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Weekly Market Report
14 March 2023
Private equity investing.
GDP figures: 2022 and quarter 4 of 2022.
Global and local indicators.
By Nick Downing
As fewer companies around the world choose to be listed on a stock exchange, asset managers are increasingly searching for investment opportunities in private equity. Entrepreneurs are often put off by the level of regulation and media scrutiny that comes with listing. In the US, the total number of listed companies has dropped by nearly 40% since 1997. The Wiltshire 5000 index, one of the broadest representations of the US market, named after the original number of constituent companies, when established in 1974 now only comprises 3660 companies.
Private equity companies can provide rich rewards for shareholders. They have different governance and incentive models to listed companies, which tend to result in stronger earnings growth. Private equity managers tend to be controlling shareholders and can therefore react more quickly to threats and opportunities.
Global private equity exposure can be accessed via listed investment companies quoted on the London Stock Exchange. These listed companies are the ideal structure for investment in illiquid assets such as private equity. The closed-end structure of an investment company is perfectly suited to investing in illiquid assets which owned directly may not be as easily tradeable as the shares of an investment company. This is one of the greatest advantages of an investment company over a unit trust. There are several examples of unit trusts having to restrict redemptions due to liquidity mismatches, which render them unable to meet their promise of daily dealings. The greatest strength of investment companies comes at a price. Holding illiquid assets in a liquid tradeable share has a price in the form of discount risk.
Listed private equity companies are now trading at very wide discounts to net asset value. Their de-rating is blamed on the rapid rise in interest rates and the impact of sharply higher bond yields on long duration assets. Companies promising returns many years in advance are especially susceptible to higher discount rates. There is some suspicion that valuations reported by private equity managers are unrealistically high. Yet, private equity managers are not generally incentivised for keeping valuations unrealistically high. They are incentivised instead on their purchases and performance fees are based on the value of their realisations. In general, earnings growth across private equity companies has remained strong, gearing has been modest so rising interest rates have not posed a material risk, and private equity realisations have continued to validate valuations.
Private equity exposure comprises 12.4% of OAM’s global growth portfolios and 10.7% of its global balanced portfolios, via holdings in 3i Group, HG Capital Trust, Rothschild Capital Partners and Scottish Mortgage. These companies exhibit excellence in management, their business models and their performance track records.
3i Group grew its NAV in the first nine months of FY 2023 by 26.8%, boosted by strong performance from Action, a fast-growing European discount retailer that comprises around 60% of its NAV, plus its other value for money private label healthcare and infrastructure investments. These are not long duration assets looking at turning a profit way into the future. In the 12 months to 1st January 2023, Action delivered a 46% increase in provisional EBITDA. 3i Group is secured by a resilient investment portfolio, investments made from permanent capital, a strong balance sheet with gearing of just 3%, and running costs covered by cash income. A careful and consistent approach to valuation means realised values of its investments are consistently above reported values.
HG Capital has delivered annualised NAV growth of 17.8% over the past decade and 15.6% over the past 20 years. It is a highly profitable company with strong earnings growth and high levels of recurring revenues. Its business model is to provide business critical software services in the tax and accounting, legal and compliance, ERP and payroll, automation and engineering, insurance, SME technology, wealth management, and healthcare sectors. Businesses enjoy repeat subscription revenues and risk is mitigated by a fragmented customer base, years of accumulated intellectual property and high margins. Far from being speculative, management’s focus is on “dull” technology companies. HG Capital’s NAV increased in calendar 2022 by 5.4%. Its top 20 investments, comprising 77% of NAV, delivered average year-on-year sales growth of 30% and earnings growth of 25%. Exits in 2022 continued to validate reported valuations with an average uplift on the three full exits of 28% versus December 2021 valuations. At 31st December, HG Capital’s liquid resources amounted to 23% of NAV. Managers say that “Increasingly, we see this environment as one of opportunity, as valuation adjustments create the opportunity to acquire businesses with attractive long-term performance.”
Rothschild Capital Partners had a difficult year in calendar 2022 with an NAV decline of 13.3% versus a decline of 12.9% for the MSCI All Country World Index. However, since its inception in 1988 to June 2022, it has delivered a valuable return profile, participating in 76% of market upside but only 40% of market declines, resulting in impressive risk-adjusted returns. Private equity exposure comprises around 41% of NAV. For this reason, the shares have derated and now trade at an unusually wide discount to NAV of over 20%, but based on the company’s track record, ability to mitigate risk, and management’s connections in sourcing investment opportunities, this discount seems too good to ignore.
Scottish Mortgage, which has around 30% of its NAV in private equity investments, its largest being SpaceX, suffered a terrible year in 2022. NAV declined 41.3%. This has detracted from its superior long-term performance but not by much, with its returns over the past ten years more than double those of the MSCI All Country World Index, and over 3 years and 5 years its NAV is still up by a remarkable 44.5% and 75.0%. The share price has dropped nearly 50% from its late 2021 peak, the largest decline since the 2008/09 Global Financial Crisis, when the shares fell over 60%. Its managers are excited, believing that novel technologies can now be acquired “on the cheap”. Just as the managers highlight that “the biggest winners are built in bear markets”, buying a manager with the track record of Scottish Mortgage after a period of weakness is generally a successful investment strategy.
3i Group, HG Capital, Rothschild Capital Partners, and Scottish Mortgage are long-term holdings in OAM’s global portfolios, providing private clients with valuable private equity exposure. The shares are trading at historically cheap levels with discounts to NAV of 6.1%, 22.5%, 22.5% and 16.6%, respectively.
By Gielie Fourie
GDP DECLINED IN THE FOURTH QUARTER OF 2022 (Q4 2022): After rallying in Q3 2022 by 1.6%, upwardly revised to 1.8%, South African gross domestic product (GDP) declined by 1.3% in Q4 2022, seasonally adjusted but not annualised. Annual real GDP increased by 2.0% in 2022 (4.9% in 2021). GDP reached an all-time high of R4.6-trillion in 2022, up from R4.5-trillion in 2021. Although GDP reached an all-time high in 2022, the economy has only grown by 0.3% from the 2019 pre-pandemic reading of R4.58 trillion. This lags the 3.5% rise in the country’s population over the same period.
THE WINNER: Agricultural activities were robust in the face of the pandemic. The industry grew strongly in 2020 while many other industries faltered, following up with further gains in 2021 and 2022. The finance, real estate and business services industry also recorded growth figures for all three years, although not as strong as agriculture.
THE LOSERS: Seven of the ten industries contracted in the fourth quarter. The finance, real estate & business services industry shrank by 2.3%. This was on the back of lower economic activity in financial intermediation, insurance & pension funding, and auxiliary activities. As the finance, real estate & business services industry is the largest industry in the South African economy, the 2.3% decrease was the biggest factor behind the decline in GDP. Six industries have yet to recover to their pre-pandemic levels of production.
GDP is computed from data gathered from ten industries. The ten industries are grouped into three sectors. The three-sector model consists of the Primary Sector, the Secondary Sector, and the Tertiary Sector. To remove the effect of inflation, GDP is measured at constant 2015 prices.
THE PRIMARY SECTOR: This sector represents companies that are engaged in extracting natural resources, like agriculture, and mining. (1) Agriculture, forestry, and fishing – QoQ growth, seasonally adjusted, decreased by 3.3%. This was primarily due to decreased economic activities reported for field crops and horticulture products. The agricultural sector is volatile, but because it is so small it shaved only 0.1 percentage point off the quarterly growth rate. (2) Mining – QoQ growth, seasonally adjusted, decreased by 3.2%. Decreased economic activities were reported for diamonds, iron ore and platinum group metals (PGMs). For 2022, the mining sector was the biggest drag on growth.
THE SECONDARY SECTOR: This sector covers all those activities consisting of the processing of raw materials, like manufacturing and construction industries. (3) Manufacturing – QoQ growth, seasonally adjusted, decreased by 0.9%. The food and beverages division made the largest contribution to the decrease in the fourth quarter. The basic iron and steel, nonferrous metal products, metal products and machinery division also made a significant contribution to the contraction in this industry. (4) Utilities – QoQ growth, seasonally adjusted, decreased by 1.9% in the fourth quarter, largely due to decreases in electricity and water consumption.
(5) Construction – QoQ growth, seasonally adjusted, increased by 0.5%. Increases were reported for non-residential buildings and construction works. Construction has been decimated. Of the ten industries, construction is in the worst shape, remaining 23.1% smaller than what it was before the pandemic. In fact, construction’s woes started way before COVID-19. A shadow of its former self, 2022 marked construction’s sixth consecutive year of economic decline. One of the contributors to this poor performance is the damage done by the Construction Mafia. The head of the infrastructure office in the Presidency of South Africa from November 2019 to 2023 was Dr Kgosientso Ramokgopa, reporting directly to the president. He will now fill the role as minister of Electricity in the Presidency. Under his watch, the construction industry declined every single year. Now he oversees the important Electricity industry. The infrastructure office in the Presidency has disappeared from the list of offices in the Presidency. Minister of Public Works and Infrastructure in the cabinet is Sihle Zikalala. Infrastructure is our smallest industry, but it should not be seen as a minor industry – it deserves red carpet treatment.
THE TERTIARY SECTOR: This sector consists of the provision of services instead of end products. Two industries, no. 6, and no. 8 below, were the biggest disappointments of the quarter. (6) Trade, catering, and accommodation – QoQ growth, seasonally adjusted, decreased by 2.1%. Stats SA attributes the weakness in the trade, catering, and accommodation sector to weaker wholesale trade. (7) Transport and communication – QoQ growth, seasonally adjusted, increased by 0.7%. Increased economic activities were reported for land transport, air transport and communication services. (8) Finance and business services – QoQ growth, seasonally adjusted, decreased at a rate of 2.3%. Decreased economic activities were reported for financial intermediation, insurance and pension funding and auxiliary activities. This sector is the largest sector in the economy. (9) Personal services – QoQ growth, seasonally adjusted, increased by 0.2%. Increased economic activity was reported for community services. (10) Government – QoQ growth, seasonally adjusted, decreased by 0.7%, mainly due to decreases in employment numbers in national government, extra-budgetary institutions, and local government.
BOTTOM LINE: Economists expect the economy to soften from a 2.0% GDP growth in 2022 to a meagre 0.4% in 2023 before gradually recovering to 1.4% next year and 1.6% in 2025. The most significant threat to economic stability is the ongoing power shortage, which according to economists’ forecasts, has effectively pushed the economy into a two-quarter technical recession between Q4 2022 and Q1 2023. Should intensified load-shedding persist, a prolonged recession will be likely. Private sector fixed investment growth will be curtailed, threatening the job market recovery. Slowing global growth, especially from South Africa’s major trading partners, and logistical constraints (Transnet and the harbours) could constrain export volumes, further depressing economic growth and government revenue. 2023 will be a tough year, but there is light at the end of every tunnel. Some tunnels just happen to be longer than others. To guide you through the tunnel, stay calm and contact one of our professional consultants. Source: Stats SA, Bureau for Economic Research
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Reference: Datastream, GDP and debt to GDP – ECR Research
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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