Omri Thomas of Abax Investments, Portfolio Manager of the Nedgroup Investments Opportunity Fund, provides context for the global economic impacts resulting from the virus.
Putting the disappointing Q1 performance into context
The fund’s 3-month performance was very disappointing. At the end of last year, the SA markets were starting to look very attractively priced. More than half of the All-Share was trading at levels below where they were trading 5 years ago. We saw quite a lot of value and upside potential in the market and consequently increased our equity exposure close to the maximum limit. Our portfolio normally has a fair amount of hedging, but it does come at a cost that you cap the upside. As we were of the view that we should catch a bit more of the upside, our level of hedging was lower than it would normally have been.
The biggest impact was felt with SASOL where we had a big position. Although we previously had a hedge down to R300/share, we had no protection when that expired. When the virus hit, we suffered a dual shock with a collapse in the demand for oil at the same time as a massive over supply. This was compounded by an ego war between Russia and Saudi Arabia, resulting in significant over supply of oil into a weak market. This put severe pressure on the dollar oil price pushing it less than $20/barrel, which is below the cost of producing for SASOL ($35/barrel). SASOL’s hedging will protect their earnings to some extent, but the risk of an extended lower oil price remains.
While there is capital protection embedded in our Eurostoxx note baskets, two of our biggest notes expired in March and April. Both were expected to deliver handsome returns. In March, European markets were down over 30% due to the virus, so all the accrued value in those notes disappeared. Some of these notes roll into next year, so this is not a permanent capital loss yet, depending on how Eurostoxx markets perform to expiry. If the market recovers a bit, we will get all our capital back when the notes expire, but it was particularly bad for us to lose all that accrued performance.
SA banking sector
The SA banking sector was another sector that really hit the fund. It was very attractively valued trading at PEs of 7–8X with dividend yields above that. Our forecast was on low, single-digit growth. Again, because of virus concerns, investors are worried about the impact on banks’ income statements and level of bad debt. This resulted in banks going down to 2-3X PEs on historic earnings and we know that forward earnings will be under pressure. April will probably be the period with the biggest impact for banks and businesses.
Putting the global environment into context
Global markets suffered three simultaneous shocks. Firstly, the virus and the lockdown of global production capacity. Secondly, the collapse of the oil price, which is a big dollar liquidity provider. As the oil price collapsed, dollar liquidity also started drying up, which led to the third shock, a freezing of capital markets. Initially, globally, there was a run to safe haven assets, such as US treasuries, US-dollar and gold. As capital markets started freezing up, even these assets came under pressure, which resulted in emergency liquidity injections by governments across the world. The economic impact has been a synchronised global GDP slowdown and record unemployment – multiples of what we saw with the Global Financial Crisis (GFC). The flight to safety has resumed with US treasuries and gold stocks being the beneficiaries as well as internet-related stocks and online businesses who can operate during the lockdown e.g. Amazon, Netflix, Tencent who have all done well. Overall, we’ve seen a massive and widespread sell off in emerging markets across bonds, equities and currencies.
Our response to the virus has been exemplary, but can we afford a first world response in a third world country? We went into this crisis in a weak position in terms of our balance sheet and income statements so this has pushed us right to the edge. It looks like the release from lockdown will be done in five stages, with different approaches across the provinces depending on the severity of the virus in each region. It’s very tough to make the right call, but if we don’t open up soon, the impact on our economy and companies will be catastrophic.
We are starting to see reforms being forced through and some hard action on SOEs, including SAA, Landbank and Eskom. The days of throwing good money after bad are over – we just don’t have the capacity to do that anymore. Our loans, for example from the IMF, will be coupled with conditions of reform, such as the state’s wage bill, which has grown in real terms by 5% for a number of years.
The outlet for all this pressure has been the Rand, which is one of the most liquid emerging market currencies and used as the proxy for other emerging markets. While the selloff of the Rand was overdone, at levels comparable with the GFC, it is now in extreme territory being one of the cheapest currencies with the weakest fundamentals. We see the catalyst for the Rand’s recovery being when the markets get a sense that the virus has been dealt with decisively and there is no fear of it re-emerging when lockdown ends and the economy opens up again. We are in an experimental phase as countries start to lift some lockdown restrictions, so the next 3 weeks will be critical.
In terms of our top equity positions, Naspers remains our biggest position at 8.8% but after taking hedges into account is reduced to 1.8%. Absa is next, just below 3%. It has been hard hit and we are currently pricing in zero earnings for the next year, 40% lower earnings than 2019 for the next 3 years and growth of 12% of that for the next 10 years. This gets them back to earning what they were in 2018 in 15 years’ time. We do think the banking sector will recover and emerge from this crisis, but it will take time and we are maintaining our banking exposure through Absa, Standard Bank and Nedbank. We haven’t bought more SASOL, which is currently about 2% of the fund. We acknowledge there is risk to them having to do a capital raise and rights issue, which could put further pressure on their share price.
To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify.