Finding value in falling markets

Iain Power, CEO of Truffle Asset Managers, Portfolio Manager of the Nedgroup Investments Balanced Fund, talks about finding value amid the massive virus selloff.

Against the backdrop of Covid-19, the consensus is that we are in a recession. The real question is the extent to which economies will slow, the amount of damage to them resulting from the lockdowns and how long it will take to recover. Given that there will be no vaccine for another 18 months, there is huge uncertainty around when we’ll return to a normalised economic environment.

In terms of the S&P 500, the median multiple is at 15,5X. This was due to the market selloff on the back of the virus, but we’ve seen quite a sharp rebound, although not at levels we would consider to be cheap. Markets are certainly discounting quite an optimistic recovery scenario, but we remain cautious and defensive regarding the portfolio’s position. The market is expecting an 8% decline in S&P 500 earnings per share, which we think is quite optimistic, and that it will be closer to 20%. We feel that the risk is to the downside from an earnings perspective and that’s why we’re cautious regarding portfolio position.

The domestic view

In South Africa, the virus has made a bad situation even worse with limited financial means and ability to support the economy, putting us in a very difficult position. The fiscal measures we have taken will have an impact on our debt to GDP ratio. The pre-Covid forecast was below 70%, but post Covid we’re going to get to the 80%+ debt to GDP mark and entering the realms of a debt spiral. Fiscally, it is looking very difficult. The tax base in South Africa will come under pressure as a result of this economic hit, at the same time as an increased need to support the disenfranchised. Our fiscal deficit post Covid looks to be about 12% of GDP, which is indicative of the public sector borrowing mainly to fund social welfare and not productive assets or infrastructure. Those expenses are going to be difficult to cut and now we’re adding debt into that. At the end of the month, we expect up to $3 billion in outflows. The backdrop for the SA economy is going to get tougher and there will be hard decisions that the government will have to make. 

What are foreign investors looking for?

We’ve had R70-R80 billion of outflows on our capital account this year so need to know what emerging market investors are looking for to come back and accumulate SA bonds and equities. Overwhelmingly, investors want to see a proper structural intervention from a fiscal perspective, which will require a cut in the public sector wage bill. IMF funding will enforce structural reforms in exchange for funding, but we think this is probably a last resort. Some options the government could consider are prescribed assets, some sort of infrastructure funds and possibly capital account controls, such as changing the limit of allowed foreign investments down to 25% from 30%. These are all potential pathways in the future and we are therefore cautious, maintaining the quality in the portfolio and hanging onto the capital that we’ve got.

In terms of domestic valuations, the JSE PE ratio (excluding Naspers) is at fairly cheap levels relative to history. We will see earnings from South African focused companies taking a big hit. Because of the future uncertainty, we want to see bigger discounts and our clients only taking the risk we want them to take. We believe that earnings are likely to disappoint on the downside and we will only buy into a lot of these businesses if the multiples are discounting a lot of that bad news.

 
The positioning of the portfolio

We have net equity of 53% post our hedges. We’ve got a lot of option protection on the portfolio of almost 9% of the fund on a nominal basis. Our offshore exposure of 33% favours the higher quality offshore earners in the resources, precious metals and industrial Rand hedge sectors. 13% is in mining and resources, 16% in foreign JSE-listed companies (British American Tobaccos, Reinet and Naspers), which shouldn’t be affected by the domestic economic backdrop. We have 10% net foreign equity exposure and we’ve picked up some stocks that were sold down in the crash, but have hedges. We continue to look for shares that have been oversold. 8% in foreign bonds and 8% in foreign cash. We’ve been very cautious and have very limited exposure to the local economy. We’ve tried to focus on businesses where there is self-help, restructuring and ability to grow earnings over the next 3 years. Some of these businesses also have 2nd derivative Rand hedges. At times like this, you want to have a higher quality portfolio and businesses with lower leverage. 21% is in domestic bonds and cash with short durations and we remain cautious. Property is very low in the portfolio. This sector is in severe distress and has applied to the Regulator to pass on dividends for the next two years so they can rebuild their balance sheet. Property values are coming under pressure and facing low loan to value ratios. The only solution is to stop paying dividends and we don’t think we’ll see income for the next 18 months from this sector.

The portfolio is in defensive mode, but optimistically looking at opportunities given the volatility in markets. We have quite a lot of cash to take advantage of higher volatility going forward and will be able to take advantage of prospective returns in financial assets, which are much higher than they were at the start of the year.

To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify.