Ross is a Portfolio Manager at Prudential Investment Managers. He has fifteen years’ experience in investment management, and joined Prudential in 2001 as an Industrial and Resources Sector Analyst. He is co-Portfolio Manager of the Prudential Dividend Maximiser Fund, which has won several Raging Bull and Morningstar Awards under his management.
Rehana is a Portfolio Manager at Prudential Investment Managers. She has 9 years’ experience in investment management, and joined Prudential in 2008 as an Industrial and Resources sector Analyst. She is co-Portfolio Manager of the Prudential Equity Fund is also responsible for equity research on the Retail sector, mining stocks and certain financial shares.
Prudential Dividend Maximiser comment - Mar 19
After the sharp losses suffered at the end of 2018, investors were able to take heart in the first quarter (Q1) of 2019 with markets rebounding as a few negative factors appeared to reverse themselves. Although evidence of slowing global growth continued to mount, global equities and bonds rallied strongly after the US Federal Reserve announced a substantial change of view and decided to pause (and perhaps even end) its interest rate hiking cycle. At the same time, other developed market central banks undertook more growth-supportive moves, and considerable progress was reportedly made in resolving the US-China trade dispute. On the negative side, an even more chaotic Brexit environment and the uncertainty engendered by Trump's unpredictability remained bearish factors for markets. Emerging markets also benefitted from the more bullish sentiment and the Fed's rate pause, but some like Turkey and Venezuela faced idiosyncratic challenges. However, for South African investors, local equities and bonds posted respectable gains in rand terms thanks to several positive developments.
In the US, it was the Fed's more dovish rate stance that proved to be the key for turning last year's losses into this quarter's gains. The Bank emphasized that it would be 'patient' when it came to further raising interest rates, given that the case for hiking had weakened in the face of slowing global and US growth. This eased fears that inexorably higher rates could choke off growth. US GDP growth for Q4 2018 was revised down to 2.2% (q/q annualised) from 2.6% previously, sharply lower than the 3.4% in Q3 2018. Dismal US retail sales data were a key highlight. Not only did the Fed opt to keep rates on hold at its January and March FOMC meetings, but on 20 March its 'dot plot' showed it had slashed its own interest rate expectations from two 25bp rate hikes in 2019 to zero, and only one 25bp hike in 2020. Adding to the general positive news was the end of the 35-day US government shutdown in January, and that good progress was reportedly being made in the US-China trade negotiations to avert higher tariffs and a full-blown trade war. This was particularly beneficial for the global growth outlook, especially for trade-dependent countries like China, Japan and South Korea, and helped push the US dollar stronger for the quarter against most other currencies (although not the yen).
In the UK, agreement was reached with the EU to extend the Brexit deadline into April, and PM Theresa May effectively lost control over determining a way forward, forced to hand over to Parliament. However, MPs rejected every possible option for structuring the future relationship, worsening the chaos within government. Meanwhile, UK GDP growth slowed to 1.4% (q/q annualised) in Q4 2018 from 1.6% previously, with the EU area equally pedestrian at 1.4% for the quarter. This deteriorating growth was a factor in keeping interest rates on hold across both regions, as well as in the US Fed's interest rate view. The European Central Bank even introduced a new cheap long-term loan plan for banks to help avoid further deceleration, as Germany's manufacturing data was negative for three months in a row.
During the quarter it was revealed that the Japanese economy returned to growth in Q4 2018 after a contraction in Q3, although exports remained sluggish amid trade uncertainty and the slowdown in Chinese growth. Japanese GDP is forecast to reach around 1.0% in 2019, supported by the Bank of Japan's ongoing easy monetary policy, but expected to be hit by a new consumption tax on spending and consumer prices to take effect later in 2019. In China, meanwhile, 2018 GDP growth came in at 6.6%, its weakest in 28 years but meeting consensus expectations. The government's new 2019 growth target is even lower at 6.0%-6.5%. There was, however, renewed optimism amid the positive US-China trade news; government pro-growth measures, including easier bank credit, took effect; and manufacturing activity accelerated - China's PMI recorded its highest rise since 2012.
South African assets were boosted over the quarter primarily by the easier global monetary outlook, recording gains across all asset classes. This mixed with some still-gloomy sentiment locally. The economy emerged with growth of 0.8% in 2018, slightly above expectations. Still, this was a very weak absolute growth level, and the SARB is now projecting only 1.3% GDP growth for 2019 (down from 1.7% previously), not including the negative impact of any ongoing electricity cuts. In some growth-positive news, retail sales growth recovered somewhat to 1.2% y/y in January from the shocking -1.6% y/y in December.
The SARB decided to keep interest rates on hold at both its January and March MPC meetings, with the latest interest rate projection model showing only one 25bp rate hike this year. Finance Minister Tito Mboweni's February Budget was greeted favourably by most analysts, reinforcing the government's commitment to reining in the budget deficit and cutting spending, while also reforming and reducing wastage at the parastatals.
Moody's sovereign credit rating report was expected on 29 March. While many were pessimistic, Moody's final decision not to review the rating and leave it at investment grade with a stable outlook granted the country a big reprieve on the final trading day of the quarter. However, the SARB remains concerned about future inflationary pressures arising from the weaker rand, as well as higher costs from fuel and electricity, among other sources. Other worries for investors remained Eskom's generation capacity and the negative impact of load-shedding on growth in 2019, the land expropriation debate, nationalisation of the SARB, and last but not least, the upcoming May elections.
Despite US dollar strength, the rand lost only 0.5% versus the greenback, but 2.1% against the UK pound sterling, while gaining 1.3% against the euro, which was hit by growth concerns and more dovish interest rate expectations.
The fund produced a return of 7.6% (net of fees) for the first quarter of 2019, outperforming its benchmark by 1.8%. For the year ended 31 March 2019, the fund returned 3.8% (net of fees), outperforming its benchmark by 2.8%.
The fund's dual focus of buying undervalued companies with strong cash flows and dividends remains intact. In the last quarter, many of the contributors to outperformance came from:
o Companies that we own Where we believe the companies to be particularly undervalued with strong cash flows, like British American Tobacco (BAT) and Anglo American.
o Companies that we don't own Where we have deliberately avoided companies due to cash flow concerns and where there is a risk that dividends may fall in the coming years, like Aspen and Tongaat Hulett.
In the last quarter of 2018, we added to our already overweight position in BAT due to the aggressive price fall. This felt like a difficult trade as we were adding to a share which the market was very worried about, and where there is a multiplicity of risks. BAT is often viewed as a 'defensive' stock due to the stability of its cash flows, but the emergence of multiple possible risks for the Tobacco sector, the notable one being the possible banning of menthol cigarettes in the US, made the market focus on these risks and reprice the share substantially lower. We view BAT as a very high-quality company with exceptionally strong cash flows and are of the view that even after taking into account all these risks, BAT is trading on valuations now which we would regard as exceptionally attractive. In fact, BAT's dividend yield is now one of the most attractive in the South African market at around 7% - 8%. We think that we are being more than suitably compensated for the re-emergence of risks and continue to think it extremely unlikely that BAT's dividend will be cut. During the first quarter of 2019, the BAT share price rallied some 30% and was one of the fund's largest contributors to outperformance.
Anglo American is a large overweight position in the fund which contributed to outperformance in the quarter. Only a few years ago in 2016, Anglo American had cut its dividend to zero and the market focused its worry on Anglo American's balance sheet. We believed Anglo American was protecting the future of its cash flows and that dividends would resume. The market appeared though to be overly concerned and many commentators referred back to the pain of holding commodity companies during the financial crisis in 2009. Over the last two years, the cash flows in Anglo American have come roaring back, debt is no longer an issue and dividends have resumed. Despite all this good news, the market in our view has been slow to rerate Anglo American and we still think it is undervalued.
Avoiding Aspen continued to contribute to relative performance for the quarter. We do not own this company due to its poor cash flow, dividend growth and dividend yield. We continue to think that Aspen trades on the expensive side of fair value, and given its poor cash flows and indebted balance sheet, we see limited scope for strong dividend growth going forward. Aspen has been very acquisitive over time and has exhibited relatively poor dividend yields.
We continue to think that offshore equity markets look very attractive, certainly relative to bond markets and also when compared to South Africa. The fund is approximately 30% invested offshore, mainly through the Prudential Global Equity Fund and the M&G Global Dividend Fund. Both these funds were top contributors to the outperformance for the quarter. Some of the larger detractors from performance over the last quarter were investments in Sappi and Tsogo Sun Holdings. Sappi continues to generate strong cash flows which has enabled it to strengthen its balance sheet over the last few years, invest in high-return-on-capital projects for future growth and resume dividend payments. Sappi is currently investing in several projects which we think will generate strong future cash flows and dividends. We think that despite the significant improvement in the return on equity for the business, the company is significantly undervalued. Sappi's share price fell 16% over the quarter, which we believe was mainly due to market concerns over the effect that potential trade disputes between China and the US might have on some of Sappi's sales in Europe and the US.
Tsogo Sun's share price fell 10% for the quarter. We continue to find Tsogo Sun undervalued despite a strong indication from management of a much tighter focus on capital allocation and a move to pay a substantially increased dividend to shareholders. Despite the pressure on the South African consumer over the last few years, Tsogo Sun has managed to tightly control costs and maintain a high margin. While we still expect the SA consumer to be under pressure and spend at casinos to be fairly static, we think that this risk is adequately compensated for in the share price as the dividend yield for 2019 is expected to be over 8%.
We acknowledge that while it is very difficult to forecast the future and we do not make any attempt to do this, we do spend a lot of time thinking about the economic cycles that various sectors are in, and where valuations are. In this way, we aim to try make money for our clients through these cycles and continue to try to buy companies that have proven dividend and cash flow track records and which can withstand the normal upheavals that occur in markets over time. We aim to continue building risk-cognisant portfolios that seek to add value through stock selection relative to the benchmark.
STRATEGY AND POSITIONING
At the time of writing, we still have no more clarity on Brexit (originally voted on by a 'misled' UK electorate back in June 2016). UK Prime Minister Theresa May appears to be running out of time. Variants of her proposed deal have been continually rejected by a majority parliament - while the EU's patience to facilitate a 'soft' exit is now wearing thin. An unplanned 'hard' exit poses risks to the South African equity market given that a large number of companies derive meaningful exposure from the UK. We would expect our overweight positions in Investec plc and Quilter plc to be particularly sensitive to the final Brexit outcome.
At home, Eskom's load shedding has battered consumer and business confidence, while Eskom's debt problems pose the single biggest risk to the economy. As we head into elections we remain underweight many of the consumer facing sectors of the market. The ANC is expected to win the upcoming elections but a bigger challenge for the governing party and President Ramaphosa will be to navigate the Eskom 'tight rope'. On the one hand, the country desperately needs Eskom to return to financial and operational health but that will require graft and excessive remuneration at the parastatal to be reined in.
The fund aims to achieve a dividend yield better than that of the market and to grow capital and dividends in line with the market. The Fund invests in JSE listed companies that meet the portfolio manager's primary criteria of high but sustainable dividend yields. The Fund also seeks out ''value situations'' by investing in shares with low relative PE ratios as well as shares that are trading at a discount to their intrinsic value. The intended maximum limits are Equity 100%, Listed Property 10%, Offshore 25%, plus additional 5% Africa (excl. SA).
Who should Invest?
Individuals with a medium-to-high risk tolerance, looking for a combination of high dividend yield and capital appreciation with an aggressive tilt towards value-type shares. The recommended investment horizon is 7 years or longer.