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Investing when the going gets tough

The sentiment towards South African companies is depressed, but Stonehage Fleming’s Jean Pierre du Plessis sees reason for selected optimism.

Investing when the going gets tough

 

By Jean-Pierre du Plessis

 

Investors in the JSE are well attuned to the current realities and challenges facing the South African economy. These have only been exacerbated by the Covid-19 outbreak and resulting lockdowns. 

However, although confidence and return expectations for the JSE are at historically depressed levels, investors are now in a better position to digest the fundamental impact of the pandemic on each company and sector at a JSE listed company level. Sifting through the ‘noise’, we have identified the following themes in our universe of best of breed JSE listed companies. 

Quality management shining through 

What matters most during times of severe stress is how quickly and effectively management teams can adapt to factors beyond their control. A central theme among the best quality management teams has been the focus on cash flows. These teams have delivered through efficient working capital management and decisive action on discretionary capital expenditure. 

Branded goods producer AVI Limited delivered a 14% increase in operating cash flows to R2.3bn for the financial year ending 30 June 2020. This was driven primarily by a material improvement in working capital. Capital expenditure was reduced by 22% to R383.6m, supporting free cash flow generation of nearly R2.0bn – a quality management response from this domestic consumer facing business.

Survival of the fittest 

Companies entering the crisis in strong financial health, with appropriate debt levels, little reliance on external funding and a durable competitive advantage have proven resilient. They should ultimately come out of the crisis even stronger and are now able to enhance shareholder returns through maintaining dividends, possible share buybacks or even opportunistic acquisitions. 

A key source of competitive advantage for global packaging and paper group Mondi stems from its low-cost asset base and focus on conservative, ‘through-the-cycle’ balance sheet management. Mondi entered the crisis in a relatively strong position, with net debt to equity of 55% and a 19.8% return on capital generated in the financial year to 31 December 2020. This has served the group well and was evident in the businesses interim results where Mondi retained its sector-leading investment grade credit ratings and resumed dividend payments. 

Growth sustainability 

Few companies have avoided the impact of Covid-19 at the revenue line. Astute management teams have used their competitive positioning to adapt business models appropriately, achieve efficiency gains or even gain market share. This has alleviated some profit line pressure and positioned these businesses to deliver optimal and sustainable future growth. 

In addition to ongoing market share gains in both retail and distribution markets, Clicks has further benefited from a ‘location tailwind’ in recent months, with 70% of stores located in convenience and neighbourhood shopping centres. This has supported relatively robust top line growth, with management guiding investors to revenue growth in the region of 10% for the financial year to 31 August 2020. 

Stringent cost and working capital management have allowed management to guide to earnings growth of between 10% – 15% for the year. They have also shown the intention to declare a full year dividend in line with the group’s targeted dividend payout ratio of 60% - 65%. 

Opportunities for best of breed companies will persist 

Management teams and business models are facing unparalleled operating conditions. We will likely see further disappointments from lower quality companies. 

Despite this, there are already clear illustrations of commendable execution and adaptability on behalf of respected management teams. These validate our confidence and conviction in these best of breed companies and in our investment approach. 

Given the elevated levels of pessimism and generally depressed valuation levels in the domestic listed equity space, this degree of confidence is not shared by the wider domestic and global investor universe. However, as investment managers we understand what is within our control and what is not – and the market’s rating of a particular company is clearly beyond. 

As long-term investors, our focus is on constructing concentrated portfolios, investing in best of breed companies at appropriate valuation and risk levels. We are confident that continued delivery from our investee companies combined with a renewed appreciation for the traits characterised by these companies should result in pleasing medium to longer-term investor returns.

 

Jean-Pierre du Plessis is a director at Stonehage Investment Management

 

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Jean-Pierre du Plessis
Jean-Pierre du Plessis Average Total Return:
9.79%
27/109 in Equity - South Africa (Performance over 3 years)
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