The world is entering an unprecedented time and there is no historical playbook for what happens next. While not our base case, calamity risk is increasing (mass infections across South Africa [SA], with dire economic consequences), and nobody knows how to quantify this risk. We have many requests from clients asking for investment opportunities in this crash and we are happy to share our fundamental views. However, investors in any equities must bear in mind that, in the shorter term, cheap shares can get even cheaper and wild swings are likely. Our views are based on a 12-to 24-month timeline, with a base case scenario of the world normalising during this time period. So, risks have to be taken into account and any investment in equities should be considered in this context. Shares only become this cheap when risks are extremely high.
The past few weeks have seen global markets endure the most volatile period in history. The VIX, a US index tracking the stock market’s expectations for volatility over the next 30 days and derived from price inputs of S&P 500 Index options, hit all-time highs recently, surpassing the records it set during the 2008 global financial crisis (GFC). This volatility was due to the rapid worldwide spread of the novel coronavirus (COVID-19) and the draconian, albeit very much justified, measures taken by global governments to fight the pandemic. Entire economies were shut down with people forced to stay at home and to enact social distancing. The ramifications which these measures will have on the global economy will be severe, but (and this is what is causing the market volatility) almost impossible to quantify.
Having said that, it is important to keep a clear mind when looking at the extreme share price movements on the JSE. While we might agree that earnings for many companies will be decimated in the next few months, as it is very difficult to sell your products/services when everybody is staying at home, the human race is also extremely resilient. Looking at how Asian economies have reacted; it would appear to us that economic activity will return to normal after about two to three months.
With this as our base case, we have decided to look for the opportunities currently being created in the SA market. Our criteria are simple – we are looking for quality, high-growth and high return on equity (ROE) companies with strong balance sheets that can withstand a short-term cash drain. Many of these companies have in the past appeared too expensive for us to stomach and this sell-off may provide an opportunity for investors to accumulate these compounders at very attractive entry points.
Naspers
Tencent, Naspers’ most significant investment, reported very strong earnings during the week of 16 March (unfortunately, not the best week to report strong results). Revenue grew by 26% YoY and operating profit jumped by 35% YoY. But what was even more heartening was how well the company is progressing at diversifying its earnings base and setting itself up for more growth going forward. Advertising, financial services and international gaming (outside of China) continue to contribute a greater proportion of revenue and management are guiding that this is set to continue. Tencent also continued to generate significant cash flow and, ironically, although management was reluctant to elaborate on this on the company’s investor conference call, the COVID-19 outbreak has resulted in a boost for its gaming segment and other online revenue.
Moving to Naspers, we note that holding company structures have come under pressure during this sell-off. Naspers is currently trading at a c. 50% discount to the value of its underlying investments or net asset value (NAV) and a 40% discount to the value of its investment in Tencent alone. This is the widest discount to NAV that we have ever witnessed for Naspers and the Group has, in its own right, established very attractive investment opportunities in the exciting spaces of online classifieds, food delivery and financial technology (fintech).
Naspers management have committed to try and close this discount and the company has sold some Prosus shares, which will potentially be used to buy back Naspers shares. At current levels, management are looking like geniuses, if they start buying now.
The wide discount to NAV, the attractive growth profiles of Tencent and the other investment companies and the additional optionality of management actively trying to close the discount, all combine to make this Naspers opportunity extremely attractive for investors.
Transaction Capital
Transaction Capital has been a great compounder over the past few years, even in the face of some dire local economic growth. Its SA Taxi financing business, which provides financing and other ancillary services (including insurance and buying groups for tyres and fuel) to mini-bus taxi operators, has continued to perform well as the mini-bus taxi industry established itself as the most effective public transport system in SA. The COVID-19 outbreak may cause some of these operators to come under pressure due to a lack of commuters, but this should be somewhat negated by a reduction in local fuel prices. Over the past few years, SA Taxi has also built a strong and widening competitive moat through its vertical integration and data collection on taxi routes.
The collection services business may struggle somewhat in the current environment but, as management highlighted, Transaction Capital purchased these collection books at very attractive prices. Thus, it should be able to weather the economic impact that may arise from the COVID-19 clampdowns.
At our last engagement with management following the COVID-19 outbreak, they maintained their guidance of 15% to 17% CAGR in earnings for the next three years, with some downside risk to this financial year (FY20). With a very strong balance sheet and trading at a historic PE ratio of c. 10x, we believe that this potential downside is more than accounted for at its current, very attractive, entry point.
BidCorp
A very experienced industrial analyst once said that BidCorp’s portfolio of assets is one of the most resilient and highest quality he has ever had the privilege to analyse, and he has covered many industrial companies globally. We tend to agree.
BidCorp has built a strong business network supplying food services to restaurants and hotels, community services (hospitals, prisons, etc.) and airlines. Over the years, the company has managed to acquire small independent food-services businesses and bring these under the BidCorp banner. This gave these entrepreneurs the stability of funding and infrastructure of a large corporate, but also provided them with the freedom to build and grow their businesses further. It was a formula that worked, and it helped BidCorp become a compounder of note, growing earnings every year by between 10% and 15%.
Unfortunately, the COVID-19 outbreak, and the subsequent clampdown, hit exactly those economies in which BidCorp operates and the market duly punished the share price. Nevertheless, we note that at our last engagement with management following the COVID-19 outbreak, they were surprisingly upbeat. According to them “… BidCorp is in the food business, people need to eat.” Bidcorp also services all food delivery and many food-retail companies that are doing very well in the current environment. BidCorp is also seeing significant opportunities in these trying times as many entrepreneurs are engaging with it to enter the BidCorp family of companies. In addition, its strong balance sheet will allow the Group to take advantage of these opportunities.
At a historic PE ratio of 12x, we believe that this is a great opportunity to buy into a high-quality company.
Discovery
Discovery is one of the few SA companies with a truly global mindset. The company’s concept of “shared values” (rewarding people who live healthier and who change their behaviour and using the data to price policies better and engage more effectively with customers) in insurance is truly a novel approach and it has a competitive advantage against its competitors, even on a global stage. One only has to look at how many competitors have tried (with limited success) to mimic the concept or how global giants such as Ping An, Apple, AIA, John Hancock, Generali and many more, have approached Discovery to collaborate with them, to see that its business model has value and significant opportunities to scale up.
Recently, Discovery has taken these same principles of “shared values” to short-term insurance and banking. The jury is still out as to whether it will be as successful in these market segments as it has been in life insurance, but the growth potential is huge. It is again interesting to note how competitors in both sectors immediately started to mimic this Discovery concept. These investments into new business segments in SA have, however, come at a cost. Despite this, we believe that over the next five years the cost of investment will start to decline and the operational leverage in these new ventures will cause a strong J-curve effect on the income statement.
Fears surrounding the negative impact of the COVID-19 on claims ratios and a weak balance sheet have caused the market to punish this share disproportionately over the past few months, in our view. Discovery is currently trading at prices last seen in 2014. We engaged with Discovery management during the past week and tested them on these two fears – we exited the meeting feeling even more confident that this is a great buying opportunity.
Management were adamant that Discovery’s balance sheet is healthy and that even in an extreme stress scenario the company will not need additional capital. One key point management highlighted was that Discovery’s greatest risk to requiring additional capital is if it exceeds its own growth expectations. Given the nature of a life insurer, and especially an early stage growth life insurer, the capital requirement is very severe upfront. If the value of new business was to reduce, the capital strain will actually decline and improve the firm’s own cash generation.
Discovery was also very fortunate, through its joint venture with Chinese financial services group, Ping An, to have experienced first-hand the consequences of the COVID-19 outbreak on everyday life in China and the subsequent impact of the virus on life- and medical insurers in that country (surprisingly, we note that the outbreak had a positive impact on premiums for these businesses). In the greater context, the mortality experience due to the outbreak was minimal vs expectations. In fact, companies had positive claims experience vs expectations, as people started to prioritise only going to a hospital in severe situations. Nobody is going to go to hospital for a toothache, while the world is on high alert due to a pandemic. Thus, insurers recorded a strong uptick in sales, as people became acutely aware of their own mortality and started to buy life insurance and medical cover.
Of course, the real risk is what will happen if the world falls into a deep recession due to the outbreak. This will be negative for earnings but allowing your life insurance and medical cover to lapse is nevertheless likely to be low on the list for most people.
Overall, we see the balance sheet and claims ratio spike risks as being overblown and we believe that Discovery can become a truly global player in the insurance space. The current market sell-off provides a great opportunity for investors to jump on for the ride.
Capitec
Capitec has defied gravity for almost a decade, navigating through the African Bank crisis, weak economic growth and even an attack by short-seller, Viceroy Research, to compound its earnings by 27% p.a. for the past decade. Over the course of the decade, Capitec has also transformed from a pure unsecured credit provider to a far more diversified financial services Group. Net transactional fee income and funeral cover sales contribute 46% of its net income and covers 91% of operating expenses. The bank is also very conservatively capitalised, with ample liquidity coverage and a very low leverage ratio of only 5 times. The company targets a ROE of 25%, but it has achieved a ROE of 27% over the past few years.
The acquisition of Mercantile Bank has opened up exciting new growth avenues for Capitec. The small- to medium-sized enterprise market has been very underserviced by the big-4 banks (ABSA, Standard Bank, Nedbank and FirstRand) and, in our view, Capitec’s simplistic and affordable product offering will be extremely attractive to these entrepreneurs. Capitec’s entry into business banking and the continued growth of its credit card book and funeral cover policies will allow Capitec to continue to grow at the high-teens to low-20% over the next three to five years.
Although we do believe that the next financial year (FY20) may be tough for Capitec, we also think that once the initial impact of the COVID-19 outbreak has passed, Capitec will resume on its high-growth path. We are mindful of the fact that Capitec is ensured by a third-party against defaults due to retrenchment and death on all of its products. The bank is also well-funded with its retail deposits exceeding its credit book.
We have always been reluctant to buy into Capitec, even considering the exciting growth prospects, because we believe that the market was pricing it for perfection at close to a 20x historic PE. However, at current valuation levels, the share provides a rare attractive entry point in a high-quality business.
Mr Price
Discretionary spending may not be a space you want to invest in when people are not leaving their homes but, sometimes, an investor has to look through one year of bad earnings and buy a quality company for the decades to come. We believe that Mr Price falls squarely into this category.
Running through our modelling and based on what we have learned thus far from European and Asian apparel retailers, Mr Price will likely see a decline in earnings of between 30% to 40% YoY. It will, however, recover reasonably strongly after that, in our view.
Sitting on a cash balance equal to c. 12% of the current market cap and still generating free cash flow of 7.7% going forward, the management team are in the fortunate position to take advantage of this difficult environment. Management have already dismissed expansion into new markets, so they may be looking at buying back shares at the current depressed share price levels.
Mr Price is a high-quality business generating ROEs in excess of 30% (including the cash drain) and is trading on a very attractive valuation of 10x historic earnings.
Growthpoint
The property sector has been under significant pressure over the past 18 months. Defaults in other jurisdictions such as the UK and US, have caused investors to question the “safe-haven” badge that the sector has carried for the past two decades. But everything has a value and we believe that the market is now discounting too much risk in some of these property companies.
Growthpoint is a quality business with prime property assets across SA, Australia and Eastern Europe. The management team is conservative and experienced. Although we do believe that distributable income growth will be depressed for the foreseeable future, due to pressures in the local and Australian economies, we are convinced that the current valuation of a 17% historic dividend yield and 0.5x book value more than compensate for this.
Even in the event that Growthpoint’s distribution rebases by 20% to R1.75, it will still offer investors a yield of 13.7%. In our opinion, the margin of safety built into this share is significant and it currently provides a very good entry point for investors. However, we highlight that some real estate investment trusts (REITS) have already indicated the temporary suspension of dividends and this is a risk across the property sector.
FirstRand
The global financial market has been in turmoil. Rumours of liquidity squeezes in the financial system have resulted in global banking counters being severely punished. Across the world, banking stocks are down by between 60% and 40%. And SA banks have not been spared!
Regulators globally have reacted by injecting liquidity into the system. We maintain that these measures should be enough, and we are not expecting (as things currently stand) to see any significant bank failures due to the COVID-19 outbreak.
As such, we believe that SA banking shares are providing some exceptional opportunities and we can probably have listed any of the big local banks here for a good opportunity to enter. However, in times of extreme dislocation the market provides the opportunity to buy an Audi at the price of a Fiat 500 and that is why we picked the gold standard of SA banking stocks – FirstRand.
Although we acknowledge that revenue growth will be lacklustre for the next few years and that bad debts may continue to tick up, FirstRand’s dividend yield should be sustainable as this environment will have a limited demand for capital. The bank is also diverse enough to absorb the uptick in bad debt and the management team has been extremely conservative on the lending front over the past few years, which should protect the bank from an extreme blowout in bad debts.
Generating a ROE of between 18% and 22% going forward and offering a dividend yield of 9% at current prices, we believe that this is a great opportunity to buy.
Bidvest
Bidvest’s stable earnings growth profile and its diversified income streams have ensured that the company has evolved into one of the cornerstone stocks in many SA portfolios. With a presence in freight, office management, trading and distribution as well as automotive dealerships, Bidvest’s presence in the domestic economy is indeed far and wide. Bidvest has also been one of the few local companies that has successfully expanded beyond our borders. It first started to venture into food services, building an attractive and scalable portfolio of assets, and later independently listed BidCorp. More recently, the firm ventured into office management and hygiene markets with the acquisition of Noonan in the UK and Ireland and PHS in England. These latest acquisitions are still in the bedding-down phase, but Bidvest’s management team has a very good track record of successfully incorporating new businesses under the Bidvest umbrella.
Several of Bidvest’s businesses are in the eye of the COVID-19 storm, which is both a positive and a negative for the company. Many of its aviation and travel-facing businesses will face tough times as the world goes into lockdown and global travel grinds to a halt. Management have guided that the company is working closely with its customers to ensure the viability of the industry going forward. Bidvest’s freight division is very reliant on export volumes of chrome and manganese to China. These volumes were significantly down while China was in lockdown but should recover as China starts to re-open its industries. In Bidvest’s automotive and trading divisions, the impact is still difficult to assess and also very fluid, but it will, in all likelihood, be a tough few months for those divisions. On the positive side, the heightened awareness of hygiene is proving to be a boon for the company’s office management and hygiene divisions.
Overall, we believe that Bidvest’s earnings will be under pressure in the short term, but then management are of the view that the Group’s well-diversified earnings stream and strong balance sheet will be able to absorb the economic shock.
In our view, the current valuation of 11x historic earnings provides an attractive entry point into a solid SA industrial company with the optionality of a successful global expansion almost for free. Given the success that Bidvest has had in building BidCorp this is a bet we will very happily take.
Curro Holdings
Since listing on the JSE in 2011, Curro has established itself as the largest private-education player in SA. From 4,200 learners in 2011, Curro has grown its learner base by 35% p.a. to 62,700 in 2020. These expansions have, of course, come at a cost with Curro spending significantly on new schools or upgrading older school to accommodate these new learners. Curro spent R1.3bn in 2019 alone, with plans to spend another R1bn in 2020. To December 2019, Curro has spent a cumulative R10.2bn in capital!
During the initial stages, Curro used the equity market to fund its expansion plans and it has successfully completed a number of capital raises from 2011 to 2015, which helped the company reach scale. From 2016, however, Curro started tapping debt markets to fund its capital requirements. With very strong and defensive cash flow generation, banks were more than willing to extend credit to Curro at very attractive interest rates. But even at these attractive rates, Curro’s interest expense started to increase aggressively, growing from R55mn in 2014 to R243mn in 2019 (by 35% p.a.). A lagging local economy resulted in Curro’s EBITDA underperforming its growth in interest expense (which advanced by 29% p.a.), and this dynamic combined with a higher depreciation and amortisation charge culminated in Curro reporting a 15% YoY decline in earnings (to ZAc51/share).
The market took these results very negatively and sold the share down aggressively. But, as always, the market tends to overreact and share prices very quickly swung from overvalued to undervalued. We believe that Curro is now pricing in a doomsday scenario, and that the market is placing too great a focus on earnings and ignoring the structural momentum which the company continues to maintain.
The key stat that we focus on is learner growth. Curro has continued to grow this measure at a robust rate, albeit at a slightly slower pace than the company would have liked. Curro’s pricing has remained strong and it has been able to maintain fee growth at a higher rate than inflation. We still expect turnover growth in excess of 15% YoY for 2020 and, in the current local economic environment, that is very strong. Earnings will continue to be depressed due to higher interest expense and depreciation charges, but we believe that Curro is past its peak in terms of capital expenditure requirements and it now just needs to fill excess capacity.
Education remains a defensive sector. People want to get the best education for their children and, even in a COVID-19 shock, people will continue to try and find a way to provide their children with high-quality education. The current poor economic conditions may place a brake on Curro’s growth ambitions, but we still think that the market is completely overpricing the counter’s downside risk. It is important to remember that Curro’s debt profile is due to its expansion and the firm can choose to slow that down if it believes it to be prudent, which will change the profile significantly for the better.
At a historic P/E ratio of 8.5x, we are of the opinion that this provides an incredible opportunity to buy into a high-quality sector and company.
