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Should you believe this smile?

How to make the best of the downgrades.

This article was first published in the latest May issue of the Moneyweb Investor.Click here to read the magazine in full, at no cost to your pocket.

There are two direct effects of SA’s credit rating being downgraded to junk: government’s substantial debt burden is going to cost a lot more, and various global portfolios will have to sell their South African bond holdings.

One wonders how these effects ripple out to industry, and what the impact will be on your investment portfolio in particular. But before we get there, a 101 on downgrades. 

Government, parastatal and even corporate debt raised on the bond markets is going to come at higher rates. It’s important to note here that it is new debt that will be more expensive; the existing debt is not affected. The current debt in issuance is already in the bank and the coupon payments don’t change. However, the existing holders of that debt have to sell it at a higher yield.

This year’s budgeted issuance is about R242 billion. If the average yield goes from 8.3% to 9% – that is the yield on the R186 – then the extra interest is roughly R1.6 billion, and it will rise by R1.6 billion each year. There are other indirect costs – for example, the weaker rand means dollar-denominated coupons are more expensive (about 10% of the total debt in issue is in dollars), while inflation is likely to rise, which means inflation-linked bonds become more expensive.

Government debt already stands at R2.2 trillion, or 50.1% of GDP, as stated by then finance minister Pravin Gordhan in this year’s budget speech. So, the government owes more than half of all the income the whole country generates per year. The interest bill on that debt is R169 billion, about 11% of total budgeted government expenditure.

In 2008, the debt:GDP ratio was less than 30%, indicating the extent of government’s increase in borrowing during that time. By firing Gordhan, President Jacob Zuma has opened the way for that ratio to continue its climb.

The secondary effects are no less serious: government’s increasing debt burden means it won’t be able to implement economic stimulatory measures (like the long-promised infrastructure programme) constraining economic growth. That, and the loss of private sector confidence, may well tip the economy into recession. 

That will compound the damage already done to the investment case made to global investors and put further downward pressure on the rand. The weaker rand pushes up the price of imported goods, accelerating inflation. Higher inflation, together with the higher yields government will pay for debt, is likely to result in interest rate increases, which means people have less money in their pockets to spend, curbing growth in consumer-facing companies and further crimping economic growth generally.

These consequences are all still to take effect, probably a few years down the line. The recent rand strength, as encouraging as it is, is a short-term consequence of various factors including SA’s bond yields that remain attractive to foreign investors. In the longer term though, SA’s economy is on a troublesome path.

Investment opportunities

It’s all a terrible, self-inflicted wound but there are always investment opportunities that make sense. Intellidex has assessed various sectors that are likely to be affected, particularly by a weakening rand, and identified companies that look best positioned for the economic conditions.

From a global macro perspective, what is happening in SA is no worse than in Turkey, Brazil and Russia, and might not even be as bad. Investors have to find their way through the noise to identify the opportunities.

The JSE has numerous companies that are dominated by offshore operations or which produce goods or services whose prices are set in international markets in hard currencies. These traditionally receive a lot of attention once investors start sniffing trouble in the local economy as they provide a good hedge against rand depreciation and low GDP growth in the local economy.

Industrials

That said, it’s not every company with foreign operations that can do the job. Investors should look for companies that have operated well through market cycles in the past – ones that can deliver growth irrespective of their rand hedge qualities. Examples include Richemont, British American Tobacco, Naspers, Aspen and Steinhoff. The table below shows the performance of these counters over the past five years, when the rand weakened from R7.93/dollar to R13.46/dollar. 

 

Company

Annualised share price growth

Current price:earnings ratio (PE)

British American Tobacco

18%

22.38

Naspers

41%

92.47

Richemont

18%

34.2

Steinhoff

20%

15.1

Aspen

19%

25.2

 

While these will probably be some of the best candidates for a rand hedge strategy, they appear expensive. All the counters except Steinhoff are trading way ahead of the All Share Index’s price:earnings (PE) ratio of 20. Largely because of this, we think investors may be better off hedging with some small- and mid-cap stocks. While there are not many small- and mid-caps with good rand hedge qualities, below is one that we think can do a good job.

Master Drilling

On a PE of 8.52, Master Drilling shares appear cheap. Despite the gruelling conditions endured by the mining industry where it derives most of the income, Master Drilling has never failed to grow earnings. It has grown dollar headline earnings at a compounded 17.1% a year or 40% a year in rand terms since 2012.

The group derives more than 72% of its income outside SA, which cushions it against any downturn in SA and positions it to benefit from any rand weakness. That, however, is not the only attraction. Over the past few years Master Drilling has invested heavily in research and development to find better ways to mine, lower costs, reduce project time and boost productivity. Some of the technologies are now coming to fruition and we see potential to monetise some of them, particularly reef boring technologies. With the mining industry under pressure and facing rising costs, innovations that boost productivity and lower costs will be in demand. Management says it is rolling out these technologies internationally and has received several inquiries.

In the meantime, we expect the improving commodity prices and a weaker rand outlook to be key earnings drivers. Should commodity prices continue improving we expect to see an uptick in exploration stage and capital stage mining activities, which will certainly be great news for this company. Master Drilling generates most of its income (about 90%) from production-stage mining activities. Exploration and capital stage activities, which used to contribute about a third of the group’s revenue prior to the commodities crisis, now contribute 10%. 

With the group utilising just 73% of its capacity, an uptick in mining activity will help Master Drilling increase its rigs utilisation capacity, which will be significant to the bottom line.

Industrial goods suppliers

Normally a weakening local currency is always bad news for importers. This is largely because they have to pay more not only for their imported products but also for their credit lines that are denominated in foreign currency,

That, however, is not necessarily so if the importers have the power to pass on the price increases to consumers, which is the case with most industrial goods suppliers on the JSE such as Barloworld, Hudaco, Invicta and Bell. While these are major importers of either finished products or equipment they use in manufacturing their own products, a weak rand is usually a welcome event. It’s the currency volatility and a possible squeeze on volumes, which comes with higher prices that has the potential to hurt their earnings.

Barloworld, Hudaco, Invicta and Bell represent leading international brands, most of which don’t have locally-manufactured rivals. They are able to pass on the higher prices to consumers (although this may be curbed by a poor economic climate, more on this below) while their operating costs remain stable. In such a scenario, sustained weakness in the rand creates the opportunity for higher operating margins for industrial goods suppliers. 

Hudaco for instance estimates that a 10% weakening in the rand against its basket of currencies – euros and dollars – without management intervention, results in an increase of about 14% in operating profit. Barloworld and Invicta have in the past reported significant bumps in sales as a direct result of a weaker rand.  

It is worth checking, however, for any negative on the balance sheet: loans and other trading credit lines. Most industrial goods suppliers use derivatives to hedge their balance sheet exposures. Hudaco utilises forward exchange contracts to meet future payment obligations. It hedges about 30% of orders to guard against spikes in exchange rates.

Invicta uses foreign currency forward contracts and interest rate swaps to hedge its risks associated with foreign currency fluctuations relating to certain commitments, expected transactions and interest rate fluctuations relating to bank loans.

Bell has a natural currency hedge. It has a substantial portion of its purchases and sales transactions in foreign currency. It utilises forward cover contracts in cases where projections of import and export cash flows show significant imbalances.

On the flip side

While a weakening rand may benefit these counters, it is not the only factor. Industrial goods suppliers can only benefit from a weaker rand if the exchange rate is not volatile. A volatile rand will always provide pricing challenges. We also think that the sluggish economic growth projections for SA may offset much of the gains these companies may enjoy from the rand weakness. Sustainable growth for most of these are pinned on SA’s broader economic performance, which even before the downgrade wasn’t looking that good. We believe it is going to be difficult for these companies to apply price increases without sacrificing volumes. 

Mining companies

Mining companies are certainly one of the best hiding places whenever one expects a slump in the domestic economy. Their prospects are influenced by the global economy, particularly the US and China.

The profit equation of mining companies is affected by two key factors: commodity prices and production costs. International prices for most major commodities have improved significantly over the past few months and most are expected to remain firm. The World Bank says it expects the crude oil price for the year to remain steady at $55/ barrel, a 29% jump from 2016. The bank also raised its metal price forecast to an increase of 11% from the 4% anticipated in its October outlook on further tightening of supply and strong demand from China and advanced economies. However, it also expects precious metals prices to decline by 7% as benchmark interest rates rise and safe-haven buying slows.

Kumba

Most mining counters are geared to benefit from the improved commodity prices and the weakening of the rand. But those that have worked to reduce their unit costs and don’t require major capital expenditure are likely to benefit the most. Kumba Iron Ore is one such mining company.

Following the sharp decline in iron ore prices in 2014, Kumba responded decisively to position itself to withstand a long period of low prices. It reconfigured its mines to reduce the amount of waste and save costs. The pit at Sishen, Kumba’s largest mine, was restructured to lower costs while production at its newer mine, Kolomela, was increased by ramping up low-cost tonnes and optimising the waste profile. Mining at its third and oldest mine, Thabazimbi, was halted. In addition, initiatives were implemented to reduce capital expenditure, overheads, study costs and head count.

The results of those initiatives are apparent: Sishen’s stripping ratio – the ratio of waste produced in relation to ore – has been reduced to about 3.5 times from about 5.7 times in FY15.  Cash costs and cash breakeven prices have also been cut to more competitive levels. In its latest interim results, the group reported an average cash breakeven price of $34/tonne, well below FY15’s $49/tonne. Such a low breakeven point cushions the group against any decline in iron ore prices while positioning it well should iron ore prices climb.

The review of Sishen’s mine plan and related mining model is complete, providing a platform for a more stable operating environment at the mine. Management is confident of delivering production of about 27Mt. At Kolomela, the group aims to produce about 13Mt in 2017. Efforts at Kolomela will be aided by further improvements in plant efficiency and throughput rates. If these targets are met the group should see total production stabilising at about 40Mt. This will be possible with minimal new capital expenditure.

With about 90% of that output destined for the export market, the impact of the exchange rate on the rand iron ore prices should never be underestimated. The graph below illustrates the impact the rand exchange rate had on the rand iron ore prices over the past 10 years. The area shaded in green shows what the rand price would have been if the exchange rate had remained at its level in January 2007. The area shaded in brown shows the contribution of the weakening rand since 2007. Roughly 45% of the rand iron ore price today is coming from the weaker rand.

 

Kumba’s balance sheet has also improved significantly: net debt:equity improved from 35% in FY15 to a net cash position.  We don’t expect the group to be putting a lot of money into capex, which will allow it to fully benefit from a weaker rand. With this improved balance sheet, we think investors should also start pricing in dividends as we expect the company to resume dividend payments soon. 

Banks

Two most common immediate effects of a sovereign credit downgrade are rising borrowing costs and a weakening local currency. Those usually have knock-on effects such as rising inflation and a weakening economy. For banks, that makes for a very bearish outlook.

Banks and, to a lesser extent, insurance firms and some industrial companies, raise funding on the bond market. As the country is downgraded, all corporate entities get downgraded automatically. The banking industry as a whole has about R182 billion of term debt instruments in issue, though this is a small proportion of the R4.5 trillion of liabilities in the banking system.

The problem is that the bond market sets the tone for the whole of the liability side of the balance sheet. Higher bond yields put pressure on interest rates across the board, as banks have to attract funding against the higher yields that investors can get in the bond market.

But the pain doesn’t end there. Banks also face challenges on the asset side of the balance sheet. Weaker economic growth means there is less demand for financing from the banks, both by consumers and companies. That makes it harder for banks to lend and puts pressure on the prices they can lend at. So banks are squeezed on both sides – higher cost of funds and lower returns on their assets.

Weaker economic conditions also make it harder for existing clients to pay their obligations, so non-performing loans inevitably increase, further eating into profits.

Not all banks are affected the same though. Banks do differ on the precise structure of their balance sheets. Banks that have fixed-cost funding will be relatively better off than those whose funding costs are variable. Banks have various ways of fixing costs – issuing bonds is one of them, but they can also hedge against rate rises by using derivatives such as swaps. Banks also get some of their funding for free, in the form of lazy balances in transactional accounts that earn no interest.

So, banks that have a high proportion of fixed costs or free funding are going to do better than those that rely on funding that is subject to change, such as corporate deposits and savings accounts. One also has to be alert to interest rate hedges the bank may hold.

 

Estimate of funding sources as a percentage of total assets based on most recent annual results

 

Equity (free funding)

Transaction account deposits (free funding)

Bond funding (fixed cost)

Variable rate funding

Derivatives

Absa

7.5%

16.6%

1.7%

66.6%

4.9%

FirstRand

9.1%

16.4%

13.3%

50.9%

3.9%

Standard Bank

9.2%

7.0%

1.3%

71.6%

3.8%

Nedbank

7.8%

8.0%

5.4%

72.7%

1.4%

Capitec

22.0%

41.1%

0.0%

34.7%

0.1%

Investec*

7.4%

0%

1.6%

70.8%

3.5%

 

The table shows that Capitec is well positioned in terms of higher levels of free funding while Nedbank, Standard, Absa and FirstRand have high levels of variable rate funding. Capitec’s assets are largely unsecured consumer loans, which earn rates based on the Reserve Bank’s repo rate. They also have shorter maturities than most other banks’ loans and can therefore be rolled over into lower risk loans if NPLs pick up.

So, relative to other banks, Capitec is better positioned from a funding point of view. Its vulnerability is a major recession leading to retrenchments. However, it hedges against retrenchment by bundling in retrenchment cover with its consumer loans, which is then underwritten. So again, from a risk perspective, Capitec looks defensive. Its share price was hit by the Gordhan saga, falling from R800 to R719 in a week, but is now back at R766, about 4% down. The bigger banks are down about 10% over the same period.

While banks are going to be at the forefront of the downgrade hardships, Capitec might be a good defensive play.

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