Q1 2019 market performance
Global emerging market equities rose in local currency terms in the first quarter of 2019 with Colombia, China and Brazil among the strongest markets, while Morocco, Argentina and Sri Lanka were some of the weakest.
Source: Thomson Reuters Datastream, as at 31 March 2019.
Newcrest, one of the world's largest gold mining companies, was a key positive contributor to returns during the period. This was driven by strong operational performance at its mines, most notably Lihir, located in Papua New Guinea. The improved volume of ore mined and higher recovery rates led to strong cost leverage and cash-flow production. The stock price has also been supported by an improvement in the underlying gold price during the period. This commodity is seen as providing a store of value during times of increased risk aversion.
Heineken, the second-largest brewer in the world, was another significant contributor to returns during the period. The company reported strong full-year 2018 results and forecasts attractive operating profit on an organic basis in 2019. The core Heineken brand saw volume growth of close to 8%, which was its best volume performance in more than a decade. Net revenue growth was strongest in Africa, the Middle East and Eastern Europe, which we believe is positive for the long-term health of the franchise.
Remgro, Shoprite and Pepkor were significant detractors to returns during the period. This was less related to any bottom-up specific company event or news but rather to the continued impact of a weak South African economy on these businesses. We believe that these companies have strong balance sheets and capable management teams and are well positioned to benefit from a reduction in the economic headwinds over time.
Portfolio activity has been in-line with our long-term time horizon. Trailing twelve-month portfolio turnover is running at around 20% for the All-Cap strategy*. We exited positions in Delta Electronics and its sister company, Delta Electronics Thailand, as a result of a corporate action and on valuation grounds. Delta Electronics’ purchase of Delta Electronics Thailand improved its future growth profile and increased the contribution from faster growth segments. This became reflected in the stock price and the new entity approached our estimate of fair value. The proceeds were added to existing positions within the portfolio. There were no new purchases during the period.
*Source: Janus Henderson Investors, as at 31 March 2019, based on a representative portfolio.
There has been no noticeable change in our investment outlook over the past quarter. We still view the valuations and growth expectations for many good quality Asian companies as being too high. At the end of last year, it looked as though there was the potential for valuations to become attractive. Equity prices for a lot of good quality companies that are on our watch list had moved from ‘very expensive’ to just ‘expensive’ but, unfortunately, not into territory where they became attractive to us. Our lack of significant buying activity during this period is a sign that a number of Asian companies that we admire still sport valuations that do not meet our long-term potential return requirements.
A recent investment trip to South Africa highlighted the significant opportunity for those willing to be patient. Near-term commentary from retailers and businesses was almost universally cautious, and it would appear that the economy is stumbling at a 1%-2% annual GDP growth rate. South Africa’s economy is still weathering the after-effects of the corruption and mismanagement of the nine-year reign of ex-president Zuma. We believe that the headwinds that the country has been facing could abate and many good quality African businesses should return to growth, and that current valuations do not reflect this. While the pace of change of economic reform within South Africa may not be helping the economy in the near-term, there are some very interesting developments.
The announcement by President Ramaphosa that Eskom, the state electricity utility company, would be split into three separate entities is a potential ‘watershed’ moment. Eskom serves as a case in point of all that went wrong with South Africa under the Zuma administration. A decade of corruption and mismanagement led to utilities’ debts rising tenfold since 2007, and the sector’s ability to produce consistent electricity for distribution diminished. It was the worst of all worlds, which sweeping blackouts attest to. The decision to split the company into generation, transmission and distribution units should allow foreign capital to restore its health. It also shows that Ramaphosa is willing to use his political capital to enforce change on a state company that employs 54,000 people. This policy is unlikely to be popular, but it is necessary for the long-term health of the country. Elections to be held shortly may provide an opportunity for President Ramaphosa to receive a national mandate for change.
Unfortunately for the South African companies in the portfolio, life remains hard and short-term results reflect the difficult environment. One example is a relatively small company called City Lodge Hotels. This company caters primarily to business travellers with hotels that are functional and good value. The tough environment in the country has led to less investment, the knock-on effect of which is that business travel continues to suffer. The company is, however, built to withstand this and continues to invest in both its people and properties through the tough times. As a team, we have always been impressed by the quality of management and the widespread ownership of the company by staff. An investment like this should do very well when confidence in the country returns and patience is rewarded.
Thinking and acting like prudent owners
Our investment philosophy and process applies both to the historical and modern connotation of the term ‘other people’s money’. We have long believed in carefully considering how we, as minority shareholders, are aligned with the interests of the managers and owners of the companies in which we invest. In addition, we also look for capital allocators that associate other people’s money with fragility and the risk of a permanent loss of capital.
Significant levels of debt can mean having less room to manoeuvre if a setback occurs and can lead to highly leveraged companies being beholden to a bank or bond markets during periods of cyclical economic weakness or shifting industry trends. There is nothing inherently ‘good’ or ‘bad’ about a management team or business owner following a particular capital allocation or investment style. One just needs to follow an investment philosophy and process that is consistent. It is our belief that the inherent vagaries of the emerging market investment landscape reward those who are willing and able to be risk aware and to act like prudent owners over the long term.
Appetite for risk and enthusiasm for the emerging market asset class has increased over the recent period. We are mindful that there are a number of fault lines opening up across the region and, more broadly, globally, and that liquidity alone cannot solve these issues. Speculation also appears to be running high. The current global appetite for loss-making Chinese ‘unicorns’ (a startup company with a valuation of more than $1 billion) in both local and international markets reminds us that, at times, discretion is the better part of valour.
We are mindful of the need to stick to our beliefs that we do not compromise on quality, we maintain a long-term approach and apply a strict valuation discipline. With a long-term perspective, we remain positive about the opportunities for equity investors created by the structural trend of rising living standards in some parts of the developing world.