Weekly Market Report

Tuesday 26 July 2022

Global Report

Europe’s investment prospects.

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Local Report

MTN and Telkom – development in the Merger and Acquisition space.

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Market Indicators

Global and local indicators.

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Global Report

By Nick Downing

Global investment portfolios mitigate risk and capture opportunities. This is largely achieved through regional weightings. The global economy is split broadly across three regions, led by the US, China, and the Eurozone. The US is slowing down but a recession is unlikely due to substantial savings and robust company as well as bank balance sheets. China will struggle to meet its official growth targets and the impact of slower growth will reverberate across the Asia-Pacific region. Most at risk over the coming two years, is the eurozone, due to its proximity to the war in Ukraine, its dependence on Russian energy, political instability in Italy and its potential to spill-over into another regional sovereign debt crisis. What does all this mean for investors?

European economic data surveys indicate a sharp loss in momentum, and these were compiled before the resignation of Italy’s prime minister, Mario Draghi, and the ECB’s bigger than expected interest rate hike. The S&P Global composite purchasing managers index, measuring both manufacturing and service sectors, fell between June and July from 52.0 to 49.4, below the critical 50-threshold that signals contraction. The reading is at its lowest since January 2021. Chris Williamson, the survey’s chief business economist said “The eurozone economy looks set to contract in the third quarter as business activity slipped into decline in July and forward-looking indicators hint at worse to come in the months ahead.” The European Commission’s consumer confidence measure continued dropping in July, falling from -23.6 to -27 below its previous low reached at the start of the Covid pandemic.

At its July policy meeting the ECB confounded expectations for a 25 basis-point rate hike, instead lifting the key deposit rate from -0.5% to 0%, ending 8 years of negative interest rates. Interest rate futures project the deposit rate will be 1% by year-end and 1.5% next year. The urgency to raise rates is being fed by surging inflation, which hit a year-on-year peak of 8.6% in June. In return for acquiescing to a higher-than-expected rate hike, the inflation hawks granted the ECB a new tool to fight the risk of eurozone fragmentation. In 2012, the ECB adopted an unlimited bond buying programme, called Outright Monetary Transactions (OMT) to shield the Mediterranean countries from rising sovereign bond yields, which translate into higher borrowing costs. The eurozone sovereign debt crisis, which threatened to tear the region apart has come back to haunt the markets. Italy’s 10-year debt spread over German debt has increased to over 2.3% its highest in three years and close to the critical 2.5% level. ECB president Christine Lagarde has launched the Transmission Protection Instrument (TPI). Its purpose is to buy sovereign and private sector debt from eurozone countries that are being unfairly punished by the markets. Purchases can be made in unlimited quantities if necessary.

The risk of eurozone fragmentation has increased sharply since the resignation of Italy’s prime minister Mario Draghi. While in power he successfully pushed through structural reforms, qualifying Italy for a €200 billion handout from the EU’s post-pandemic recovery fund. Under a new more populist prime minister, possibly elected in September, it will be doubtful whether Italy continues to qualify for the handout, in which case, coupled with its 150% debt to GDP ratio, the country may not qualify for TPI support either. The result is a potentially big selloff in Italian bonds and a repeat eurozone sovereign debt crisis. The Italian-German 10-year government bond spread has crept up to 2.38%. This debt crisis would occur with inflation around 8.6% rather than 0% as it was in 2012.

Russia has switched the Nord Stream 1 pipeline back on following maintenance work. The immediate scare of a full gas embargo has lifted, but the temporary outage has left lasting scars. Markets fear that Russia will use gas as a geopolitical tool in the future. Gas prices for forward delivery in July 2023 and 2024 remain at record highs, at €134 and €82 per megawatt hour, well above the average for the past decade of €40. Over 40% of the EU’s gas imports come from Russia. Deutsche Bank estimates Germany, which relies on Russia for over half of its gas imports could suffer a 5-6% pullback in GDP in 2023 if Russia launches a full gas embargo. Italy is a country most at risk due to its dependence on gas fired electricity. Fitch credit rating agency warned that gas rationing for industrial users could cut eurozone GDP by 1-2% in 2023, with a knock-on effect across supply chains. A complete loss of Russian gas could cut eurozone GDP by up to 2-4%, a calculation which excludes the impact on household spending and the impact on business sentiment.

At face value, Europe currently appears to be the least appealing region for investment. But even a bad story can make for a good investment at the right price. European shares are trading at record discounts to the US market, although this phenomenon has been evident for at least a decade. Relative to their own long-term averages, European shares are also very cheap, but they have been cheaper in the past, in the aftermath of the 2008/09 global financial crisis and during the 2011/12 eurozone sovereign debt crisis. Nonetheless, it’s a market worth watching closely as a new investment opportunity may be just around the corner. Valuations are getting attractive. For the EU as a whole, the historic PE ratio is at 12.5x compared with the long-term average of 15.5x and the price-to-book ratio is 1.43 versus the long-term average of 1.77. Germany’s valuations are even more compelling, with a PE and price to book of 10.4x and 1.43 versus long-term averages of 16.0x and 1.80. Italy’s comparisons are 9.6x versus 17.1x on its PE ratio and 1.16 versus 1.55 on its price-to-book.

Although valuations are already cheap, there is further downside to Europe’s equity markets. Bear markets tend to have two down-legs. The first usually occurs ahead of a recession and while earnings are still growing the market de-rates via a compression in PE multiples, due to the impact of rising interest rates and a deteriorating economic outlook. In the second down-leg, equities pull back due to a decline in earnings as recessionary conditions start to bite. In this phase, the market will drop even if the PE remains steady. The market could fall in line with the earnings decline but the PE multiple could be shaken down at the same time to its record lows, especially if the war in Ukraine persists, Russia weaponises its gas supply, inflation remains stubbornly high, or the ECB lifts its interest rate too high. It is often said that policy tightening continues until something breaks. Perhaps a renewed eurozone sovereign debt crisis will be that “break”. Please contact one of OAM’s wealth managers for advice on European investments and our privately managed global investment portfolios.

Local Report

By Gielie Fourie

INTRODUCTION: The announcement on 15 July 2022, that Telkom is in talks to be acquired by MTN is not the first time these two companies have flirted with some sort of transaction. They have had an on-and-off relationship for many years. It is certainly not the first instance of Telkom looking to merger and acquisition (M&A) activity to solve its situation of being sub-scale in the mobile telephony industry. The announcement lifted Telkom’s market capitalisation by 20% to R20 billion.

SCALE: Vodacom is the biggest cell phone company in South Africa. MTN and Telkom are number one and three. Having scale in the mobile industry is critical. Being sub-scale, Telkom would always play second fiddle in South Africa. The telecoms business is highly capital intensive – not dissimilar to mining. Having scale is important. You only gain a competitive edge and commercial sustainability once you’ve got economies of scale. Drastic increases of units (users) drive down unit costs. Telkom is simply too small to successfully compete with the big players. MTN realised long ago that being number one or two in the industry provides a barrier to entry, or a moat around the business. MTN is the biggest mobile operator in Africa with a market capitalisation of R270 billion. Vodacom is second with a market capitalisation of R260 billion. Telkom, with operations in 38 African countries, has a market capitalisation of only R20 billion. If successful, the deal has the potential to create South Africa’s largest telecommunication operator, experts say. Efficiencies only come with size – size is important in telecoms.

TELKOM ASSETS – OPENSERVE: Apart from its mobile business, Telkom owns attractive assets. A recent MoneyWeb article even had a headline: “Why MTN wants, no, needs Telkom.” While MTN is going after 100% of Telkom, the consensus is that the real prize are its vast fibre assets, housed in Openserve. Some analysts suggested that Openserve was worth more than Telkom’s market value prior to MTN’s advance. MTN needs Openserve, the largest fibre operator in South Africa. At the same time, Openserve needs a deep-pocketed parent like MTN. Most of the other Telkom assets will probably be disposed of after a potential takeover. Regulatory barriers make a complete acquisition of Telkom unlikely. The consensus appears to expect a breakup of Telkom.

Openserve has more than 169,000 km of fibre in the ground. By contrast MTN has at the most 25,000 km of fibre in the ground. Vodacom and its partners, Vuma and Dark Fibre Africa, have 76,800 km of fibre in the ground. A Telkom deal will put MTN far in front with fibre. It is clear, the takeover offer is about one thing only: Telkom’s market-leading fibre network. Liquid Telecom (formerly Neotel) has around the same fibre length as MTN. Everything else is smaller after that. Consolidation in the market is inevitable. South Africa has at the most a market to accommodate two or three mobile operators. We have five mobile operators (including Rain).

TELKOM’S OTHER ASSETS: Swiftnet, BCX, Properties and Telkom Consumer: Telkom was expected to separately list its masts and towers business, called Swiftnet, earlier in the year but delayed the transaction owing to volatility in the market after Russia’s invasion of Ukraine. MTN has listed its existing tower business and is expected to either sell the Telkom tower business or list it separately. In the 2000s, the race was about which operator had the most cell phone towers. Now it’s about fibre. This is especially true in a world of 5G connectivity and data centres that all need fibre. South Africa, and MTN, were falling behind in the fibre space. MTN is now making its move, going after South Africa’s largest fibre operator, Telkom. If allowed to proceed, the tie-up would create SA’s largest telecoms group.

MTN has the financial muscle to pull off such a deal, ending the last financial year with R38.3 billion in free cash. This is almost double Telkom’s R21.1 billion market capitalisation or R41.40 a share. Back in 2020, the group valued itself at about R100 a share. Telkom’s stock peaked at R96.70 a share in mid-2019. In 2022 MTN sold 5,701 towers in a sale and lease back agreement with MTN to IHS Towers, a US listed company. IHS Towers is the world’s largest independent multinational tower company solely focused on emerging markets. It also operates in South Africa, allowing cell phone companies to focus solely on mobile telephony. MTN will then be dominant in both the mobile market and the fixed line market.

BCX (Business Connexion) is an international information and communications technology (ICT) company owned by Telkom. It can be unbundled and sold and even separately listed. Telkom also has a big property portfolio which consists of 1,332 properties managed by Gyro. Gyro can also be sold off or listed separately. That leaves only the Telkom Consumer business, including the fixed-line and mobile businesses. This can also be sold off, perhaps to Cell C. South Africa will then have a consolidated mobile phone market with three players – MTN, Vodacom and Cell C.

RED TAPE AND REGULATORY HURDLES: Competition authorities and the Independent Communications Authority of South Africa (Icasa) are expected to weigh in on the proposed transaction given its size. For years competition authorities and the regulator have regarded the dominance of MTN and Vodacom, which hold a combined three-quarters of the 100-million mobile customers in South Africa, as a source of inefficiency in the local market. The South African government and its investment arm, the PIC, own a combined 54% of Telkom.

GOVERNMENT: Government and its investment arm, the Public Investment Corporation, own a combined 54% of Telkom, amounting to around R10 billion. To sweeten the deal, government would be ending up with shares in a higher growth, larger, more liquid business, and could potentially realise value relatively quickly if it so desires.

BOTTOM LINE: Currently MTN is trading at a price of R142.00, a market capitalisation of R270 billion, a PE Ratio of 14.5 and a dividend yield of 2%. Telkom is trading at R41.50, a market capitalisation of R20 billion, a PE Ratio of seven and no dividend yield. This makes MTN (started in 1994) 13 times bigger than Telkom (started in 1910). Mergers and acquisitions are by their very nature, some of the most complex and prolonged processes. You have to deal with government red tape and the cultures of the different companies. It is also costly. Our clients are invested in MTN – we will follow developments closely.

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The Bottom Line: Innovation and the Magic of Compounding

By Carel La Cock

The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.

Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.

After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.

Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.

As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.

Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.

Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.

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