ALPHAWEALTH PRIME SMALL & MID CAP FUND COMMENTARY APRIL 2018 2 May 2018 AlphaWealth (Pty) Ltd. Reg. No.: 2004/026495. An authorised financial services provider - FSP Licence No. 13808. www.alphawealth.co.za
ALPHAWEALTH PRIME SMALL & MID CAP FUND INVESTOR LETTER APRIL 2018. 2 DOMESTIC VOLATILITY The AlphaWealth Prime Small & Mid Cap (AWSM) Fund was relatively flat for April 2018 (-0.28%) while the Small Cap Index rose only 0.9% and the Mid Cap Index (our benchmark) jumped 3.2% during this month. AWSM Fund is still beating both of these indices (along with the Top 40 Index) on a year-to-date basis. While we hold more small caps than mid caps in AWSM Fund, the Mid Cap Index s performance was driven by +7.1% jump in retailers and a +7.4% bounce in the beaten-up property stocks during this period. We have been strategically underweight retailers and domestic retail-focussed listed property for over a year. Although this has stood AWSM Fund in good stead over a number of time periods (the JSE Property Index is -14.3% YTD!), during April it counted against us. WHY WE DON T HOLD RETAILERS & RETAIL PROPERTY While we are optimistic on South Africa (and hope for a continuance in the rebound after the land debate is behind us we expect a positive outcome here), we remain negative on South African retailers and domestic listed retail REITs (i.e. property). This may sound like a contradiction but it is rooted in simple logic. South African listed retailers are currently trading on historically high margins (Figure 1) but both global competition is entering the domestic market and domestic retailers are steadily deploying capital outside of South Africa. The former should drive margins down via competition and the second is a vote against the fundamentals of the sector (if domestic retailers saw relatively better growth in their South African businesses, then they would be allocating capital here and not offshore). Figure 1: FTSE/JSE General Retailers Index Gross Margin History 40 35 30 All-time high margins 25 20 15 10 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Sources: Bloomberg & AlphaWealth workings Interestingly, domestic retailers have not just been earning excessively high margins, but they have been gearing their equity higher and higher to invest in incrementally worse assets (i.e. more and more marginal stores). This is best illustrated by showing the Debt:Equity ratio against the Return on Capital (not equity). Not just has debt (i.e. risk) been rising across our retail sector, but the yield on each incremental Rand invested has been dropping (i.e. returns).
ALPHAWEALTH PRIME SMALL & MID CAP FUND INVESTOR LETTER APRIL 2018. 3 Figure 2: FTSE/JSE General Retailers Index Debt:Equity Ratio & Return on Capital 70 60 50 40 Rising debt 30 20 10 0 Falling returns 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Debt:Equity (%) Return on Capital (%) Linear (Debt:Equity (%)) Linear (Return on Capital (%)) Sources: Bloomberg & AlphaWealth workings Against this background, the retail stocks are not actually cheap. They are expensive against their long-term averages (Figure 3) and, arguably, these long-term averages may, in fact, be inflated. The last decade s global interest rates falling, domestic unsecured lending boom and historically lower competition than their futures are likely to face, are some of the last decade s tailwinds that no longer exist. Thus, one could argue for a lower forward valuation for this sector. Figure 3: FTSE/JSE General Retailers Index Price Earnings History, Average and Standard Deviations 23 21 High valuations 19 17 15 13 11 9 7 5 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Price Earnings (x) Standard Deviation Standard Deviation Average Sources: Bloomberg & AlphaWealth workings Next, (and this view builds into our decision extending to retail property) many of the retailers have managed to grow on a store-basis. You can hide a lot in a retailer empire when your number of stores is growing South Africa has seen an unprecedented boom in shopping centre development over the last two decades, but this development drive is over. South African has a disproportionate shopping centre per capita (see here) and the large construction group, WBHO, just reported in its H1:18 Building segment s results that it is experiencing a minimal order intake from the retail sector due to an oversupply of shopping centres, the poor state of the economy and over-indebted consumers.
ALPHAWEALTH PRIME SMALL & MID CAP FUND INVESTOR LETTER APRIL 2018. 4 Domestic retailers will not be able to hide store-level stagnation or declines by rolling out new stores. Domestic competition may eat into gross margins while offshore bets with their balance sheets may see write-downs or, at least, foreign currency volatility. And, you are currently paying top dollar for these risks as the stocks are all highly valued! Couple that with the fact that retail property stocks are pretty much aligned to this sector s success (via any pipeline developments, rental escalation, potential vacancies of marginal stores down the line and, ultimately, their property valuations), and we believe that (in the long-term) we are making a good decision to avoid these two sectors. Just because South Africa is politically stabilising, it does not mean that consumers automatically have more money to spend. Likewise, just because retailers and retail REITs have performed well over the last decade, it does not mean that they will perform well over the next one. WHY WE DO HOLD CONSUMER & DOMESTIC YIELD STOCKS Despite our hard-line view of retailers and retail REITs, we are optimistic regarding South Africa s interest rate environment and see the pressure on consumers abating somewhat. On the former, we expect South Africa s SOEs, credit rating and, ultimately, the South African Reserve Bank s key repo rate to improve slowly over the medium-term. On the latter, we think that consumers will first take to the necessities and more defensive products before turning to luxuries. Hence, our bias towards a falling domestic interest rate environment has made us receptive towards holding nicely yielding stocks, like Metrofile Holdings (MFL) on a 7.5% dividend yield, Coronation Fund Managers (CML) on a 6.0% dividend yield, and Sirius Real Estate (SRE) on a 4.4% Euro-dividend yield. Interestingly, falling domestic interest rates occurring at the same time as the US Fed is hiking its interest rates implies coming Rand weakness. Hence, something like Sirius Real Estate (German property), as well as our other Rand Hedges in the portfolio (c.34% of AWSM Fund is Rand Hedge), play nicely into that theme too. Coming back to consumers, we believe that the beneficiaries are the less-obvious consumer stocks with more defensive underlyings. For example, we have noted our Adcock Ingram (AIP) investment previously, as a consumer branded healthcare and OTC stock. Likewise, we have previously noted our investment in Blue Label Telecoms (BLU) as a seethrough to Cell C, being a consumer-facing telcos stock selling cost-sensitive consumers a defensive communication product suite (airtime, data, electricity, water and hardware). Slightly more cyclical, our investment in Hosken Consolidated Investments (HCI) is effectively an investment into Tsogo Sun (TSH). The latter offers us the best quality portfolio of hotels, casinos and limited pay-out machine real estate in South Africa. This too should be a direct beneficiary in a recovering domestic scenario, while HCI offers some degree of diversification (it holds other investments too, from etv to property to coal mines to Golden Arrow Bus Services) and it does so at no cost to us (HCI is pretty much trading at the market value of its investment in Tsogo Sun without us actually paying anything for its other investments). Hence, while we are negative on retailers and retail property in South Africa, we are not negative on consumers nor negative on domestic growth. Rather the contrary, we are positioned in cherry-picked investments to growth from South Africa s currently low base at our currently low valuation.
ALPHAWEALTH PRIME SMALL & MID CAP FUND INVESTOR LETTER APRIL 2018. 5 CONCLUSION It is always worth remembering that the AWSM Fund s strategy is: Quality: Above all else, we try to find good quality, fast-growing, listed small cap businesses. Value: We invest in the cheapest of these, though limit our investments to different industries and/or geographies to maximize diversification. Concentration: Finally, we limit the number of stocks we hold to only the very best fifteen to twenty positions. Utilizing this strategy, we continue executing on AWSM Fund s quality-focused mandate while being conscious of both valuations and growth prospects. As a co-investor into our Fund with the majority of my liquid net worth, I have absolute conviction in what we are doing and I am confident in our Fund s future. Kind regards Keith McLachlan CA (SA) Fund Manager of the AlphaWealth Prime Small & Mid Cap Fund
ALPHAWEALTH PRIME SMALL & MID CAP FUND INVESTOR LETTER APRIL 2018. 6 Disclaimer: Collective Investment Schemes in Securities are generally medium to long-term investments. Different classes of units apply to these portfolios and are subject to different fees and charges. A schedule of fees and charges and maximum commissions is available on request from the Company. Commission and incentives may be paid and if so, would be included in the overall costs. The price of a participatory interest is a marked-to-market value. Forward pricing is used. The purpose of the money market yield is to indicate to investors a compounded annual return for all money market portfolios on a comparable basis. The yield calculation is not used for income distribution purposes. A forward-looking yield is used. This means that the last seven days yield (less the service charges, including VAT) is taken and is annualised for the next 12 month period, assuming the income returns are reinvested. Yields for money market funds are published daily. The value of participatory interests may go down as well as up. Past performance is not necessarily an indication of future performance. Performance numbers and graphs are sourced from Global Independent Administrators (Pty) Ltd are calculated on a NAV to NAV basis and do not take initial fees into account. The Company does not provide any guarantee either with respect to the capital or the return of the portfolios. Income is re-invested on the reinvestment date. Actual investment performance will differ based on the initial fees applicable, the actual investment date and the date of reinvestment of income. Dealing prices are calculated on a net asset value and auditor s fees, bank charges and trustee fees are levied against the portfolios. The total return to the investor is made up of interest received and any gain or loss made on any particular instrument. This will have the effect of increasing or decreasing the daily yield but in case of abnormal losses it can have the effect of reducing the capital value of the portfolio. Excessive withdrawals from the portfolio may place the portfolio under liquidity pressures where a process of ring-fencing of withdrawal instructions and managed pay-outs over time may be followed. CIS are traded at ruling prices and can engage in borrowing and scrip lending. The manager may borrow up to 10% of the market value of the portfolio to bridge insufficient liquidity. Prime Collective Investment Schemes Management Company (RF) (Pty) Ltd is a registered Collective Investment Scheme Manager in terms of Section 5 of the Collective Investment Schemes Control Act and is a wholly owned subsidiary of Prime Financial Services (Pty) Ltd, a member of ASISA. 0105942100.