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REFOCUS
PORTFOLIO MANAGER MONTHLY - MARCH 2016
This document describes our thinking behind selected recent portfolio management actions in our
portfolios and provides context to their current positioning against the backdrop of their investment
opportunity set. Our funds always consist of a diversified portfolio of opportunities and risks; please
bear that in mind when evaluating our commentary about individual positions.
OH JUNK!
South African investors, and the public at large, have been gripped by a mass fear of a potential
downgrade in the sovereign debt ratings of the country. “Junk status” and “Downgrade” have become
Jan van Niekerk
buzzwords and a favourite topic of newspaper scare articles.
There is just nothing like a looming ‘debt downgrade’ to add to the intrigue of the political drama playing out at the moment.
Now RECM has long been vocal in our view that investing on the base of forecasting the future is a mug’s game. We do think however
about the environment within which we live, within which companies, governments and families operate and how these affect behavior
and therefore asset prices. In doing this, we try to remove the emotion and consider facts, some of which are listed below:
•
The South African Government has total outstanding debt of R2.18 trillion according to http://www.nationaldebtclocks.org/
debtclock/southafrica (and the SARB).
•
The sovereign rating of a country’s debt applies to its external debt – that is, the debt that is denominated in currencies other than
its own currency. The debt ratings on local currency debt is normally much stronger than foreign currency debt as a country prints
the currency in which its local debt is issued and therefore has a stronger ability to repay local debts.
•
South African government debt was only awarded “Investment Grade” status in 1997 for the first time by more than one ratings
agency. Before that, the debt was either “junk rated” or not rated (which is similar to being ‘junk’ anyway in the eyes of those, so
called, investors that matter).
•
The total amount of foreign currency debt of South Africa is about R198bn, which comes to 9.8% of the total outstanding debt of
the Government. (South Africa issued bonds in US$, Euros and Yen).
•
The total amount of debt, relative to the economy, as measured in the Debt-to-GDP numbers, are at similar levels today (49%)
vs 1997 (50.4%). This measure bottomed at 26% during 2008, and has been deteriorating rapidly over the last three years – a
development that rightly concerns investors and rating agencies alike.
•
The total amount of government expenditure that is consumed by interest payments has reduced from 20% in 1997 to just over
9% currently. This is a reflection of the lower rates of interest on outstanding debt. Older debt had higher coupons, which have
now been settled and new debt has been issued at lower rates.
•
The source of Government’s income – its tax base – has increased from 20.3% of GDP in 1997 to 23.1% recently. In that period,
the South African economy grew be a nominal average annual rate of 10.1%, while tax revenues grew by 11.0% per annum, from
R142bn in 1997 to slightly more than R 934bn in the last financial year.
A credit rating is not a popularity contest – it is a (mostly) formulaic assessment of the macroeconomics of a country, which aims to
judge a country’s willingness and ability to service and repay its debts. When considering the various measures that rating agencies
watch, it is clear that a debt downgrade is on the cards – but that is no secret.
The popularity contest happens in financial markets, where prices of government securities and the currency is set based on investors’
views of the situation (or based on their view of other investors’ views of the situation, to paraphrase JM Keynes).
RECONNECT
One crude measure is to compare the interest rates on 10-year bonds. Chart 1 shows the history of the difference between the rates
the South African government has had to pay over time with those that the US Government has paid – both in their respective local
currencies. One can see how investors were generous around 2006, but recently have started demanding a much higher premium to
lend their money to the South African government. Only for a few months during the emerging market crisis of 1998 was this spread
higher than it is currently. It’s safe to say that South Africa has gone from the ‘Belle of the Ball’ to Cinderella in the last 10 years.
Chart 1: 10-Year Local Currency Bond Spreads SA Vs US
16
14
12
10
Company
Last 12 Months Returns
EOX Emerald Oil Inc -95.88%
-95.88
6
FXCM FXCM Inc -94.67%
-94.67
AAMC Altisource Asset -94.61%
-94.61
4
EMES Emerge Energy Services LP Commo -91.55%
-91.55
BTU Peabody Energy Corp -90.54%
-90.54
2
ISH International Shipholding Corp -89.27%
-89.27
LINE
Linn
Energy
Llc
-87.75%
-87.75
0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
LNCO Linn Co Llc 2.65 -87.74%
-87.74
Source: Bloomberg
GNK
GencoChart
Shipping
& Trading
Ltd -86.20%
-86.2
The second indicator one can use is the level of the
currency.
2 shows
the ZAR/USD
exchange rate, compared to its ‘theoretical
VNCE
Vince
Holding
Corp.
Common
Stoc
-86.06%
-86.06
value’, calculated by comparing the relative producer prices of the two countries over time. Classic purchasing power parity suggests
Enphaseand
Energy
Inca -85.06%
-85.06
that this measure should give a good indication ofENPH
the direction
level of
currency’s movements. Assuming the rating agencies
were correct in 1997 when they awarded South Africa
its
investment
grade
rating,
and
taking
that
date
as
the
starting
date
of the
BBEP Breitburn Energy Partners -85.03%
-85.03
calculation, suggests that the market is currently discounting
a very
bad futureCompany
for South Africa.
Even if one does a ‘best fit’ analysis,
CENX Century
Aluminum
-84.89%
-84.89
it is clear that the currency has overshot.
MPO Midstates Petroleum Company -84.88%
-84.88
MCEP Mid-Con Energy Partners LP 2.74 -84.63%
-84.63
Chart 2: ZAR/USD Vs PPI Parity
BTE Baytex Energy Corp 4.70 -82.88%
-82.88
ORIG Ocean Rig Udw Inc 2.25 -82.14%
-82.14
18
BCEI Bonanza Creek Energy Inc -82.08%
-82.08
ECR Eclipse Resources Corp -81.35%
-81.35
16
QUMU Qumu Corp
-81.06
8
14
10
8
6
2015
2015
2014
2014
2014
2013
2013
2012
2012
2012
2011
2011
2010
2010
2009
2009
2009
2008
2008
2007
2007
2007
2006
2006
2005
2005
2004
2004
2004
2003
2003
2002
2002
2002
2001
2001
2000
2000
1999
1999
1999
1998
1998
1997
4
1997
ZAR / 1 USD
12
Source: Thomson Reuters Datastream
RECONNECT
The theory of risk-and-reward in lending suggests that the less able you are to service or repay your debt, the higher the interest
rate your creditors will charge you to borrow their money. If South Africa’s creditors take a dim view of the country’s ability
to repay its debts, then interest rates could increase further, pushing up the cost of funding for everybody operating in the
economy.
So if your business model depends on employing generous amounts of leverage – especially the short term variety – to operate
or to achieve adequate returns on your capital, then you should rightly be worried.
In managing our South African portfolios, we have been acting on these signals, by reducing offshore exposure gradually, and we
have recently dusted off our bond calculators for the first time in 10 years. We continue to tread lightly around local businesses
with significant gearing and high expectations priced in – notably banks, listed property and some industrial companies.
Having said that, we are currently running with significant cash exposures in our funds. A downgrade to junk status, might just
give us the buying opportunity in good quality local assets that we have been waiting for.
Disclosure
Collective Investment Schemes are generally medium to long term investments. The value of participatory interests or investments may go down as well as up and fluctuations or movements in exchange rates may also cause the value of underlying
international investments to go up or down. Past performance is not necessarily a guide to the future. The manager does not provide any guarantees either with respect to a funds’ capital or investment returns. Collective investments 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 where insufficient liquidity exists. A schedule of fees and charges and maximum commissions is available on request
from the manager. Commission and incentives may be paid and if so, would be included in the overall costs. The quantifiable deduction is the annual management fee (and performance fee where applicable), whilst non-quantifiable fees included in
the net asset value price may comprise brokerage, auditor’s fees, bank charges, taxes, trustee and custodian fees. Collective investment prices are calculated on a net asset value basis, which is the total value of all assets in the portfolio including any
income accrual and less any permissible deductions from the portfolio. Forward pricing is used. Where a fund is exposed to foreign securities, investors should consider the (a) potential constraints on liquidity and repatriations of funds, (b) global
macro-economic risks, (c) political risks, (d) foreign exchange risks, (e) tax risks, (f) settlement risks and (g) potential limitations on the availability of market information. Funds may be closed. Prior to investing, please read the Minimum Disclosure
Document for your chosen fund/s available at www.recm.co.za.
This document contains objective factual information about our products; does not constitute advice and the reader should approach a financial adviser to determine suitability before investing. No warranty is given as to the accuracy or completeness
of the information and no liability is accepted for reliance upon the information. The Manager is RECM Collective Investments (Pty) Ltd, Company Registration Number: 2004/027540/07, registered under the Collective Investment Schemes Control Act
of 2002 and is a member of the Association for Savings and Investment SA (ASISA). The Investment Manager is Regarding Capital Management (Pty) Ltd, FSP No 18834 and the Trustees, the Standard Bank of SA Limited, PO Box 54, Cape Town, 8000.