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The Confidential Report - October 2021

America

The S&P500 is in a correction which began after 2^nd September 2021 when it made an all-time record high of 4537. Since then, it has fallen by as much as 249 points to an intra-day low of 4288 on Friday (1/10/21). This correction has taken 20 trading days and amounted to 5,4% at its worst. There are a variety of reasons for the correction:

1. The US Federal Reserve Bank’s guidance that “tapering” might commence as early as the end of this year. This means that they may begin reducing the amount of cash that they are creating and injecting into the economy every month through their quantitative easing (Q/E) program. At the moment, they are effectively printing $120bn a month to support the economy.
   
   
2. The Evergrande property crisis in China has threatened to spill over into other parts of the Chinese economy and even world markets. The Evergrande problem has been seen as similar to Lehman Bros. collapse in 2008 which caused the sub-prime crisis. Evergrande is also a property developer/financier, and it has debt of around $300bn – which makes it about one third of the size that Lehman was at in 2008. In our view, Evergrande is not nearly as serious as Lehman was, so this is probably a case of the market looking for reasons to continue a downtrend which was already in progress when the news of Evergrande came to light. The Chinese authorities have injected significant liquidity into their economy and may go as far as reducing the reserve rate to address and contain the situation so as to prevent the collapse of the various banks which are affected.
   
   
3. The rise in the yield on the US 10-year treasury bill to above 1,5%, in the last weeks of September 2021, has investors worried. In the US, investors typically move from equities to bonds and back again depending on their perceptions of the risks and returns on offer. Rising yields on treasuries indicates that the economy may be moving back towards recession and become less accommodating. So, this, in part at least, reflects the Fed’s rumblings about tapering.
   
   
4. The US government is running out of money to pay salaries and meet expenses (apparently by 18^th October 2021). Republicans and Democrats are busy arguing about extending the allowable deficit. This type of political conflict about the size of the deficit are relatively common and are normally resolved fairly quickly, but sometimes they can be problematic for a few weeks.
   
   
5. Biden is at a difficult place in his Presidency as he tries to manoeuvre two massive spending bills (for $1,2tr and $3,5tr) through the Senate. If approved, these bills amount to a further significant fiscal stimulation of that economy – and would obviously have a positive impact on equities. Investors are battling to factor this into their predictions.
   
   

Consider the chart of the S&P:

You can see here that the correction began on Thursday 2^nd September 2021 after the all-time record high of 4537. The initial drop was a fairly slow 4% which took the market down to a support level at 4353. From this point there was a mini rally which petered out and the index broke down through that support on Thursday (30/9/21). On Friday the market rallied strongly to test the previous support level (which had now become a resistance level) at 4353. During Friday the bears were able to push the market down to an intraday low at 4288, but from there it made a convincing “double bottom” and rallied strongly.

The market action that we are seeing here is that of a “reluctant correction” where there has been much bullish talk of “buying the dip” and a considerable response by the bulls, including a small rally. This should be compared with the more normal 9,6% correction which took place a year ago in the 14 trading days between 2^nd and 23^rd September 2020. In that case the bears gained complete (temporary) domination and there was little or no talk of buying the dip.

International markets, led by Wall Street are dominated by the alternating emotions of fear and greed and the transitions between them. These are sometimes also characterised as “risk-off” and “risk-on”. During a bear trend 80% of investors are negative and only 20% are positive and vice versa. Our sense of the current correction in the S&P500 is that about 55% of investors are negative while 45% are positive – which accounts for its sluggish progress. Of course, it is always possible for negative sentiment to gain momentum, especially if there is unexpected bad news, but in the absence of that, our view remains that this correction is now losing downward momentum.

Economists in the US predicted that consumer spending would rise by 0,6% in August whereas in fact it rebounded by 0,8%. This is a large jump from the decline of 0,1% in the previous month. The decline in COVID-19 cases is resulting in better consumer confidence. Inflation remained high during the month and has yet to show any signs of the decline which both the Federal Reserve Bank and the President have confidently predicted. Personal consumption expenditure (PCE) prices increased 0,3% in August (the same as in July).

But essentially the massive US economy is still growing, creating jobs, and increasing the profits of S&P500 companies. In our view, the current correction appears unlikely to morph into a major correction (i.e., of between 10% and 20%), but it is impacting some of our blue-chip shares on the JSE and thus offers potential buying opportunities. Of course, we are on the cusp of October month so you may want to stay out of the market until that month is substantially behind us. In our view, the bulls are gradually gaining the ascendency in the US and elsewhere and when they do, we can look forward to yet another new record high on the S&P500.

 

Political

Gwede Mantashe, Minister of Minerals and Energy, has once again shown that he is part of the problem in South Africa by issuing a new plan to build a 2500mw nuclear power plant. This plan is not part of the Integrated Resource Plan (IRP) because nuclear power is far more expensive than renewables and takes far longer to bring into production. In the South African context an expensive and long-term project of this sort, which would necessarily be run by government, smacks of the corruption and endless delays and cost over-runs which characterised Kusile and Medupi. Needless to say, there has been a public outcry against it. Notably, the CEO of Eskom, Andre de Ruyter has proposed that Eskom spend as much as R106bn by 2030 on wind and solar power to replace coal-fired power stations. Towards the end of September 2021, the UK, France, Germany, the EU and the US sent an envoy to South Africa to assess the viability of concessional financing to help South Africa transition to renewable energy and away from coal-fired power stations. In a paper produced by Meridian Economics, it has been suggested that 9 coal-fired power stations be retired in return for concessional financing. Obviously, this will need to get Treasury’s approval.  

Allowing the ANC to go ahead with the late registration candidates in about 30 municipalities combined with the Constitutional Court’s decision not to postpone the elections will certainly impact on election outcomes. The ANC is in disarray (Ace Magashule’s legacy) with debts said to be of the order of R200m which will make it difficult for the party to fight the election. No doubt opposition parties are happy with the situation as it gives them a better chance to win in key metros. Clearly, the ANC is struggling to overcome the impact of the Zuma years on its internal organisation and finances. It is open to the attack that if it cannot organise itself internally, how can it possibly govern the country effectively?

The ANC’s Lekgotla provided some clarity on two important issues. The President indicated that a basic income grant (BIG) which has considerable support within the ANC, would not be implemented until it had been properly evaluated and, secondly, he said that the “just energy transition” offered an opportunity to fast track the move to renewables, even though it means that Eskom will have to take on additional debt. This shows that the President is throwing his weight behind Eskom CEO, Andre de Ruyter, in his effort to raise R180bn of “concessional financing” to pay for the development of renewable energy and the closure of coal-fired power stations.

Minister of Trade Industry and Competition, Ebrahim Patel, has become obsessed with the level of executive pay in South Africa and is in the process of getting the Companies Act changed to force companies to disclose what executives are paid. The average wage for a CEO of a top listed company in South Africa is around R24m per annum, which is about 6 times what the President receives, but is comparable to the salaries earned by executives at that level internationally. Patel is concerned to close the “wage gap” in South Africa between those earning the highest and lowest salaries in an organisation. The problem with this idea is that it could well lead to South Africa’s top executives leaving the country with a concomitant impact on employment and job creation.  

Investors of all sizes, including overseas investors, will be encouraged by the words of our new Minister of Finance, Enoch Godongwana at the Sunday Times Investment summit. He says that the government’s first goal was to ensure a consistent electricity supply, the second was to get access to broad spectrum, the third was to address the green revolution and climate change, the fourth was to sort out logistics and the fifth was to improve the environment for business. Hopefully, at least some of these objectives will be met in the near future. Godongwana has been making the right noises since he took office, but he remains an unknown quantity at this stage.

 

Economy

The Old Mutual prediction that gross domestic product (GDP) will grow by 5,5% in 2021 is above earlier economists' predictions. Both the Reserve Bank and Fitch ratings agency have also now increased their predictions to 5,3%. This shows that the economy is recovering more quickly than expected from the COVID-19 recession of 2020. We have always thought that there would be a strong recovery because of the under-utilised capacity in the economy. This “slack” is now rapidly being taken up and should begin to impact on the unemployment figures. The civil unrest in July month, although a setback, should not be a major factor in GDP growth. Despite this growth, South African GDP will remain below 2019 levels.

The Monetary Policy Committee (MPC) once again held the repo rate steady at 3,5%, but its economic model now anticipates that interest rates will be hiked in November this year. We believe that rates will only be hiked early next year as the economy is still showing signs of distress resulting from COVID-19 and the civil unrest in July 2021. First world economies are also showing signs of moving towards a more hawkish monetary policy, especially in the US where there is the possibility that “tapering” will commence as early as November this year. It is apparent that central banks, including our Reserve Bank, are moving towards tighter monetary policies worldwide. South Africa’s massive current account surplus, which is mostly due to commodity exports, will shield the currency against rising interest rates overseas.

Governor of the Reserve Bank, Lesetja Kganyago, says that the inflation target for South Africa should revised downwards to between 3% and 4% from its current range between 3% and 6%. He says that the target range has enabled South Africa to have exceptionally low inflation among emerging economies and that, in turn, has enabled the Reserve Bank to implement ultra-low interest rates to help the economy recover from COVID-19. Inflation targeting in South Africa has been in force for 21 years and has come in for considerable criticism at various times. In our view, however, it has been a major factor in sustaining the economy during the Zuma excesses.

Much of the current resilience in the South African economy is due to the commodity boom. It is noteworthy that exports were up about 50% in the first half of 2021 when compared to 2020 – and about 46% when compared to 2019. The trade surplus in the first half of the year was well over R250bn compared to about R55bn at the same time last year. Exports have been negatively affected by the disruptions at Transnet, but despite this they have been the economy’s saving grace. We expect commodity prices to continue to rise as the world economy recovers and moves into a boom phase. This can be seen in the North Sea Brent oil price which is still rising strongly: Consider the chart:

The US dollar price of Brent has been rising steadily in a clearly defined channel since bottom of the downward spike caused by COVID-19. In August the price came down to touch and confirm the lower channel line. We expect commodity prices, led by oil, to continue to rise as the world economy moves further into a boom phase.

Obviously, South Africa’s trade surplus is having a powerful positive impact on the strength of the rand. The June trade surplus of almost R58bn was a new monthly record for South Africa. July’s surplus will probably be lower because of the civil unrest.

The sustained attack on Transnet’s rail infrastructure is rapidly becoming unsustainable and threatens our exports, especially of commodities. Organised gangs are mounting systematic rounds of cable theft which bring trains to a standstill. In two weeks, the company has had over 150 cable thefts conducted by large heavily armed gangs who were not afraid to use their weapons. This is clearly a police matter and a reflection of the parlous and ineffectual state of law enforcement in the country and especially in Natal. The impact is to cause overseas investors to take their much-need foreign direct investment elsewhere. The mining industry is the primary victim because it cannot get its exports to market and is losing ground in the midst of a commodity boom. The tax revenues of the mining industry are essential to the recovery of the South African fiscus.   

In the five months from March 2021 to August 2021 the Treasury has been able to collect about R70bn more in tax revenue than was budgeted for. The substantial proportion of this came from company taxes and was due to the boom in commodity prices. Some of this money (R32,85bn) has been used to pay for the relief paid by the government to unemployed people and those who suffered from the civil unrest in July 2021. However, this shows that the commodity boom is impacting directly on the country’s fiscal position and should significantly reduce the national debt by the time of the mid-term budget at the end of October 2021. The effects can also be seen in the steady strengthening of the rand against first world currencies.

So-called “fiscal rebalancing” is a euphemism for the paying down of South Africa’s massive government debt. Luckily the increased tax revenues have given the country a lifeline and should help us to reduce the deficit by as much as R80bn in this tax year. However, the ratings agency, Fitch, is still concerned that the debt problem will continue into the future. The rebasing of GDP in August showed that the economy was about 11% larger than had previously been thought – so this improves the debt-to-GDP ratio further. The mid-term budget policy statement (MTBPS) will be delivered by the new Minister of Finance, Enoch Godongwana in early November – a few days after the elections.

Godongwana, has been making the right sort of noises since he took office two months ago. In a recent webinar the minister said emphasised the need for “structural transformation” and “increased productivity” in the economy. Hopefully these are more than just empty words for him. Of course, the term “structural transformation” could mean many things, but hopefully Mr. Godongwana understands it to mean the elimination of government-imposed restrictions and impediments to the effective functioning of business. It is an indictment that manufacturing only contributes 12% of GDP where it used to contribute 22% in the pre-ANC era. Productivity is the key to everything in South Africa, but this is the first time we have heard a member of the ANC use the term since they came to power almost 28 years ago. As a commodity exporting nation our relative productivity determines whether we can compete on an international stage with countries like Australia and Brazil. Unfortunately, productivity has been virtually ignored by the ANC since it took power in 1994 with the result that GDP growth has declined while unemployment has reached record levels.

Year-on-year South African retail sales shrank by 0,8% in July when economists expected them to grow by 3,3%. This was a direct result of the civil unrest and shows its direct cost. Month-on-month sales were down 11,2% in July which compares with a 0,7% growth in June. Most listed retailers have now reported on the costs of looting and vandalism at their stores, some of which is covered by insurance. Fortunately, the unrest appears to have been a once-off event that is unlikely to be repeated. The longer-term and deeper costs of lost confidence and lost foreign direct investment (FDI) will take time to manifest.

The threatened NUMSA strike in the mining, automotive, steel and construction industries is set to begin on 5^th October 2021 and will be accompanied by an employer lock-out. The industry is offering an increase in line with inflation (4,4%) which the union is demanding 8%. To us it seems that the gap between the parties is not that great and prolonged strike action is unlikely. In the aftermath of COVID-19 these industries are still trying to recover and cannot really afford excessive wage increases. At the same time the union movement has definitely lost a considerable amount of support and bargaining power with the 34% unemployment rate. So, we believe that the matter will be settled fairly soon without long-lasting negative impact.

The agreement reached between South Africa’s 257 municipalities and the unions is significant because it is for a basic increase of 3,5% which is below the current inflation rate of 4,4%. The discipline imposed by the Treasury on the civil service unions appears to have taken hold and forced government and quasi-government unions to accept more frugal settlements. The curtailing of union demands is critical to the long-term growth of the economy and hence the stock market.

The appointment of Duncan Pieterse as head of assets and liabilities management at the Treasury shows that the government is willing to find highly competent people to place in key positions. The appointment comes just before the mid-term budget policy statement (MTBPS) which Pieterse has been involved in preparing. Appointments based on merit rather than on race or black economic empowerment (BEE) will help to improve the effectiveness of government at every level.

Many of the largest listed companies on the JSE are in the process of, or are considering reducing office space. COVID-19 has demonstrated that a large proportion of their staff can work from home, saving both the company and the employee costs. For example, Mommet, in its recent results for the year to 30^th June 2021, says that it may be able to reduce its office space by as much as one third. Obviously, this trend will have a major negative impact on the property sector which is already suffering with record office vacancy rates. It will probably also see a significant shift towards converting offices to residential spaces.

One of the most important impacts of the civil unrest in July month has been an increase in the number of professionals seeking to emigrate from South Africa. Taxpayers earning above R750 000 per annum (R62500 per month) has declined by more than 9000 over the past two years. These people have been burdened with an increase in the marginal rate of tax to 45% and are being proposed as a source of further tax revenue in the future to fund such projects as the National Health Scheme. High income earners usually have the financial ability to emigrate but when they leave they exacerbate the unemployment situation and reduce South Africa’s ability to operate efficiently.

 

The Rand

As the chart shows, the rand is in a long-term strengthening pattern which has been there since the COVID-19 spike in March 2020. It reached a cycle low at R13,43 to the US dollar on 4^th June 2021, but since then it has weakened because of a variety of factors. Some of those have been internal like the civil unrest and the cabinet reshuffle which saw Mboweni replaced by Godongwana as Minister of Finance. Others have been external resulting in shifts towards “risk-off” in the international investment community.

In our view, the rand remains under-priced against first world currencies and as the situation normalises, we can expect it to resume its strengthening pattern. A major factor which has substantially softened the impact of the move to risk-off has been the commodity boom which has seen a significant inflow of cash into the country. We expect that boom to continue and even to gain further momentum. Almost all South African quality shares have a rand hedge component or some exposure to the rand, so it is essential for the private investor to have a well understood view on where it is likely to go in the future.

 

COVID-19

The new C12 variant of the virus has begun to spread in South Africa, accounting for as many as 2% of all infections in July. It may cause the 4^th wave which has been much anticipated by scientists. Obviously, a 4^th wave of the Corona virus would be bad for the economy and hence the share market, especially if the current vaccinations offer no protection from it. This seems unlikely since the research shows that the vaccinations offer considerable protection against both the beta and delta variants. The country is out of the third wave and infection rates have dropped significantly. Vaccination rates have slowed, and various efforts are underway to encourage people to vaccinate.

It would appear that vaccine passports will become a reality in South Africa as they are in other countries around the world. There is a growing perception that those who refuse to get vaccinated are potentially endangering the rest of the population and so will be restricted from participating in activities which involve close contact with other people. At the moment, this is mostly impacting on international travel where passengers are required to be vaccinated and often have to endure a 14-day quarantine period at their own expense at their destination before being allowed to mix with the general population. This approach is likely to spread to include proof of vaccination at restaurants, schools and other venues where people gather. In time, vaccination certificates will probably be included into identity documents.

The decision by Discovery and more recently Sanlam to insist that all its employees are vaccinated shows the direction in which this debate is going to progress. Piet Mouton’s open letter in which he suggests that unvaccinated people be banned from all shops, schools and other public institutions adds to the momentum. No doubt other large JSE-listed companies will soon follow suit so that soon being “anti-vax” will carry with it some serious problems. No doubt the legality of this decision will be tested in the courts, but our view is that it highly likely that the courts will allow companies to insist on their staff being vaccinated since it is demonstrably in the best interests of the majority.  

The move to level 1 lockdown is welcome but will probably not have a significant impact except in specific industries like the liquor and restaurant businesses. Now everyone is holding their breath in case there is a 4^th wave of the pandemic.

 

Companies and Sectors

 

CONSTRUCTION

Afrimat says that the construction industry has seen a 55% improvement in activity in the second quarter year-on-year and grew by 4% quarter-on-quarter. While activity in the sector in 2021 was almost 7% below 2019 levels, there are indications that the sector is recovering rapidly. The industry has benefited from the repair and reconstruction following the civil unrest and also from an increased number and value of government contracts. Some of the construction companies have benefited from additional work with the mining industry which is experiencing a boom. The construction industry accounts for about 8% of employment in South Africa.

 

MUSTEK 

Mustek (MST) is South Africa's largest assembler of personal computers under its brand name Mecer. It also imports a variety of computer products such as Samsung, Acer and Microsoft. The company consistently trades well below its net asset value (NAV). It is beginning to benefit from its fibre-to-the-home activities and selling additional hardware as a result. The CEO, David Kan, is very excited about the exploitation of the fibre-to-the-home market. He says there can be exponential growth of as much as 500% in their sales of cables for this market. There is a possibility that the company will also benefit from remote education and work-from-home following COVID-19. Mustek is well-positioned to exploit this through its existing products. In its results for the year to 30th June 2021 the company reported revenue up 25,6% and headline earnings per share (HEPS) up 247,5%. The company's net asset value (NAV) rose by 28% to 2046c compared with a share price of 1379c. The company said, "...the revenue growth was across the Board with the Group’s two largest segments Mustek and Rectron growing their revenue by 22.6% and 30.0% respectively. Rectron benefited from the surge in demand for their products. The addition of HP Printers, Zebra and DJI Enterprise to their range of products towards the end of the 2020 financial year, assisted their growth. The gross profit percentage increased to 14.8% (2020: 14.2%) predominantly as a result of the increased demand for the Group’s products and worldwide supply shortages". On 16th July 2021 the company reported on the unrest and looting saying, “The Group is assessing the damage caused to its branches and total losses to inventory and equipment is not expected to exceed R20 million". On a P:E of 3,12 and dividend yield of 5,22%, the share seems very cheap to us. Consider the chart:

ARCINVEST

This is an investment holding company which trades at a discount of more than 60% to the value of the investments which it holds. The joint CEO says that the company intends to reduce its investments from 47 to about 30 and use the proceeds to pay dividends and buy back its own shares. It owns Tymebank which is growing its client base rapidly and looks to have a good future. This seems like a good opportunity for private investors. Technically, after the COVID-19 spike in 2020, the share has completed a “saucer bottom” and now looks to be in an uptrend. Consider the chart:

It does not pay dividends, but trades on a price:earnings multiple of 5,37 – which looks cheap to us.

 

TELKOM

When Telkom shares began falling in July 2019, we advised investors to apply a 65-day simple moving average and wait for a convincing buy signal. That buy signal came on 2^nd June 2020 at 2178c. A second buy signal was given in October 2020 and since then the share has moved up to current levels around 4479c. In the process it first had to penetrate resistance which developed at 3700c (the horizontal line on the chart below). Once that resistance was broken, the share continued its upward trend but has returned to the 3700c level on two occasions subsequently – which shows that a resistance level becomes a support level once the resistance is broken. Consider the chart:

In recent days Telkom has announced that it will separately list its property and towers division separately under the name “Swiftnet” before the end of this year. That pushed the share up strongly as investors anticipated a significant release of value. We still believe that Telkom has got some distance to run and will release further value in the future.

 

CITY LODGE

This is share which has been hammered by the general decline in the economy during the Zuma years and then in 2020 by the lockdowns and restrictions associated with COVID-19. This forced the company to conduct a rights issue at a very disadvantageous point diluting its existing shareholders substantially. The shares fell to a low of 225c on 4^th November 2020. Since then, however, the share has been recovering slowly as lockdowns disappeared and the vaccination roll-out began to take effect. The company has seen its turnover drop by 56% from R1,1bn to about R0,51bn – a massive hit. It has cut costs drastically and sold off assets. But what is noteworthy is the resilience and skill of management in this excessively difficult environment. In our view, City Lodge’s hotels are probably worth about R10.50 per share but the share is trading for 497c. Business travellers are returning, and company should have all its hotels open and operating by the end of this year. In our view it represents a bargain at current levels, especially given the quality of its management. Consider the chart:

GRAND PARADE  INVESTMENTS

Grand Parade Investments (GPL) is an investment holding company which had franchises for Dunkin' Doughnuts, Baskin Robbins and Burger King. It is now out of the fast-food business and focused on its gaming business. The share price fell from its high of over 750c in October 2014 to around 191c in September 2020 and is now staging something of a recovery. At current prices, it is about 70 percent of its intrinsic net asset value (which is based on future earnings) of 451c. It is also significant that the turnaround specialist, Value Capital Partners, originally acquired 8,05% of the company but increased its holding to 20,88% in April 2019, probably by buying up Hassen Adams' 20 million shares. Consider the chart:

We suggested that investors wait for a convincing break up through its downward trendline which began in February 2020. That upside break happened on 18th September 2020 at 190c, and the share has since moved up to 313c. 

 

BIDCORP

Bidcorp (BID) is a diversified international food company which operates in 34 countries around the world. It was spun out of Bidvest in June 2017 to release shareholder value. We see this as a solid blue chip, rand hedge share which should perform well. About 95% of its income is generated outside South Africa. Bidcorp focuses on the wholesaling and delivery of what it describes as "fit-for-purpose" product ranges which it says will continue to grow strongly. In its results for the year to 30th June 2021 the company reported revenue down 4,8% and headline earnings per share (HEPS) up 21,8%. Following the spike down as a result of COVID-19, the share has been in a strong upward trend, but remains volatile.  It is on a P:E of 36,86 - which is an indication of its blue-chip, rand-hedge status. Consider the chart:

We expect it to continue to perform well, benefiting directly from the general recovery of the world economy. Technically, the share fell back with the impact of COVID-19, but it is recovering rapidly. We see it as relatively under-priced at current levels.

 

CAPITEC

This new bank is now South Africa’s largest in terms of client numbers with about 16,8m active customers. Its growth has been nothing short of amazing and it is continuing to take market share away from other banks. In its results to 31^st August 2021 the company grew its net asset value (NAV) by 22%. Consider the chart:

Capitec:  February 2020 - 1st October 2021. Chart by ShareFriend Pro.

You can see the impact of COVID-19 and then the island formation which followed. Form August last year the share has been recovering rapidly with a strong upward trendline. In the last few days it has adjusted in line with the correction on Wall Street and the general shift to risk-off. This has brought the share’s price back to touch the underlying trendline. In our view this represents a relatively rare buying opportunity.

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