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May global market commentary: Most major markets maintain upward momentum/ Paychex, ICICI Bank

04 June 2020

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by Peter Little, Fund Management

Global markets maintained their momentum through May, with the MSCI World Index up another 4.8% MoM (after an 11% rally in April). Major economies headed down a path of easing movement restrictions and restarting economic activity as central banks continued to apply record levels of monetary stimulus and governments applied similarly unprecedented levels of fiscal stimulus. During May, US biotech company, Moderna, announced promising results from first-round testing of its coronavirus vaccine candidate.

US companies wrapped up 1Q20 earnings reporting with aggregate earnings down about 8% YoY and most of the damage coming from the financial sector, where banks were forced to take huge bad-debt provisions as unemployment spiked. Online companies continued to attract the largest interest with the tech-heavy Nasdaq 100 Index up 6.3% for May, leaving it 10% higher YTD.

In Emerging Markets (EM), the MSCI Emerging Market Index was up 0.8%, lagging developed markets (DM) for the third consecutive month as the benchmark’s Chinese component was down in aggregate for the month as tensions between the US and China escalated. US Congress started the passage of two sets of legislation, the first aimed at sanctioning Chinese officials deemed responsible for human rights abuses and another making it more difficult for Chinese companies to raise capital by listing on US exchanges. China responded to the escalating tensions with a pledge to change Hong Kong legislation to give China more autonomy over the region. Brazilian and Russian stocks offset the drag from Chinese counters as their energy and mining-heavy exchanges helped drive their equity benchmarks to high single-digit returns for the month.

Brent crude oil was up 40% for May as it reached $35/bbl by month-end – almost half the $66/bbl-level at which it started the year, but substantially higher than the $19/bbl-low it reached in April.

A flood of stimulus helped keep US 10-year bond yields anchored around 0.7%, while programmes to support corporate credit helped US investment-grade credit spreads tighten by 0.25% to 1.75% and US high-yield credit spreads compressed 1.1% to 6.4% – still significantly above the 3.3% level at which they started the year, but substantially better than the 11% peak they reached in March. The US dollar was strong against major DM peers, particularly the British pound which was 2% weaker against the US dollar for May (7% weaker YTD). EM currencies finally found some support, with the Mexican peso (9% stronger against the US dollar in May) leading the way, while the Russian rouble and the South African rand rallied by 6% and 5.6% MoM, respectively.

Paychex: Opportunity in an overreaction

by Henry Biddlecombe, Investment Analyst

Paychex is one of the largest payroll and HR services firms in the US, processing the payroll of 1 in 12 employees in the private sector. The broad base of over 670k clients means that the firm’s growth is a semi-proxy for US employment and the economy.

This is a conservatively managed business, with no debt, that has delivered consistent revenue growth of between 5%–10% every year for the past decade. This has translated into earnings growth of 5%-15% p.a.

The business model is highly cash generative, owing to the negative working capital cycle that results from employers paying wages to Paychex upfront before Paychex distributes the cash to employees. This, together with the company’s modest capex requirements, has meant that the board has been able to maintain a payout ratio of 80%.

Although US unemployment now sits at a record high level (15%), Paychex’s limited exposure to those sectors of the US economy severely impacted by COVID-19 (hospitality and energy – combined revenue exposure of 7%) has meant that management have been able to guide to a relatively limited negative impact to fiscal year 2021 earnings. On a YoY basis, management expect earnings to fall by around 7%.

Despite this limited impact, the share sold off more than 40% in the wake of this year’s crash. In our view, this gave investors a superb opportunity to buy the business at a meaningful discount to its intrinsic value.

On its 3Q20 earnings call in March, management also emphasised their intention to maintain the 80% dividend policy going forward. Additionally, they are looking at share buybacks as a mechanism to enhance shareholder value given the recent steep decline in the share price. We view both factors as positive confirmation of our thesis.

ICICI Bank 4Q20: Despite COVID-19, it remains a proxy for future India growth

by Liam Hechter, Fund Management

ICICI Bank reported operationally sound 4Q20 results (for the quarter ending 31 March 2020) in May. The bank’s net interest income grew 17% YoY, with loan growth of 10% YoY and deposit growth of 18% YoY. Its net interest margin advanced by 10bps to 3.9%. Non-interest revenue rose 13% YoY, while costs increased 16% YoY. A few abnormal staff charges relating to big retirement provisions saw staff costs rising by 18% YoY. Pre-provision operating profit grew 19% YoY. Credit quality, for the most part, was stable and within expectations – up 9% YoY. It would have been down 11% YoY if not for the additional COVID-19 (CV19) provisioning. As has become common with banks reporting results to end-March 2020, there is an additional layer of provisioning due to CV19. ICICI’s common equity tier-1 (CET1) ratio of 13.4% was steady from 13.6% reported in both 3Q20 and 4Q19. No dividend was allowed as per the regulator.

We believe ICICI is well capitalised going into the current period of stress. The thesis was playing out according to plan, with CV19 obviously a hindrance. The Indian economy was also in the process of undergoing some big structural changes, most of which were seen to be more business-friendly in the longer term. The country has a young and very large labour force, and productivity is still quite low, making the value proposition compelling. We note that India’s economy is not as structurally vulnerable as the likes of Brazil, South Africa or Turkey so the selloff in India has not been as aggressive as those in more challenged emerging markets, with the Indian rupee losing c. 10% YTD. According to a statement on CV19 from its results, ICICI explained its approach in the current scenario highlighting that it is well-capitalised and has a strong deposit franchise. Its digital and technology platforms are key strengths and the present scenario provides an opportunity to re-engineer the delivery of banking. ICICI said that it is using this period to further strengthen its digital platforms, the ability to capture market potential and its delivery capabilities, while at the same time enhancing efficiency.

 

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