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Global Report
Reconciling the global equity rally.
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Local Report
Food retailing.
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Global Report: Reconciling the global equity rally
By Nick Downing
Given the gloomy analyst forecasts at the start of the year, it may surprise many that the MSCI All Country World Index is up year-to-date by 13% (in US dollar terms). A lot of the rally has been centred around a handful of giant US technology stocks that are believed to be the big winners in Artificial Intelligence. However, the rally is broadening across other shares and other regions.
The broadening global equity rally appears at odds with the near consensus forecasts of impending recession. Recessionary signals are widespread. Inverted yield curves suggest central banks have over-tightened interest rates. They indicate sharp interest rate cuts to come as the delayed impact of rate hikes take their toll. Oil and commodity prices are weakening. Credit conditions are tightening, and credit demand is weakening.
The rally might be attributed to growing confidence that central bank interest rates are close to their peak. After all, inflation has already peaked and is gradually declining. US consumer price inflation receded in May to a more than two-year low of 4.0% year-on-year, down from 4.9% in April. However, the detail behind the data is less straight forward. Most of the decline is due to sharply falling energy prices. Core inflation, excluding food and energy prices, dipped by far less from 5.5% to 5.3% and maintained its month-on-month increase of the prior two months at 0.4%. Core goods prices, which fell steadily in 2022 as supply chains were repaired, have reaccelerated rising in both April and May by 0.6% on the month. Core services inflation, scrutinised by the Federal Reserve, due to its close association with wage pressure, remained firm at 0.4% on the month the same increase as in April and March.
Inflation is clearly stickier than most had predicted, including the Fed and most central banks. In acknowledgment, the Fed at its latest policy meeting on 14th June increased its projected terminal fed funds rate yet again. This is the fourth upward revision in the current monetary tightening cycle. Most Fed participants now project a further 50 basis point increase will be needed before year-end.
Yet, sticky inflation may be a key reason behind the global equity rally. Inflation lends pricing power to companies. During the first quarter in the US, 78% of companies representing the S&P 500 index beat consensus earnings forecasts and earnings projections are being ratcheted higher. Independent global investment research firm, Alpine Macro believes “relatively high inflation may offer some protection to nominal earnings.” Earnings are always reported in nominal terms unlike GDP data which are always reported in real terms after adjusting for any distortion caused by inflation or deflation. According to Alpine Macro, since corporate revenue and profits are nominal variables, rising prices should help rather than hurt corporate profitability. Indeed, nominal GDP is a close proxy for corporate revenues. Nominal GDP growth can remain positive even when the US economy enters recession, especially if it is shallow and short-lived as most analysts are predicting.
Recessions in the 1970s and 1980s were severe, but earnings per share drawdowns were much milder than those in recent decades when low inflation prevailed. Alpine Macro makes a strong case: “Assuming a mild (US) recession reduces annualised real GDP to 0% and inflation falls by an additional 150 basis points by year-end, nominal GDP would still be growing at around 4%, which is the same as the average nominal growth rate during periods of normal economic expansion since the Global Financial Crisis. Moreover, operating earnings per share growth was 12.3% during this period.”
The caveat to the constructive outlook is that inflation does not reaccelerate. Equity markets should remain buoyant even if inflation is sticky at around 4% but a reacceleration, although unlikely, would be met with another damaging cycle of central bank tightening.
Local Report: Food retailing
By Gielie Fourie
INTRODUCTION: Food retailers are struggling, some more than others. There are several reasons for this. The food market is competitive – increased competition leads to thinner profit margins. Consumer preferences changes and new shopping habits are continually evolving. Other factors include increased online competition, higher operating costs, supply chain disruptions, and changing market dynamics like economic fluctuations, inflation, and changes in government regulations. In South Africa we can add loadshedding, and our strict labour laws. The four largest supermarket retailers have spent nearly a combined R3 billion on diesel over the last nine months to enable them to run generators so they could trade through the near-constant loadshedding. The Covid pandemic lockdowns that started three years ago in March 2020 were a severe setback. The share prices of only two of the big four food retailers, Shoprite, and Woolworths (Woolies), have returned to pre-Covid levels. We look at three large retailers with exposure to food retailing.
SHOPRITE: Shoprite Holdings, with its combined subsidiaries, is the largest fast-moving consumer goods (FMCG) retail operation on the African continent. The group enjoys a presence in 16 countries across Africa through its various brands including Shoprite, Checkers, Usave, OK, House & Home and Hungry Lion.
For the year ending 30 June 2022, Shoprite’s core South African supermarket segment, which accounts for 80% of its sales, increased sales by 10.1%. For the 26 weeks ended 31 December 2022 Shoprite’s total sales increased by 16.8% to R102 billion (2022 R91 billion). HEPS was up 10.2%. To achieve this in an economy that grew by only 1.9% in 2022 is outstanding. Its on-demand one-hour delivery app Checkers Sixty60 continued to innovate and grow its sales. Shoprite is trading at R227.00. It has a market capitalisation of R135 billion, a PE ratio of 20.50x, a dividend yield of 2.70%, a return on equity of 24%, a return on assets of 9.75% and a Price/Book ratio of 4.8x. The share price is up 118.67% over the last three years, well above pre-Covid levels. The consensus forecasts of analysts consider it as a Hold.
SPAR: Spar was hit by a perfect storm. It experienced a wave of negative publicity in 2022, including allegations that it manipulated the value of stores – the standards of its governance were questioned. The board said it takes allegations of fictitious and fraudulent loans extremely seriously. SPAR denied allegations of ‘dodgy’ accounting. It led to a board shakeup in January 2023. CEO Brett Botten stepped down at the end of January 2023, while the chairperson, Graham O’Connor, departed in February 2023 amid reports of fictitious and fraudulent loans, and ‘dodgy’ accounting. The non-executive chair, Mike Bosman, took on the role of Executive Chairman and “very short-term” interim CEO to strengthen governance. A permanent CEO has not yet been appointed.
Spar’s operations in Poland came under pressure due to increased competition and rising costs. Spar Poland is lossmaking. Of the 180 Spar stores in Poland, 58 stores left the group in 2022. The Russia-Ukraine war added to its woes. Poland shares a border with Ukraine. Spar only expects its Polish venture to breakeven in 2024. Spar’s implementation of SAP software at its KwaZulu-Natal distribution centre was a disaster. The group suffered R786-million in lost wholesale turnover in the six months to end-March 2023. Implementing new software carries risks. Loadshedding has cost Spar more than R700-million in diesel for generators over the latest six-month period. Spar announced on 1 June 2023 that it expects its HEPS for the six months to March to decline by between 25% and 35%. Spar is trading at R103.00. Spar has a market capitalisation of R20 billion, a PE ratio of 8.89x, a dividend yield of 3.88%, a return on equity of 15.91%, a return on assets of 4.54% and a Price/Book ratio of 1.89x. The share price is down 40.04% over 3 years, still far below pre-Covid levels yet the consensus analyst forecast is a Buy.
WOOLWORTHS: Roy Bagattini, former executive vice-president of Levi Strauss, took over from Ian Moir as group CEO of Woolies on 17 February 2020. In December 2022 Woolies finally sold its Australian operation, David Jones, that it acquired in 2014. The sale removed about R22 billion of debt or liabilities associated with the purchase of David Jones from the balance sheet. The share price was R70.00 in 2014 when it acquired David Jones, the same price that it is today.
The sale of David Jones changed Woolies’ financial profile significantly. The balance sheet has been transformed – it is the strongest it has been for the better part of the last ten years. Profits have improved – for the six months to the end of December 2022, Woolies reported its biggest first-half profit ever. Dividends are up by almost 100%. After dividends have been paid the total cash position is so healthy that Woolies has implemented a programme of share buybacks. 90% of Woolies stores have backup power. Roy Bagattini has proved his skills as a turnaround specialist. Over the last three years the share price is up 109.7%, well above pre-Covid levels. Woolies shares are trading at R71.00. It has a market capitalisation of R70 billion, a PE ratio of 16.39x, a dividend yield of 4.29%, a return on equity of 44.70%, a return on assets of 10.59% and a Price/Book ratio of 5.39x. The consensus analyst forecast consider Woolies a Buy.
Please use this information as a reference only, rather than as a basis for making investment decisions. To take the emotion out of investing, you are welcome to contact one of our friendly consultants for a free consultation.
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Reference: Capital Economics – Historical bond and equity return data.
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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