Rootstock SCI Worldwide Flex comment - Sep 19
The Rootstock Fund delivered top-quartile performances for the three- and 12-month periods, with corresponding returns of 6.4% and 9.5%. Over the 12-month period, the Fund beat its CPI+5% benchmark, presently 9.1%, while the average peer group return was 2.2%. There have been a number of significant political, market and economic events during the last quarter, many of which are likely to have lingering effects on equity markets. We discuss a few of the more notable events below. The present global investment environment, marked by persistently low interest rates and fears of an impending economic slump, makes finding high-quality companies, particularly those trading at reasonable valuations, a progressively more challenging task. For reference, only two sectors in the MSCI World Index, viz. Energy and Financials, are currently valued below their ten-year average price-earnings multiples. Energy looks fully valued, despite low multiples, on account of a rapidlyshifting market structure, while banks have secular balance sheet difficulties brought on by a decade of unprecedented monetary policy. High equity valuations, measured on a historical basis, along with deteriorating global growth prospects, make for capricious markets. Due to the present market volatility, the Rootstock Fund has maintained its relatively conservative equity exposure, 78% at quarter end. Our cash position provides meaningful optionality should short-term negative news flow provide an opportunity to buy high-quality companies that meet our fair value criteria. Rising uncertainty makes liquidity valuable. Taking into consideration our guarded stance, we remain optimistic on the Fund’s prospects.
Global GDP growth forecasts continue to drift lower. The World Bank’s expectation for global real GDP expansion in 2019 has been revised down to 2.6%, from a 2.9% forecast in January. US-Sino trade tensions, Brexit and rising antagonism between Japan and South Korea threaten to upend the established global business environment, hurting investment. In the absence of progress in the USSino trade talks, the World Bank expects to slash its 2020 real global GDP growth forecast by a full percentage point to just 1.7%. Major central banks, led by the US Fed and ECB, have tried to counter trade headwinds with interest rate cuts. This monetary stimulus has yet to offer a discernable offset to the strangling policy uncertainty spreading across the world. A deceleration in global investment and the ensuing decline in business confidence may portend an economic contraction. Despite the gloom, China posted real GDP growth of 6.2% for the second quarter of 2019. This is however the lowest rate since 1990, but still healthy for a country that is transitioning from a production to consumption-driven economy. Indeed, many indicators of global macroeconomic expansion make for unpleasant reading. Purchasing Managers Indices (PMIs), a gauge of the direction of growth in the manufacturing sector, a bellwether for economic growth, have fallen, globally, below their neutral 50-point mark. The US PMI, long the exception, has joined other major economies’, including China, Germany, England, Japan and South Korea, in signaling contraction. The US PMI fell to 49.1 in August, the lowest level in three years.
A recent attack on Saudi Arabian oil facilities, allegedly orchestrated by Iranian-backed Yemeni rebels, took out roughly 5% of global oil supply. Fortunately, no oil shock is likely; the OPEC cartel has significantly diminished relevance in the global oil industrial complex, brought about largely by US onshore shale. While its broader economic impact may be limited, the attack does highlight the emergent theme of a fracturing global order. The US, now a net exporter of oil, is likely to limit its involvement in future Middle Eastern conflicts. The poor economic data have not yet noticeably filtered into equity markets. For reference, the MSCI World Index, a measure of global equity markets, has produced a US-dollar total return of 0.7% for the quarter and 2.4% for the 12-month period. Concerningly, consensus-earnings expectations have declined across the globe over the past year, with emerging -market earnings expectations marked down some 20%. Developed-market earnings expectations have been revised lower by a relatively modest 6%. While equity markets are not valuated at historic highs, they are on the more-expensive side, and with limited price action and falling earnings, are growing more expensive still.
On the local front, South Africa faces multiple, well-documented crises. Despite a fairly open economy, the country has seen little benefit from the robust global growth of the last decade. Asymmetrically, an extended global slowdown is likely to have a confounding impact on the already moribund economy. Poor policy decisions, the ill-conceived and fiscally profligate National Healthcare Insurance plan, merely the latest own goal, continue to starve the economy of much-needed risk appetite and, accordingly, investment. According to the Bureau of Economic Research, the Business Confidence Index, where 50 indicates a neutral outlook, stands at 28, the worst level since 1999. Not even during the height of the global financial crisis in 2009 have executives been as pessimistic. In a low-growth environment with government policies hostile towards business, developments with workable economic returns are scarce. One only needs to glance at the performance of corporate South Africa, proxied by the JSE All Share Capped Index, which limits the weight of dual-listed companies, that has returned, in rand, 0.4% for the last year, and a compounded annual rand return of 5.1% for the past five years. Barring wholesale structural reforms, including improved governance and rational, factbased policy making, we see little opportunity for meaningful investment return. Despite short-term headwinds abroad, growth prosepects remain more healthy than in South Africa. Consequently, the Fund will remain largely invested in global equity markets, which are likely to deliver longer-term performance in excess of the eroding South African equity universe.
The Fund’s equity exposure declined marginally from 80% to 78% at the end of June. Foreign equity exposure, measured as a percentage of our total equity holdings, remained unchanged at approximately 96% during the quarter. Naspers’ proposed unbundling and listing of a 26% stake in Prosus on the Euronext in Amsterdam was successfully implemented in September. We maintain our reservations on the merits of the scheme. Management claim that access to an enlarged foreigninvestor base and the inclusion of Prosus in international indices will serve to reduce the perennial discount to nett asset value (NAV) at which Naspers trades. Before and after the Amsterdam listing, Naspers’ discount to NAV was roughly 35% and at 30 September 2019, 42%, respectively. Prosus trades at a 25% discount to NAV at quarter end. So far, the transaction, which came at considerable cost, has yet to unlock any real value. While management’s attempts to reduce the discount are laudable, we advocate improved disclosure and the abolition of the Board’s super-voting rights as the easy path to value unlock. For now, we reserve judgement on the ultimate outcome, however, as the Prosus listing may lay the groundwork for further corporate action, with the ultimate break-up of the group a possibility.
In the short term, the separate listing of Naspers’ Classifieds division, OLX, is likely. With no meaningful difference in the underlying assets between Prosus and Naspers, the latter offers significant value. Over time, as the non-Tencent assets turn meaningfully profitable, we hope, the discount is likely to markedly unwind. We remain patient. In other corporate undertakings, after a failed attempt in July, AB InBev successfully listed its Asia-Pacific (APAC) operations in Hong Kong. The subsidiary, Budweiser Brewing APAC Limited, produces, imports and sells more than 50 brands of beer in the greater South East Asia region. While retaining control, AB InBev raised almost $6 billion from the sale of a 13% stake, implying a market value of some $44 billion for the fast-growing APAC business. Together with the July sale of its entire Australian business to Asahi, generating net proceeds of $11 billion, the $17 billion proceeds will be used to pay down some of the AB InBev parent company’s roughly $112 billion of debt. Despite AB InBev’s cash-generative nature, investors’ legitimate concerns over its large debt pile have weighed on sentiment. With net debt-to-EBITDA, a measure of debt serviceability, below the company’s 2020 target of four times, market sentiment may recover.
During the quarter we made several adjustments to the portfolio’s composition. Most notably, our long-term holding in British American Tobacco (BATS) was completely sold. Since our initial investment in 2009, the stock has yielded an annual compound total rand return of approximately 14%. While the business remains highly cash-generative and attractively valued, growth prospects are somewhat uncertain. Any meaningful forthcoming investment return is premised on a rising valuation multiple, presently 10.4 times. In our considered view, a progressively more stringent regulatory environment and rapidly-falling cigarette volumes are likely to keep its multiple depressed for significantly longer than our investment horizon. Globally, excise duties continue to rise, driving up cigarette prices to excessive levels in many jurisdictions. Governments, reliant on the significant revenue generated from cigarette tax seem to be ignorant to the growing defection to illicit products. At the margin, reduced smoking is a meaningful headwind to Big Tobacco’s earnings prospects, particularly when considering the rapidly-withering Baby Boomer smoker demographic. For reference, cigarette volumes in the lucrative US market are falling much faster than previously expected. In 2015, when BATS bought the remaining 58% of Reynolds American that it did not already own, it assumed US cigarette volumes would decline annually by about 2%. The actual experience has been in excess of a 5% annual decline. Most recently, volumes have fallen by close to 8% year-on-year. While tobacco companies maintain that these externally-calculated figures are overstated, the fact remains that the decline in cigarette volumes in their most profitable market is accelerating.
To offset the decline in traditional cigarettes, tobacco companies are investing heavily in so-called Next Generation Products (NGPs). NGPs account for only about 5% of the total nicotine-consumption market, but are growing at roughly 50% per annum. However, the space is proving difficult for Big Tobacco, with increased competition from outside entities. Notably Juul, the dominant e-cigarette brand in the US with some 66% market share, was founded in Silicon Valley only four years ago. The regulatory and distributive moat that BATS previously enjoyed looks to have been breached. Moreover, enormously negative recent press has dented NGP growth. Even accounting for smokers who transition to NGPs, the tobacco market continues to contract ever more rapidly. Another longerterm concern is the increased Environmental, Social and Governance (ESG) pressure placed on large global-investment mandates. In time, a large pool of capital is likely to eschew companies that have products deemed socially undesirable, BATS not excepted. Increased regulatory attention on Big Tobacco, epitomised in the NGP market, forms part of the growing ESG lobby. Thus, despite its optically attractive valuation, the steady attrition of its most profitable business may place BATS on the wrong side of history. Other notable portfolio changes include the complete disposal of our resource holdings, Anglo American Platinum and BHP. These stocks realised exceptional rand-based total returns of 102% and 17%, respectively, over the past 12 months. Both stocks, after a multi-year holding period, reached our estimate of their fair values during the quarter. Being highly cyclical businesses, particularly given the global growth backdrop, we deemed it prudent to take profit. We believe the capital will be better deployed elsewhere.
On the capital-deployment front, Microsoft is an exciting addition to the portfolio. It is a business in the midst of a fundamental transition with an extremely impressive management team. The successful transition to a Software-as-a-Service model for Microsoft’s Office, Dynamics and Xbox divisions portend a growing customer base, creating scope for tremendous top line growth. In addition, margin expansion, largely driven by the success of its Azure cloud platform, should see meaningful profit growth over the next few years. The company is a distinguished business-productivity application provider, whose relevance has not waned with time.
The global mood is decidedly gloomy. While contracting industrial activity, slowing economic growth, political uncertainty and possibly overextended equity market valuations are cause for concern, highquality businesses will continue to thrive, as they have done in times much more precarious than the present, over the long term. We maintain our steadfast focus on valuation and are incessantly probing our portfolio holdings for hidden risks. Our process has served us well in the past and provides us with a rational decision-making framework when dealing with emotionally-charged news flow. We believe high-quality businesses are invariably run by high-quality management teams, and that industries with favourable operating dynamics offer some comfort in this disorderly world. Falling interest rates should filter through into the global economy in the next few quarters, helping to offset the supply shock created by trade tensions. Investors may take some solace that rate cuts tend to support equity valuations in the short term. Global growth should recover over time, even in the absence of a resolution to the US-Sino trade dispute, as businesses adapt to the new regime, shifting production and reworking supply chains. We will stay true to our philosophy of investing in highquality, growing companies, and, importantly given the current ambiguous environment, not overpaying for assets. The Fund owns a portfolio of structurally-profitable businesses with exciting prospects, which should stand us in good stead. Please feel free to get in touch if you have any questions regarding the Rootstock Fund and its holdings. We maintain our open-door policy and are always available to assist. As ever, we strive to preserve and grow your, and our, capital as best we can. We thank you for your continued support.
The portfolio may invest in global and local securities, government, corporate and inflation linked bonds, debentures, non-equity securities, property shares, property related securities, preference shares, money market instruments and asset in liquid form.
The portfolio may also invest in participatory interests and other forms of participation in portfolios of collective investment schemes or other similar schemes operated in territories with a regulatory environment which is to the satisfaction of the manager and trustee of a sufficient standard to provide investor protection at least equivalent to that in South Africa and which is consistent with the portfolio's primary objective.
The manager may make active use of listed and unlisted financial instruments to reduce the risk that a general decline in the value of equity, property and bond markets may have on the value of the portfolio. The manager shall have the maximum flexibility to vary assets between the various markets, asset classes and countries to reflect the changing economic and market conditions.
Nothing in this supplemental deed shall preclude the manager from varying the ratios of securities or assets in liquid form in changing economic environment or market conditions, or to meet the requirements in terms of legislation and from retaining cash or placing cash on deposit in terms of the deed and this supplemental deed.
The Manager will be permitted to invest on behalf of the portfolio in offshore investments as legislation permits.