Weekly Market Report

27 September 2022

Global Report

Is the pound still sterling?

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Local Report

Tiger Brands and AVI.

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Global and local indicators.

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Global Report

By Nick Downing

The pound’s performance over the past week is reminiscent of Black Wednesday, the 16th September 1992 when the UK government was forced to withdraw sterling from the Exchange Rate mechanism. Less than a month in the job, the new government’s Chancellor of the Exchequer Kwasi Kwarteng has delivered a shock and awe budget, comprising massive tax cuts on top of the already substantial energy price subsidy. Following the budget, the pound tumbled against the US dollar by 3.7% last Friday and at its worst point by another 4.8% on Monday. Financial markets are dismayed by the cost to the Treasury. The energy subsidy alone is expected to cost £60 billion and the tax cuts another £103 billion over four years. This comes almost immediately after the unprecedented Covid rescue programme.

The pound’s weakness is partly a US dollar story. The US currency, backed by energy self-sufficiency, the Federal Reserve’s tightening monetary policy and shrinking global dollar liquidity, has been beating all currencies over the past year, but the pound’s weakness stands out. Blame is directed at the government’s economic policy. The newly announced tax cuts amount to 2% of GDP and another £72 billion of government debt. Government debt is already at 100% of GDP a far cry from the 40% debt ratio when the Thatcher government launched a similar growth budget 40 years ago.

The budget tore up all rules and conventions. Perhaps most alarming is that the Office for Budget Responsibility, which traditionally provides independent oversight of fiscal decisions, was completely side-lined. In fact, the budget provided no forecasts on public finances. The Institute for Fiscal Studies called the budget the “biggest tax cutting event since 1972”, which risked putting UK debt on an unsustainable path. Former US Treasury Secretary Larry Summers said, “Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time.”

Kwarteng is going all out for growth. With this budget, and he has since stressed that this is only the start, he hopes to put the economy on a trend growth rate of 2.5%. It is now likely that the UK economy will skirt recession next year, unlike Europe and many parts of the world, but at what cost? Added fiscal stimulus will worsen the inflation outlook forcing the Bank of England to be more aggressive in hiking interest rates. Rate hikes may also be needed just to shore up the pound, especially as the UK is running its largest current account deficit since WW2 at 8.3% of GDP and is therefore excessively dependent on foreign capital inflows. Interest rate futures predict the BOE’s benchmark interest rate, which was hiked last week to 2.25% will be 3.75% by the end of November and above 6% by May. Gilt yields have surged by the most since 1992. 10-year yields jumped after the budget to 4.14% compared with 3% at the start of the month. 2-year yields jumped from 3.51% to 4.45% over two days.

Lower income taxes will help consumers, but the benefit will be taken away by higher interest rates. Sharply higher mortgage rates will impact the residential property market, which according to many analysts is in dangerous bubble territory. Lower corporate tax rates and stronger economic growth will assist share prices, but higher interest rates will lift the discount rate used to value company earnings.

The Chancellor believes his policy will boost the economy’s supply side. He is also implementing regulatory reforms, including around 40 new low-tax investment zones, looser rules on new infrastructure investment and the scrapping of caps on bankers’ bonuses. The reforms may be helpful but the biggest constraint to growth is the country’s labour shortage. Brexit has put an end to the abundance of migrant labour. Without it, the economy will have to rely on substantial productivity improvements to achieve growth targets.

Will the pound keep dropping? Given its substantial decline so far, it is tempting to believe that it can’t weaken further, that parity with the dollar is such a strong psychological level and unlikely to be breached. However, in 1972 ahead of the last great fiscal gamble, the pound traded at £2.61 only to depreciate to £1.59 by 1976 and to £1.07 by 1985 following the Fed’s brutal inflation beating monetary policy. History tells us that the pound could weaken further, especially in the current strong dollar environment. Meanwhile, Brexit woes continue. The bonanza of new post Brexit trade agreements just haven’t materialised. Existing trade deals have largely been replicated. Since leaving the EU, the UK has signed replicated deals with 69 countries. Only 3 new trade agreements have been signed. The big prize, a new trade deal with the US, has fizzled out. There are no current negotiations with the US, and Prime Minister Liz Truss has threatened to tear up the exit deal it negotiated with the EU.

What does all this mean for investors and Overberg’s client portfolios? There is a lot of cash in portfolios, which has been raised over the past 12 months to position portfolios more defensively. The cash is currently held in US dollars. The investment companies, listed on the London Stock Exchange, which comprise our clients’ portfolios, are quoted in pounds but the underlying exposure is across global markets and asset classes and so will not be affected by the currency’s weakness.

Local Report

By Gielie Fourie

INTRODUCTION: Tiger Brands (TBS) and AVI are two remarkably similar companies, but also two quite different companies. Both companies are food producers rather than food retailers. TBS is the biggest of the two with a market capitalisation of R30 billion. AVI has a market capitalisation of R25 billion. Smaller companies with similar product ranges and their market capitalisations, are: RCL Foods R11 billion, and Libstar R4 billion.

TIGER BRANDS (TBS): TBS owns strong brand names. In baby and food products it owns Purity products, Albany Bakeries (bread), Crosse & Blackwell mayonnaise, Colman’s mustard, and traditional brands like the Koo canned fruit and Koo fruit jams ranges, and All Gold Tomato Sauce. To top it up TBS owns Mrs Balls Chutney, Jungle Oats and Tastic Rice. TBS owns eleven of the number one food brands in South Africa. TBS also diversified into a small range of personal care brands, mostly hair and skin care products.

AVI: AVI owns 53 strong brand names. Popular food beverage brands include Freshpak Rooibos, South Africa’s best-selling Rooibos tea, the extensive range of Five Roses tea, Ellis Brown Coffee Creamer, and Bakers Biscuits. It owns I&J, the supplier of frozen Cape Hake and Cape Abalone. It diversified into personal and fashion brands. In personal brands it distributes the full Yardley range of fragrant sprays and beauty products. In clothing, it owns licences to distribute exclusive fashion and lifestyle footwear brands like Spitz, Carvella, Lacoste, Kurt Geiger, and Green Cross. It owns brands that have survived for centuries – Yardley was established in London in 1770. Both I&J and Bakers are more than 100 years old.

RCL FOODS AND LIBSTAR: RCL, 85% owned by Remgro, owns strong brand names like Rainbow Chicken, Nola mayonnaise, Selati sugar, Yum Yum peanut butter and Ouma Rusks. It also owns Vector Logistics; the distributor of all Pick n Pay and Shoprite’s frozen foods. Libstar owns brands like Denny mushrooms, Lancewood cheese, Montagu Foods and produces both Robertsons spices and Cartwrights curry powders and spices, under licence. It also produces private label brands for Pick n Pay, Shoprite Checkers, Spar, Woolworths, and internationally for Aldi in Europe and Loblaws in Canada. Libstar produces three popular ready-to-eat products and meals for Shoprite Checkers. It also produces all the meat and chicken for McDonalds products. These retailers account for more than 50% of Libstar’s sales.

Scale is important in the food business. When an industry is fragmented with many small players, consolidation can cut costs and drive profits. Merger and acquisition rumours in the food sector suggest that RCL and Libstar could merge. One scenario is where RCL will sell Rainbow Chicken, which is big enough to stand on its own legs, sell Vector Logistics, and merge its food portfolio with Libstar.

HISTORIES: The food industry is a Fast-Moving Consumer Goods (FMCG) industry. Products have sell-by dates. AVI’s management has a clean record, untainted by scandals. It had to close its Green Cross factory in Cape Town, which caused all workers to lose their jobs. The factory was unprofitable, so it was a financial decision.

TBS is, unfortunately, a serial offender. The first “cereal” offense was the 2014 case when it was fined for fixing bread prices. In 2018 there was the listeriosis scandal – the spectre of a class action case against TBS has not gone away yet. Product liability insurance may not cover any or all punitive damages. On 7 September 2022 TBS had to recall its Purity and Elizabeth Anne baby powder products after traces of asbestos were found in test samples. TBS described it as a batch-specific issue. These events cause reputational damage, which is a pity because TBS has a top-quality product range that serves as a wide protective moat around the business.

BOTTOM LINE – DO YOU BUY TBS OR AVI? Analysts are split on this question. There are analysts that prefer TBS. TBS is the biggest holding (11.4%) in John Biccard’s NinetyOne Value Fund. Biccard is a value investor. TBS trades on a PE ratio of 14.44x, a dividend yield of 5.13%, and a Price to Book (P:B) ratio of 1.97. The result is a Blended Multiplier of 28.45 (14.44 x 1.97), which indicates that there is value. TBS is ungeared. These figures indicate that TBS is reasonably priced at R178.00.

Both Standard Bank and First National bank prefer AVI. AVI trades at a PE ratio of 13.69x, a dividend yield of 6.36%, and a P:B ratio of 5.09. The result is a Blended Multiplier of 69.68 (13.69 x 5.09), which is high, making AVI more expensive than TBS. The Blended Multiplier (BM) is a ratio developed by Benjamin Graham. He said the BM should never be more than 22.5. AVI has a low gearing. It is a steady, reliable performer. International firms noticed it. Last year Mondelez, maker of Cadbury, made an offer to buy AVI’s snack business. They were unsuccessful, but they managed to take AVI’s Chief Financial Officer with them. We own AVI in our clients’ portfolios. Critics may say AVI is a boring company. Warren Buffett avoids companies prone to rapid and continuous change. We just love simple, boring companies.

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Reference: References can be supplied on request.

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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