Bateleur Flexible Prescient Fund 2018 3rd quarter report back to investors
1 Bateleur Flexible Prescient Fund 2018 third quarter report back For the nine month period to end September, the fund returned +3.8% net after fees. This compares to the JSE All Share Index that declined 3.8% (including dividends reinvested) over the same period. In terms of other major asset classes, a basket of SA bonds (ALBI) gained +4.8%, while cash (STeFI) returned +4.9%. Investors appear to have finally lost patience with the economic recovery potential of SA, as evidenced in the decline of the JSE over the review period. Although the sell-off has been in tandem with other emerging markets due to the rising interest rate environment globally, SA has fared especially poorly with the share prices of some prior stalwarts under notable pressure. While some of these companies have scored own goals through strategic missteps, others are suffering almost exclusively as a consequence of the weak domestic economy. Businesses can only cut costs, improve efficiencies and gain market share up to a point. If the overall demand for goods and services is not there, then unfortunately, it cannot be created out of thin air. Some of the more notable YTD share price moves* include Aspen down 50% and back to levels last seen in 2012, MTN down 41% and back to levels last seen in 2006, Tiger Brands down 41%, Imperial down 39%, Mediclinic down 38%, and Woolworths down 26%. The fund did not own any of these securities, although more recently has begun to accumulate a long position in Woolworths at depressed levels. A key difference this year, is that even with a weaker Rand, the traditional offshore/rand hedge shares have not come the JSE s rescue as they have done on so many occasions in the past. In particular, Naspers and British American Tobacco (BAT) have both fallen 25% and 20% respectively YTD*. Naspers has declined despite announcing long overdue plans on the unbundling of the video entertainment business (MultiChoice) and the potential future separate listing of the online classified businesses. The negative sentiment surrounding the share was on the back of Tencent reporting a disappointing set of results in its latest June quarter due to a regulatory freeze on new game launches in China and recently introduced legislation that will negatively impact the monetisation of its payments business. These factors serve a stark reminder of the regulatory risks facing big technology companies globally. Under different market circumstances, the Naspers unbundling announcement would have been favourably received and led to a narrowing of the rump discount underlining that in the short term, timing is everything! Naspers remains a core holding in the fund principally due to the material discount that it trades at relative to its holding in Tencent. We estimate that the share trades on a one year forward P/E multiple of less than 20 times earnings, with underlying earnings growing at a faster rate. The company has no net debt, has net cash on the balance sheet of over R100bn and is at the early stages of a multi-year value unlock process. *Pricing in ZAR as at 25 October 2018 10am.
2 Turning to BAT, the market appears to have decided that the end game is near for combustible tobacco companies based on the sharp de-rating of the share from approximately 20 times earnings three years ago to 12 times currently. This de-rating has occurred even with the company recently reiterating both its short and medium term upper single digit earnings per share growth guidance. Concerns for traditional tobacco companies such as BAT revolve around two issues. Firstly, regulators (such as the US Food and Drug Administration FDA ) are getting tougher on proposed maximum nicotine levels (the addictive part of combustible cigarettes) and secondly, the emergence of potentially lower health risk next generation smoking products ( NGP s ), comprising either vaping or heat not burn (HNB) products are expected to gain market share at the expense of traditional combustible tobacco. On the first point, industry experts largely agree that any changes to maximum nicotine levels will first require hard scientific evidence to implement. This is at least five years away and is therefore unlikely to impact tobacco companies cash flows over the medium term. The topic of NGP s is more complicated. While there are lower barriers to entry in the vaping market due to the lack of regulation (witness the sharp inroads that new entrants like JUUL have had in the US), the competitive barriers to entry in the HNB category are more pronounced (more capital intensive and technically more complex) and are in any event already dominated by the existing tobacco incumbents such as Philip Morris and BAT. Moreover, after an initial surge in demand for HNB products such as in Japan (led by Philip Morris s IQOS brand) where the category quickly gained traction to command a 20% share^ of the overall tobacco market, demand has subsequently tapered off, while the experience in other markets has not been as vibrant as in Japan. This led to Philip Morris recently revising its growth expectations lower for its NGP products in the short term suggesting that the traditional combustible cigarette category will be a slow and steady decline rather than a cliff edge event. Earlier this year we attended Deutsche Bank s consumer staples conference in Paris where many of the world s premier branded consumer goods companies presented including Procter and Gamble, Reckitt Benckiser, Unilever, Coca Cola, Colgate Palmolive, Nestle, Henkel, Heineken, AB InBev, and BAT amongst others. The incumbent staples companies are generally well run businesses with high operating profit margins and return on invested capital, however, many are currently struggling to grow volumes and have lost some pricing power. One of the reasons for this is that traditional marketing and distribution methods; that previously entrenched the dominant brand power of the majors, are now being displaced by alternative internet based marketing methods that are more targeted and cheaper, making it easier for new entrants to gain a foothold in the market at lower price points. An often quoted example of this changing trend is in men s grooming (a euphemism for shaving), a substantial $14.5bn global category* that for many years was dominated by Gillette. The Procter & Gamble subsidiary enjoyed strong pricing power and robust financial metrics as the industry behemoth, but ultimately became complacent. ^ Source: UBS research report dated 22 August 2018 *Source: Euromonitor
3 The attractive financial returns were noticed by a young upstart called Dollar Shave Club, that wanted a piece of this profitable category, and through a clever internet club or subscription based approach, at significantly lower price points ($2.25 for a similar quality blade to Gillette s $5.61 Fusion blade #), quickly took market share from Gillette. Gillette had to respond by lowering price points from its inflated levels to stay competitive, but the damage had already been done. Shaving is now a declining category for Procter & Gamble where it is estimated that they have lost a considerable 15% share* of the market in the US, while Dollar Shave Club was swiftly acquired by Unilever in 2016, in what was a very astute deal by the large multinational. This disruption is not limited to shaving. It is also taking place in personal care (where consumers are demanding organic products), home care such as washing detergents (where there is a backlash against plastic packaging) carbonated soft drinks (where organic and non-carbonated alternatives are sought) and even beer (where craft beer and healthier alternatives are making inroads). The mood of many of the speakers at the conference was somber as they grapple with these new challenges and especially the rate of change in the marketplace. The pressure that traditional combustible tobacco is facing from NGP s is no different to the challenges these other consumer goods companies are facing from new competitors, with two exceptions. Firstly, tobacco incumbents still have tremendous pricing power in their combustibles business due to the addictive traits of nicotine and smoking, and secondly, they are also active participants in the NGP space (i.e. they are willingly disrupting themselves). It is no coincidence that the tobacco companies presenting at the conference appeared more confident in their earnings guidance than many of their consumer staple peers. The fund continues to hold a meaningful position in BAT based on its attractive cash flow dynamics, steady upper single digit earnings growth potential and attractive valuation (12 times P/E multiple, 5.5% dividend yield), that in our view provide a sufficient margin of safety for both the regulatory and competitive pressures. Reiterating our position on SA domestic equities Our general stance on the SA domestic equity market has not changed since our prior quarter report back. In summary there are three points that make us constructive on select equities on the JSE despite the weak macro environment and uncertain political landscape. The first is that the operating profit margins of domestic corporates are well below trend. The second is that the P/E multiples of domestic equities are considerably below the long term average, and the third is that the balance sheets of corporates are generally in good health, as they wait for a more certain policy environment before deploying capital. This backdrop contrasts with many global developed equity markets where profit margins and P/E multiples are above trend, and corporate debt levels are high going into a rising interest rate environment. * Source: Euromonitor # Source: Business Insider July 21, 2016
4 The fund s domestic equity holdings are largely unchanged from the prior quarter, and remain centered on stock specific opportunities predominantly in the mid capitalisation space that are attractively valued and offer a reasonable margin of safety. These include Adcock Ingram, AECI, Afrox, Assore, Hudaco, Italtile, MPact, RMI, Supergroup and Tsogo Sun amongst others. The earnings profile of these companies are all positively geared to any recovery in SA GDP growth. A summary of the fund s positioning at end September 2018 is shown below. Strategy Exposure (%) Core long JSE listed equities 65.5% Core long foreign listed equities 14.1% Total equity exposure 79.6% Cash 20.4% Rand 19.1% Foreign 1.3% Kevin Williams Fund Manager James Easterbrook Head: Distribution
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