Month: July 2018

Naspers managers – how to play defence

There is a much better defence for the R1.6bn of employment benefits received recently by Naspers CEO Bob Van Dijk than that only R32m so far has been taken in cash, as Naspers has argued so extraordinarily. Try telling Steinhoff or Facebook shareholders that they have not in fact made a loss until they cash out, or for that matter inform Naspers shareholders who have held on to their shares that they paid R300 a share for in early 2010, now worth over R3000, that they are not now much better off.

The defence I would make on behalf of Naspers managers is that the difference between the market value of Naspers and the market value of its stake in Tencent and other listed entities has narrowed sharply, to the clear benefit of Naspers shareholders. This difference between the value Naspers and the value of its stake in Tencent has been widening almost continuously since 2014 and was as much as R800bn in early 2018. It has recently however halved to about R400bn.

 

I would argue that such an improved rating in the market is to the credit of the Naspers managers. Clearly they have very little ability to influence the market value of its stake in Tencent, by far its most important asset. Were they to have done nothing but hold their 30% plus stake in Tencent, their shareholders would now be R400bn better off.

But the Naspers managers have done much more than this. They have undertaken a very active and ambitiously expensive investment programme. They have invested the growing flow of dividends they receive from Tencent into this programme and have raised much extra equity and debt capital in order to fund their investments.

Given the difference between the value of Naspers and the value of its listed assets (overwhelmingly Tencent) it is clear that the market place has a very poor regard for the ability of this investment programme to add value for shareholders. That is to say, to earn returns from it that will exceed the returns shareholders could realise for themselves if the cash derived from Tencent were distributed to them. And the extra equity or debt capital had not been raised on their behalf. The share market expects Naspers to lose rather than add value with its investments and ongoing business activity. Hence the company is valued at much less than the sum of its parts. But the value gap has closed significantly recentl,y for which management deserves credit.

The difference between the market value of its assets net of debts and the market value of Naspers itself can be attributed to one of three essential forces and judgments of them. Firstly, and surely the most important influence, is the expected net present value (NPV) of its investment programme. That is the market’s negative estimate of the difference between what the (large) sum of capital expected to be allocated and the value to shareholders these investments (however funded) are expected to deliver. All such estimations will be calculations of expected present values – that is estimates of cash out and cash expected to flow back to the company in the future, with all such flows discounted with the appropriate discount rate or cost of capital to repreasent the opportunity cost of the investments.

Ideally the expected NPV would have a positive value. In the case of Naspers, given the R400bn value gap, the estimated NPV can be presumed to register a large negative number. Though this pessimism about the value of the investment programme may not be the only drag on the market value of Naspers. The expected cost to shareholders of maintaining the Naspers head office – including the benefits provided to its CEO in cash or in shares or in options on shares – also reduces the value of a Naspers share- as it does for all companies.

A further factor adding to the gap between the sum of parts valuation and the market value of a holding company might be differences between the book or directors’ value attached to unlisted investments by the holding company and the market’s perhaps lower estimate of their value. Listing the assets and/or unbundling or disposing of them may prove that the market had been underestimating their value, and so help to close the value gap.

All these value adding or destroying activities (including deciding how much to reward themselves) are the responsibility of the senior managers and the directors of Naspers. It would appear that, in the opinion of the market place, their recent efforts in these regards have been more rewarding for shareholders, some R400bn worth. It’s the result, perhaps, of a more disciplined approach to allocating fresh capital that the market place has appreciated. It may reflect the more favourable market reaction to a more predictable, less dilutive approach taken by managers to rewarding themselves with additional shares. And also perhaps by a greater apparent willingness to list and sell off subsidiaries capable of standing on their own two feet.

We would suggest to Naspers that incentives provided for managers in the future be based upon one critical performance measure: closing the gap between the sum of parts value of Naspers, that is its NAV and its market value. Shareholders would surely appreciate such an alignment of interests. 30 July 2018

 

 

Dangerous curves

The danger in the US is not rising interest rates themselves, but rises that surprise

US President Donald Trump, being the businessman he was (or is), woke up one recent morning worrying about interest rates and what the Fed might do to the US economy (or perhaps his real estate portfolio) with higher interest rates.

Being Trump, he immediately Tweeted his concerns to the world at large, so defying the convention that the Fed should be independent of political forces, causing predictable consternation. But with more reflection he might have noticed that the market place was doing the job for him: of actively restraining the upward march of interest rates expected in the future.

While short term rates, under the direct influence of the Fed, have been on the rise and are confidently expected to rise further over the next 12 months, the pace of further increases is expected to slow down to very gradual increases over the next three years. The current yield on a one-year US Treasury Bond is 2.42%. In a year’s time this yield is expected to be 2.87% but in three years’ time it is expected to be only a little higher, at 2.94%.

One can interpolate the expected rate of interest from the term structure of interest rates. Investing in a one year to maturity Treasury will yield 2.42%. A Treasury Bond with two years to run now offers little more, or 2.64%, and a three year Treasury Bond yields but 2.73%. An investor can secure 2.73% by committing to a three year investment, or alternatively invest for a year at 2.42% and then reinvest for a further year at what will be the one year rate in a year. The expected returns must therefore be very similar given the alternatives of investing for longer or shorter periods.

Given the alternative of investing for a longer period or a shorter period and then reinvesting the proceeds, the longer-term rates can be regarded as the (geometric – allowing for compounding of interest) average of the expected short term rates. The difference between the fixed yield on a two year bond and the fixed yield on a three year bond can be used to calculate the one year rate expected in three years’ time and so on for any one year period in the future. We have reported these expected one year rates above from a table provided by Bloomberg (The US Treasury Active Curve).

Thus the steeper the yield curve – the greater the difference between long and short term – the more short rates must be expected to rise. The flatter the yield curve – the smaller the difference between long and short rates – the smaller must be the expected increase in short rates. Should the yield curve turn negative, that is when short rates are above longer term rates, this means that short rates must be expected to decline in the future to provide average returns in line with the currently lower longer-term fixed rates.

Borrowers typically incur debts with extended repayment terms. So what is expected of interest rates (more than current interest rates) will influence current decisions to borrow and to spend. Such modest increases in the expected cost of servicing debts in the US is unlikely to be a deterrent to current borrowing and lending decisions undertaken by firms, households and banks or other suppliers of credit.

In the US, the gap between longer and shorter term interest has been narrowing sharply as we show below. Short-term rates have been rising much faster than long term rates – the yield curve has therefore flattened – giving rise to very modest further expected increases in short-term rates reported upon earlier. The difference between the fixed yield on a 10-year US Treasury Bond (2.93%) and a two-year bond (2.64%) is currently a mere 27 basis points (0.27 of a percentage point). The extra rewards for investing currently at a fixed rate for 30 years in a US Treasury Bond (3.05%) rather than 10 years is therefore a very scant 12 basis points. Clearly this reflects a very flat yield curve beyond two years and very limited expected increases in interest rates to come.

 

We therefore need to consider the causes as well as the effects of rising or falling interest rates. Short-term rates can be expected to rise with economic strength and the upswings in the business cycle and fall as economic activity slows down. A sharply positive yield curve implies faster growth and higher interest rates expected. And these higher interest rates can then be expected to slow down the pace of economic growth, hopefully to a rate of growth that can be sustained over the long term. A flat or negative yield implies slower growth to come and in turn lower interest rates to come; that is to help stimulate economic activity enough to enable the economy realise its long term growth potential without deflationary pressures.

The flattening of the US yield curve, while encouraging current spending by restraining the expected cost of debt service, may portend slower growth to come and therefore less reason for the Fed to raise short-term rates in the future and so act as the market expects it to act.

The danger to the US economy however does not come from higher or lower interest rates – provided that they behave as expected – and so move consistently with the expected state of the economy. If this were to happen, interest rates would have little real effect on borrowing, lending, spending and the economy. The danger is therefore not that interest rates may rise, but rather that they rise unexpectedly rapidly. This would disturb the economy and slow down growth unnecessarily rapidly. Trump might have noticed just how carefully the Fed has been to make its actions as predictable as possible, so aligning actual and expected interest rates. His and our concern as economy watchers should be about the danger of interest rate surprises – not interest rate levels. 26 July 2018

 

Is pessimism about the SA economy overdone?

The SA economy: will it gain relief from a stronger rand and less inflation?

The SA economy (no surprise here) continues to move mostly sideways. Growth in economic activity is perhaps still slightly positive but remains subdued. Two hard numbers are now available for the June 2018 month end: for new vehicle sales and the real supply of cash – the notes in issue adjusted for prices that we combine to form our Hard Number Index (HNI) of economic activity. Because it is up to date, the HNI can be regarded as a leading indicator of economic activity that is still to be reported upon.

Its progress to date is shown below. It shows a falling off in activity in 2016 and a more recent stability at lower levels. It is compared to the Reserve Bank’s business cycle indicator based on a larger number of time series that continued to move higher in 2016-17 but has also levelled off in recent months. The problem with the Reserve Bank series is that it is only available up to the March month end for which GDP data is also available.

 

We show the growth in the HNI and the Reserve Bank cycle below with an extrapolation 12 months ahead. The HNI cycle suggests growth of about 1% in 2019 while the Reserve Bank cycle is pointing lower.

 

 

It is striking how well the real cash cycle (included in the HNI) can help predict the cycle of real retail sales. Retail sales volumes gathered momentum in late 2017 stimulated it would seem by an increasing supply of real cash. This momentum has however slowed more recently as inflation turned higher in the face of a weaker rand. Retail sales have been reported only to April 2018.

The key to any revival in domestic spending will be less SA inflation. And inflation will, as always, take much of its momentum from the exchange rate. The recent weakness in the rand has been a body blow for the SA consumer. It has little to do with events in SA and much to do with slower growth expected in emerging market economies, especially China. Where the dollar goes, driven higher by relatively stronger growth and higher interest rate prospects in the US, emerging market currencies, including the rand, move in the opposite direction.

The best hope for the rand and for the SA consumer is that the pessimism about emerging market growth has been overdone. If so some recovery in EM exchange rates can be expected – and that the rand will appreciate in line with capital flowing in rather than out of emerging markets. Some of these forces have been at work this week, helping the rand recover some of its losses and improving the outlook for inflation in SA. It may also if sustained even lead to lower interest rates in SA – essential if any cyclical recovery is to be had.

The importance of inflation for the business cycle is captured in this correlation table of key growth rates in SA. Inflation may be seen to be negatively correlated (and significantly so) with the growth in retail volumes and new vehicle sales. It is even more correlated (0.85) with the growth in the supply of real cash – that is in turn highly correlated with the growth in retail activity. And as may be seen, the growth in retail activity is also strongly correlated with growth the Reserve Bank’s cyclical indicator (Resbank) (0.80 correlated):

 

The problem for South Africa and the Reserve Bank that targets inflation, is that so little of the inflation experienced in SA is under its control. The exchange rate takes its own course – driven by global sentiment – so pushing prices higher or lower, that in turn drives spending lower or higher. Interest rates that may rise with more inflation and then fall with less inflation make monetary policy pro-cyclical rather than counter cyclical. 11 July 2018

Why China is so important to SA

The outlook for the SA economy depends on China

Emerging markets (EMs) and their currencies enjoyed a strong comeback in 2017, after years of underperformance when compared to the S&P 500. The JSE All Share Index kept pace with the S&P 500 in 2017 in US dollars. An EM benchmark-tracking stock would have returned over 40% in the 12 months to January 2018 while the S&P 500 delivered an impressive 26%, less than the 28% delivered to the dollar investor in a JSE tracker.

Investor enthusiasm for equity markets in general and for EM securities and currencies in particular however ended abruptly in January 2018 and waned further in April. The EM equity drawdowns since January have been depressingly large. The MSCI EM Index and the JSE have now lost about the same 16.5% of their end January US dollar values, while the S&P 500 was down by a mere 4% at June month-end.

 

The carnage was widespread across the EM universe. The SA component of the EM Index, with a weight of 6.5%, has been an averagely poor EM performer in 2018, as shown in the figure below. Turkey is the worst performer in 2018, down nearly 30% in US dollars in the year to June. The All China component of the EM benchmark, with a large weight of 31.7%, has lost about 12% over the same period, with much of this loss suffered since March, including a large 7% decline in June. The Brazil Index has suffered a heavy 27% decline in its US dollar value in the past quarter.

 

 

The capital that had flooded into EMs and their currencies in 2017 has rushed out even more rapidly, presumably back to the US, so driving the US dollar higher and other currencies, especially emerging market currencies (including the rand) weaker. The rand has traded mostly in line with its peers in 2018, though it has lost ground to them recently.

 

 

It should also be recognised that the similar flows of dividends and earnings from the JSE and EMs over many years, in US dollars shown in the figure above, is not some co-incidence. It is the result of the similar economic performance of the companies represented in the two indices.

The JSE has been well representative of the EM universe taken as a whole, when measured in US dollars. Naspers, with a 20% weight in the JSE All Share Index and a close to 30% weight in the SA component of the EM benchmark, is largely a Chinese IT company. Naspers is riding on the coattails of its subsidiary Tencent, and this helps account the similar behaviour of the respective indices.

In the long run, it is past performance reflected by earnings, dividends and return on capital invested that drives equity valuations, not sentiment. Reported dividends, discounted by prevailing interest rates, do a very good fundamental job in explaining the level of an equity index over time. In the short run, expectations of future performance (sentiment), will move markets one way or another, as they have moved equity markets in the past.

The sell-off in EM equity markets is not explained by their recent performance, which has benefited from synchronised global growth. It reflects uncertainty about the prospective growth in dividends and earnings and therefore global growth rates to come. We may hope that pessimism is being overdone.

The impact of the performance of companies that operate in China, on the outcomes for EMs generally (including SA), cannot be overestimated. Not only is the direct weight of China in the equity and currency indices a large one, but China is an important trading partner for all other emerging market economies.

Therefore the ability of China to maintain its growth and trading relationships successfully and manage its exchange rate predictably and responsibly will be a vital contributor to the prospects for all EMs. Realised global growth, including growth in the US, Europe and China, will determine the outcomes for EM equity and bond markets and exchange rates. The performance of the global economy and the companies dependent upon it are as good or better than they were a year ago.

The performance of the SA economy would be assisted by a stronger rand and damaged by a weaker rand that moves inflation, interest rates and spending faster or slower. Exchange rate and inflation trends in SA are bound to follow the direction taken in all EM economies, especially China. We must hope that renewed respect for growth in China will make this happen. Our immediate economic future depends more on what happens in Beijing than in Pretoria. 5 July 2018