Weekly Market Report

17 October 2023

Global Report

Enter the Dragon.

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Local Report

October – Transport Month, and Motus Review.

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Market Indicators

Global and Local Indicators.

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Global Report: Enter the Dragon

By Nick Downing

We are in the year of the Rabbit, which for China’s CSI 300 equity index has not been especially auspicious. The index has dropped 6.4% year-to-date, amid extreme negativity from global investors. The property market is depressed, Xi Jinping is steering towards increased socialism, and the post-Covid recovery has fizzled. Jinping cemented his leadership for an unprecedented third 5-year term last year. His most controversial policies include crackdowns on the private sector, in particular internet, gaming, and online education. He has also forced the deleveraging of China’s all-important property sector, which comprises an estimated 74% of household wealth. The policy has burst China’s property bubble. The pre-financing model used by property developers, which required prices to keep rising, has been broken. Property developers have been going insolvent, starting with the giant, Evergrande two years ago, and most recently Country Garden, the largest in the private sector with about $200 billion in liabilities is struggling to survive.

It is ironic that foreign investors have been clamouring for years for a restructuring of China’s economy away from its dependence on property and infrastructure investment spending. Now that it is happening, there appears to be little applause despite the obvious tilt to a more sustainable consumer led economy. Foreign investors have been pulling out of China at a record pace. Yes, the property market is depressed. Housing sales are 22% down from last year and new housing starts down by 29%, while the inventory of unsold homes is at an all-time high, signalling a long adjustment ahead. Yet, property prices have not crashed. They are only 5-10% below their peak and while new home sales have collapsed, existing home sales are only down by 10-15%. The deleveraging of China’s property sector is far more controlled and less damaging than the US property crisis in 2008/09.

With the property sector in the doldrums, which traditionally comprises 25% of GDP it is no surprise the post-Covid recovery has been weaker than expected. Exports, key to China’s growth, have also contributed little due to weakening global demand. This is a cyclical factor beyond China’s control. Meanwhile domestic industrial and consumer demand is showing signs of picking-up. Official manufacturing and services purchasing managers’ indices (PMIs) gained ground in their August readings: Manufacturing from 49.7 to 50.2, above the expansionary 50 level for the first time since March and Services from 51 to 51.7. Both the official and independent composite PMIs, comprising all economic sectors, have been in expansionary mode for nine successive months. GDP growth is on track to meet the government’s 5% target in 2023. Next year’s growth is expected to slow as the country continues to adjust to a more sustainable consumer led growth model. The World Bank and IMF forecast growth of 4.4% and 4.2% respectively in 2024, far slower than in previous years but nonetheless solid in the global context.

The greatest hindrance to investor sentiment must be government’s ideological pivot from market-oriented growth to the “common prosperity” and increasingly isolated “new whole-nation system.” Government’s private sector crackdowns have undermined domestic business and consumer confidence, as well as foreign investor sentiment. It is clear though that Beijing cares very much about economic growth and like previous governments will not be too proud to admit past mistakes. Independent research firm Alpine Macro reminds us that “The Communist Party has engineered massive directional changes in its ideologies throughout history. Beijing is aware of the damage to the private sector and has been trying to revive business confidence. It is premature to conclude that the current left turn is permanent.” Deng Xiaoping’s famed “southern tour” in 1992 and Jiang Zemin’s “Three Represents” theory in 2000 are key examples of policy adjustments that unleashed dramatic growth.

Xi Jinping’s government is quietly promoting the stock market as an alternative source of wealth for households. There has long been a negative correlation between the performance of property prices and the performance of the stock market. They have rarely performed well at the same time but as one declines the other tends to pick up the slack. They have traditionally been competing asset classes. With property accounting for 74% of household wealth, above any other country in the world (US:52%), and financial assets making up only 11% of household wealth compared with an average of 30% or more in other countries, there is scope for a significant pendulum swing. There have been 200 new listings on the Shanghai Stock Exchange this year, with particular focus on new economy sectors, including semiconductors, biotech and electric vehicles, hi-tech manufacturing, and renewables.

China is already a global leader in Artificial Intelligence. AI is set to have a transformative effect on economic growth with the benefit of enhanced productivity. Today, Chinese technology giant Baidu unveiled the newest version of its generative AI model, Ernie 4.0, claiming that its capabilities are equal to those of ChatGPT’s latest model. Meanwhile, China’s renewable energy and Electric Vehicle markets are booming. China is the undisputed leader in the EV market representing 60% of global sales. 30% of the cars on China’s roads are EV.

It is often worth considering a contrarian investment position, especially when there is such overwhelming negativity. Alpine Macro says “Recall lessons of the late 1990s Asian crisis: panic produces the best bargains long before the crisis ends… The best bargains were available in the first year of the crisis, 1997.” As the year of the Rabbit ends on 9th February, the year of the Dragon, the rarest and most auspicious of all Chinese zodiac signs will be expected to usher in a period of luck, success, and good fortune.

Local Report: October - Transport Month, and Motus Review

By Gielie Fourie

TRANSPORT MONTH: Since 2005, October is Transport Month in South Africa. Transport Month is about showcasing service delivery and reminding the nation of the significance of transport in our daily lives. Naamsa is a pre-eminent industry representative that represents the interests of local vehicle manufacturers and assemblers. Naamsa hosted the South African Automotive Week (SAAW) from 11-13 October 2023 at the Gallagher Convention Centre in Midrand.

VEHICLE EXPORTS AND SALES: Various external business factors, including higher fuel prices, high inflation, ongoing challenges in transport logistics, Eskom’s incapacity to meet industry’s energy demands, the volatility in commodity prices, and the intricate external environment, have exerted significant pressure on the automotive industry. Despite these challenging conditions, the industry has displayed a modest yet commendable resilience from January to September this year. Vehicle exports for the year-to-date (YTD) are 8.3% ahead of the same period last year, at a total of 285 200 units. New vehicle sales for the YTD are 2.5% ahead of the same period last year, recorded at 401 315 units. Although the South African Reserve Bank maintained the repurchase rate at 8.25% in September 2023, the automotive industry continues to grapple with concerns over consumer affordability.

ECONOMIC CONTRIBUTION OF SA AUTOMOBILE INDUSTRY: The automotive industry contributes 4.9% to GDP. In 2022, the export of vehicles and automotive components reached a record amount of R227 billion (bn), equating to 12.4% of South Africa’s total exports – the industry accounts for 21.7% of the country’s manufacturing output. Vehicles and components are exported to 152 international markets. The industry is responsible for approximately 457 000 jobs.

MOTUS: We hold Motus for our clients. The year ending June 2023 was a special year for Motus. For the first time sales for the year crossed the R100 billion mark. Sales were R106bn for the year, up from R92bn the previous year. Motus sells Hyundai, Kia, Mitsubishi, and Renault vehicles. Toyota is by far the top seller in SA, Motus is second and Volkswagen (VW) third. Toyota sells more passenger vehicles than Motus and VW combined. YTD Toyota sold, with last year’s figures in brackets, 104 300 (91 716) units, Motus 57 595 (69 077) units and VW 49 567 (52 810) units. This includes all vehicles from passenger and commercial vehicles to buses. Vehicle sales are cyclical and have been in a downward cycle for seven months, and the fact that interest rates and inflation were high did not help. At the end of September, on a 3-month moving average, total new vehicle sales were down 2.0%.

Motus has recently published its financial results for the year ending 30 June 2023. While Motus’ results were mixed, they were achieved in a difficult financial year for the vehicle industry. There was a slowdown in vehicle volumes. Motus’s slowdown in sales and high debt levels are a concern. Key financial highlights: revenue was R106bn, profit before tax was R4.3bn, 3% down from 2022, net asset value per share was R101.89, up 25% from 2022, diluted headline earnings per share were R19.63, a little up from R19.25 per share last year, and the dividend was R7.10 per share, the same as last year. Debt increased from R4bn last year to R12bn in 2023. The net debt to equity ratio is high at 77%, up from 36% last year. This is a concern – we prefer companies with low debt levels. The reasons for the significant increase in debt include higher working capital levels – up from R7bn to 14bn, re-fleeting of rental vehicles – rental vehicles were de-fleeted during Covid-19, and debt incurred to finance acquisitions and capex.

As indicated above, net debt to equity is high at 77% – it has doubled from 36% last year. To understand, and visualise debt better, we also compare debt with annual profits. Last year debt was standing at R4.2bn, while annual profits before tax was standing at R4.4bn. On paper, Motus could pay off the capital portion of its debt within one year. In 2023 profit is still R4.4bn, but debt has jumped by R8bn to R12bn. Although the debt-to-equity ratio has doubled, debt has tripled. On paper Motus now needs not one year, but three years’ profits to pay off the capital portion of the debt. It is a comparison that is easy to understand. The extra R8bn borrowed to grow the business did not generate additional profits. We will monitor Motus closely.

BOTTOM LINE: Transport is a big industry. Transport month is a commendable initiative – it covers four modes of transport – roads, railways, airlines, and shipping. Unfortunately, all four modes have been shoddily managed by government. Our sole investment in the transport industry is Motus. Motus supplies mainly entry level vehicles to the market. It is a big, lucrative market. Motus is much bigger than its listed peers, Combined Motor Holdings and Zeda, combined. In addition, it is the only company with offshore exposure. Motus must just watch its growing debt levels. Sources: Naamsa, Motus.

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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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