Rand hedges versus SA Inc: Where to lay your bets

By Nedgroup Investments

Neville Chester, Portfolio Manager at Coronation Fund Managers, discusses whether we should be taking our money offshore via the Rand hedge stocks that earn most of their revenue from offshore countries and markets or if we should be tilting our portfolio to more SA Inc, domestic companies that generate most of their revenue from South Africa.

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This is an almost daily debate at Coronation. Part of the success of Coronation’s Top 20 return in 2020 was being heavily overweight the Rand hedge shares and underweight domestic shares. We are cognisant of what’s happened in markets where valuations have come down considerably and at the margins and resilience of some of the SA Inc shares. Having said that, we’re overweight the Rand hedge shares. This is not a view on global shares per se. In our multi asset funds, we’ve been reducing our developed market weighting in favour of increasing our SA equity exposure.

What’s attractive in terms of Rand hedges?
Within the SA equity exposure, there are two buckets we think are still attractive. The first is mining shares. We’ve been overweight resources for many years in our portfolios, with phenomenal returns over the last 2-3 years. This is a sector that has had significant underinvestment for many years, which means this cycle is very different to some of the previous commodity cycles we’ve seen. Due to the underinvestment, we still see significant shortage of supply coming into the market. Even though demand continues to grow, you haven’t seen massive increase in supply and even if some of those mining companies pulled the trigger today to start new mines, the leads and lags are typically 5-7 years before any supply comes on to the market. Across the key commodity baskets, we are still seeing continued deficits for the majority of these companies that trade on the JSE, like Glencore and Anglos, and think that the prices should stay high for quite a bit longer. In addition, these companies are not taking the cash generated from good markets and building new mines, but are returning it to shareholders. In an environment where a lot of shares are not paying dividends at the moment, particularly some of the domestic shares, which are under a bit more balance sheet stress and are worried about the economic environment, these companies are returning the cash to shareholders. The majority of these companies are on very significant free cash flow yields, so we still think that Rand hedge of resources is attractive and we remain very overweight some of the key holdings in our portfolios.

The second bucket is global companies listed on the JSE. We think global markets are looking quite full, but think that specific shares listed locally have meaningful upside. This includes Naspers where we’re sitting with a significant discount in that structure, which we think management is working to unlock and hope to see something in the near future in that regard. That on its own could release upwards of R400 billion of trapped discount into the domestic market. Some of the more unexciting, but solid, cash generative companies like British American Tobacco continue to pay good cash dividends in an environment where some other companies are constrained from doing so. Quilter, which was unbundled out of Old Mutual, is a UK platform business and you will see it in Top 20 in our domestic holdings. These are capital light businesses that are still generating meaningful profits and able to pay this back to shareholders. Quilter trades at a huge discount compared to some of the other UK platform businesses. Now that it’s implemented its major system review, we expect the share price and business to do really well. Aspen is a home-grown business, which is domiciled in SA with its head office here, but it has a big emerging market footprint on the pharmaceutical side. It has fixed its balance sheet and is well positioned to benefit from the vaccine rollout in terms of increasing the throughput in its SA facilities. We think it’s got a very interesting and attractive growth profile.

On the domestic side, we acknowledge that there is a price for every asset. Through this period of crisis, we took the opportunity to buy what we think are higher quality businesses. We increased our holdings in some of the FMCG businesses, including Shoprite and Spar that managed to grow profits through this environment and were able to pay good dividends to shareholders. South Africa at the moment is not attractive on the global investment stage. Domestic funds are largely sellers of equity. The UIF had to be a big seller of equities in order to pay claims. We’ve got a shrinking formal savings pool, so to see domestic equity markets take off, you do need the marginal foreign buyer and they’re just not interested at the moment with more attractive growth profiles elsewhere. You should position yourself with companies who can generate good cash flows and pay that back to shareholders.

What are the prospects for South African banking stocks?
Bank stocks are cheap and we don’t think they can generate superior returns in comparison to some of the other opportunities in the market, so we are underweight in banks. Banks delivered in a very tough environment and came out with very good results. But, given the size of the banking industry in South Africa, they are inherently linked to economic growth. If you can’t see an environment where the economy is going to grow meaningfully, it’s very hard to see how the banks are going to achieve growth significantly ahead of that.

What are the expected returns for equities over in the short term?
We are optimistic on the returns that the JSE is going to deliver. We think broadly that assets are cheap. Domestic shares, resource shares and specific global shares are all cheap. We’ve increased our allocation to domestic equities and reduced our global equity. The remarkable returns globally have been driven by this wash of liquidity, which South Africa hasn’t benefitted from yet and in fact has gone the other way. In our 3 to 5-year forecasts we are looking for 12%-15% potential market return and the ability for alpha to add a couple of percentage points on top of that. After a decade of mediocre and 5 years of very poor returns from domestic equities, we are quite optimistic on the future outlook for the SA equity market.