing robust signs of recovery, heralding the first US interest rate hike in almost a decade in December of a quarter percentage point.
Economists polled by Financial Times expect another hike of 75 basis points this year and 100 basis points in 2017. That could discourage risk-averse investing behaviour and perhaps even drag up growth and commodity prices in the rest of the world.
The bottom line, however, is that international factors remain rand negative. Domestically, much depends on politics and signals of a willingness by the ANC to pursue rational economic strategies designed to support increased economic activity. Stability in power supply will also help, while the weak rand should be a boon to, particularly, industrial activity. However there is little indication of a major step change in prospects domestically either.
Given that, the best investment strategy appears to remain rand negative. Rand hedges obviously offer the best way to do that.
There are, though, some problems with that strategy. First is that most stocks offering protection against rand weakness are trading at demanding valuations. So you may think you are protecting yourself from rand weakness by buying certain stocks, but that is at the cost of taking on significant market risk. Second is that traditional rand hedge stocks are facing issues that cloud their performance picture. Rand weakness may therefore not be enough to compensate for those performance issues.
We would normally be enthusiastic about mining companies, but with the collapse in commodity prices and worsening economic conditions in China, this seems unwise. Apart from falling commodity prices, the sector is also facing sharply higher energy and other administered costs so margins are under pressure despite the weak rand.
Larger industrial counters with operations which generate the bulk of their earnings from abroad are the other obvious beneficiaries to the weak rand environment. These include the likes of Naspers, British American Tobacco, MTN, Richemont, Steinhoff and Aspen. While those may still present decent investment opportunities, everyone wants them. Valuations for some have shot through the roof. Furthermore, some of those, particularly Naspers, Richemont and Steinhoff, may be affected by the slowing Chinese economy.
So we went in search of hidden gems that do not normally come across the radar screens of the large institutional investors but are also strong beneficiaries of a weak rand. Here are our top four.
Astoria was incorporated in Mauritius in April 2015 and later listed on the Stock Exchange of Mauritius (SEM) and the JSE’s AltX. Its mandate, also its main attraction, is to invest in global equities, niche funds and global private equity opportunities.
The stock offers SA investors with the purest rand hedge. Its assets are denominated in dollars, making its performance inversely correlated with the value of the local currency. As the rand weakens against the dollar its holdings, expected to be mainly American stocks, will be getting a healthy boost. Other than the rand hedge attributes, Astoria shares also provides a tax-efficient alternative for gaining offshore diversification. Its envisaged fees structure without performance fees seems reasonable.
The major downside is that, having been incorporated last year, the company doesn’t have any track record. This means you have to believe in management’s ability to deliver in order to find its investment case attractive. Also, with its share price exhibiting strong correlation with the rand/dollar exchange rate, it is bound to take a hit if the exchange rate changes course.
Its share price has been flying, gaining 27% since its listing in November last year. Based on the net asset value (NAV) of $1/share reported at its listing, its current share price of R18.50 implies a 10% premium. Due to the extra burden of management and operating costs, investment holding companies normally trade at a discount to their NAV. However, considering that most of Astoria’s assets were in cash at listing, anticipated value creation from the allocation of its cash into higher return assets justifies the current valuations.
By investing in Rockcastle shares local investors are also able to hedge against the depreciating rand. The group has its primary listing on the SEM and secondary listing on the JSE. It is largely the same as Astoria except that it invests solely in global real estate securities.
The group’s current portfolio consists primarily of listed real estate securities in Canada, New Zealand, Australia, Singapore, France, the Netherlands, Hong Kong, the US and the UK. It receives regular distributions from its investment portfolio which it aggregates and pays over to investors as dividends on a semi-annual basis. Its portfolio of assets and distributions are denominated in dollars, allowing SA investors to benefit from any weakening of the rand.
The market currently values Rockcastle shares at a price: earnings (PE) multiple of 30. While this looks rich relative to the All Share Index which commands a PE of 18, it is less demanding when compared with its peers within the JSE Real Estate Development and Services Index, which is sporting an average PE of 46. The company’s shares also come with a decent yield of 3.09%.
Rockcastle’s share performance since listing in 2012 has been impressive, growing at an average of 50% per year.
This technology company expanded aggressively into global markets during the late 1990s and now generates more than 90% of its sales outside SA. It has dual listing on the JSE main board and the Alternative Investment Market of the London Stock Exchange. After collapsing in 2000 along with the other global tech stock crash, its share price has been on a steady recovery path. Its earnings performance has been decent. Increasingly, the fortunes of its share price appear tied to movements in the rand. While we don’t think Datatec will fly, we certainly believe its consistent performance and dollar-denominated earnings base makes it a solid candidate for a rand hedge,
Our last pick is Oceana. After its R4.6 billion acquisition last year of American fishmeal and fish oil company Daybook Fisheries, close to half of its annual earnings will be generated from markets outside SA. With that mix, the depreciation of the rand against other currencies will be a boost as its foreign earnings are increased substantially when exchanged into rands.
There are other reasons to support an investment in this company. Oceana boasts a defensive business with a management team that is good at capital allocation. Although vulnerable to exogenous vagaries, the fishing industry exhibits some defensive qualities. It is also a limited and highly regulated sector. Most governments impose maximum catch limits and issue a limited number of licences. Adding to that, operations are highly capital-intensive which create barriers to entry for smaller players. These restrictive elements bode well for Oceana.
The acquisition of Daybrook has entrenched the group as Africa’s biggest fishing company. It also diversifies Oceana’s fishing rights and licences, fish species, operational geography and currency exposure. This brings flexibility which was previously lacking. These factors, coupled with impressive market share numbers for its products, are great for shareholder value creation over time.
At a one-year forward PE multiple of 13 times, we think Oceana shares also deserves consideration. The major weakness with the stock is that it doesn’t offer a clean rand hedge. Its earnings are almost evenly split between rand and non-rand currencies. Furthermore, a substantial portion of the group’s cost base is denominated in dollars, which means the depreciation of the rand will have mixed effects on the group’s bottom line. Overall though, we expect the company to benefit from the weakening rand.