August 2019 Update

Making the News

Investors remain cautious towards SA assets due to their concerns for the economic outlook of the country given the on-going challenges at State-Owned Enterprises, specifically at Eskom. Abroad, threats of additional tariffs on Chinese goods continues to create a volatile environment for emerging markets in particular and as a result, growth assets ended August in the red.

After shrinking sharply in the first quarter of 2019, the South African economy rebounded from a low base to record positive growth of 3,1% in the second quarter. Mining, finance, trade and government services were the main drivers of growth while construction, agriculture and transport detracted partially.

As confidence is low and economic growth sluggish, we look at an article written by JP Landman (an experienced and capable political analyst) which highlights the imperative changes we have already seen by the Ramaphosa administration (which seems to have gone by unnoticed).

Digesting the News

As human beings, it is natural to look at head-lines and allow those to deter us from our long-term goals. While we know that the current gloomy economic backdrop does raise questions if staying invested is the right decision, we need to filter through the media noise and find factual information to make informed decisions going forward.

As our readers know, we are cognizant of Eskom (locally) and trade tensions globally as we have touched on them in every monthly wrap up over the last year. While we cannot predict the future, we can assess how our country has improved, what changes have been made by our new president and his administration, and therefore apply prudence when constructing our portfolios.

Firstly, on the point of our country improving, we have seen positive economic growth in the second quarter. GDP in Q2 was up +3.1% with 7 out of the 10 main industries appearing in the green as the chart below indicates.

The negative agriculture figure for the quarter may be a surprise following healthy rainfall in the second quarter. However the main reason for this was the lower field crops and horticultural products (i.e. gherkins and tomatoes, etc.). This resulted in a 4.2% decline from the previous quarter. The other large negative was the 1.6% decline in the construction sector on the back of limited activity in non-residential property and heavy construction works.

Conversely, the biggest winner in the second quarter was the cessation of load shedding which hampered all industries (particularly Mining and Manufacturing) in the first quarter. Other prominent industries which added to the robust second quarter GDP growth was the General Government which was temporarily boosted by higher employment for national elections in May. The second quarter turnaround leaves GDP growth virtually flat for the first half of 2019. Although not where it needs to be, we are not in recession.

Given the factual data of our country improving in the second quarter of 2019, we now look at some structural changes that President Ramaphosa has implemented over the course his presidency to date. These facts have been summarized from the Act 1 article by JP Landman highlighting the important changes made so far. For the purpose of keeping our wrap up concise, we have taken the five main changes that have occurred during the period. These are:

1. Reclaiming the country from the forces of State Capture

Four commissions of enquiry – two are still in session

• Zondo Commision
• The Mpati Commission into the PIC

2. Cleaning up SARS

• Tom Moyane and Jonas Makwakwa are gone.
• Ms Makheke-Mokhuane (Head of IT) is gone.
• The appointment of Edward Kieswetter as the new SARS Commissioner.
• In the last week of July, three SARS executives were suspended.

3. National Prosecuting Authority of South Africa

• The appointment of Director Batohi (a woman with experience at the International Court in the Hague) who took office in February.
• In March, a special investigative unit to focus on cases arising from state capture revelations was formed. Hermione Cronje (a well-known corruption prosecutor) was appointed in May to lead this new unit.

4. A serious clean-up at Eskom

• Brian Molefe, Anoj Singh, and Matshela Koko are gone.
• Brian Molefe needs to repay R10 million to the Eskom Pension Fund.
• 365 managers were subject to lifestyle audits (44 cases have been referred to special investigation)
• More than 1 000 disciplinary cases were instituted (116 employees resigned including 14 senior executives)
• Of 25 employees who had “business interest in suppliers dealing with Eskom”, 7 resigned and the rest terminated their interests.

5. Public Investment Corporation

• New board has been put in place
• CEO and two senior executives are gone (and a number on suspension)
• New chair: Reuel Khoza

There are more positive changes that have been made which the article discusses in greater detail. In addition to the changes listed above, another prominent one has been the change to the President’s cabinet which now consists of 28 members (at most five of those can be described as Zuma- or Magashule-supporting).

Markets in the Month

As mentioned above, EM assets/currencies continue to bear the brunt of the volatility offshore. The Rand depreciated around 6.6% against all major currencies in August as the escalating US-China trade war weighed on emerging-market assets, while Eskom’s troubles made investors wary about South Africa’s fiscal outlook. Over the last year, the Rand remains weaker against the Dollar but is stronger against the Pound and Euro.

Locally, growth assets struggled with SA Equity and Listed Property down -2.4% and -3.6% respectively. Relative to other emerging markets, South Africa struggled during the month due to changes in index weights which caused about $1.4bn worth of outflow from our equity market.

Despite global equity (measured by the MSCI AC World) delivering a robust return in August of +4.9% in Rands, this was a function of the weaker Rand as the market was down -2.0% when measured in USD, as the escalation of trade tensions steered investors away from risk assets.

Bonds and Cash delivered +1% and 0.6% respectively during the month. Key risks towards the fixed income asset class remain the credit rating agencies (Moodys & Fitch) assessment on our sovereign rating given that the debt burden will continue to grow as some State-Owned Enterprises apply for additional government funding and bail-outs. Markets are looking at how Tito Mboweni and Pravin Gordhan manage the budget and the debt of the SOEs, with news related to the turn-around  strategy expected in the coming months.

Impact on Our Portfolios

Three of the CWM multi-asset models were down during the month because of the softer equity and listed property markets, however CWM Defensive and Flexible were both up +0.5%. In the low equity space, three of our five managers within the CWM Defensive model were up with the best performer being the Nedgroup Stable fund given the fund’s exposure to the R186 SA Bond (c. 26.7%) and the NewGold ETF (c. 4.0%).

The CWM Flexible model on the other hand was boosted during the month due to our Foord and Truffle holdings within the portfolio. These funds have high offshore exposure and therefore taking into account the significant weakening of the Rand during the month, it is no surprise that these funds delivered +3.9% and +2.1% respectively.

Looking at our models holistically, we note that CWM Retirement Growth and RI-Growth continue to struggle in the short term given the allocation to property within those models. Our CWM Balanced fund has had a tough period of performance over the last few months with exposure to Allan Gray Balanced, PSG Balanced, and Bridge Managed Growth hurting performance.

5 Year Returns (p.a.) CWM Local Model Portfolios / Foreign Strategies

Given the recent recovery in growth assets in 2019, our models have participated in a reasonable amount of the upside (on average are up +3.8%). We are reasonably satisfied with the performance of the CWM portfolios versus peers over the last five years, despite the modest absolute returns shown above. Only CWM Retirement Growth and CWM Defensive have lagged their respective peer group averages over this period, largely dragged lower by the exposure to the SA Listed Property sector.

Given the significant depreciation of the Rand during the month versus major currencies, the performance of our Foreign Houseviews (HV) were very good in Rand terms (up 4.9% on average). YTD performance also remains robust, with Foreign Balanced and Equity generating +14.8% and +20.7% respectively.

A bias towards growth assets is essential for investors with a long-term time horizon in order to ensure outperformance of inflation over the long-term. Current projections for the next 5 to 10 years from growth assets are very attractive compared to inflation and are expected to be better than returns seen in the last 5 years.

Looking Forward

We continue to encourage clients to assess performance throughout a full market cycle. With SA equity (+4.7% p.a.) and SA listed property (+3.6% p.a.) both delivering less than 1% above inflation (before fees) over the last five years, it is understandable why many SA based investors feel disheartened having endured an extended period of seeing their wealth struggle to grow in real terms. When one looks at the 15 year average returns of local growth assets, patient investors have seen their wealth grow in excess of inflation by +9.7% (SA equity) and +11.2% (SA listed property) per annum which importantly includes the last 5 years’ lacklustre return environment.

While we know that current sentiment is negative towards SA assets, this provides attractive valuations on most SA shares trading on the JSE and therefore attractive future returns . This is well illustrated in the exercise done below on five local shares; namely: Investec Plc, AECI Ltd, Aspen Pharmacare Ltd, Sappi Ltd, and Tsogo Sun Gaming Ltd.

SA Equities Are Attractively Priced

The reason we chose these shares is because they are well run businesses with long-term track records dating back to March 2004 (common for all five shares giving a data set of just over 15 years) and are currently trading at Price Earnings (PE) ratios significantly below their long-term averages as at end of August 2019 (simply put these shares are very cheap to buy). Importantly, these shares are included in the Allan Gray Funds (Tsogo Sun Gaming priced for 166% upside to reach fair value) and Coronation funds (Aspen priced for 265% upside to reach fair value) to name a few which are included in some of the CWM models.

The exercise looks at an investment horizon of 10 years and assumes these shares simply revert back to their long-term averages over that time period. The result is an expected return of about +19.6% per year if we held the five shares equally in a portfolio. This is before including the nearly 6% in dividends, which would push the potential annual return over 25% p.a.

To illustrate the extreme level of the current prices, if you had a hypothetical portfolio of R1 000, and invested half the portfolio (R500) in a basket of attractive opportunities with an expected return of 19.6% p.a., and the other half R500 loses all its value and goes to zero, the overall portfolio would still grow to R2 981 after 10 years. This represents an annual return in excess of 11% per year over the next 10 years. Taking into account a ten year inflation number of 6%, a real return of about +5% is achievable. This is well above what can be expected from cash over the long-term and illustrates the importance of ensuring investment decisions are based on when researched facts without getting caught up in peripheral noise.