SPW team’s top stock
picks for 2018
As we approach the end of a turbulent year, our analysts look to the year ahead and choose the stocks they expect will offer most value to our investors.
Valuation and earnings recovery
Alwyn van der Merwe, Director of Investments
In terms of local share price performance, 2017 was a year of extremes. Within the Top 40 shares, the winners stacked up spectacular performances – Naspers, for instance, gained 87.4% from 1 December 2016. The losers, on the other hand, performed diabolically – Netcare bringing up the rear with a share price decline of 27%. Only 11 of the Top 40 shares outperformed the average of the index, which reflects how narrow the advance of the widely quoted indices was. It was a year in which investors rewarded successful operational results exponentially, but they were equally punitive when companies disappointed.
Our stock picks for 2017 have generally lagged the market, which again serves as a warning against forecasting over the short term – investor sentiment can often drive share prices way off their intrinsic value over the shorter term. There is still popular demand for one-year stock picks, but we offer these with the ‘health warning’ rightly associated with short-term recommendations.
Over the past few years, I’ve followed a process of picking from a universe of shares that have underperformed in the preceding three years, show value based on a number of valuation criteria, and are starting to show recovery in earnings expectations.
Here are my picks for 2018:
Tongaat-Hulett: Tongaat is an exciting recovery story, underpinned by organic capacity growth. The company’s results have declined over the past three years due to an extended drought in its cane-growing areas, exacerbated by high maize input prices to its starch business (which usually acts as a diversifier) over the past year. Over the next three years, we expect the business to benefit from operating leverage as sugar volumes recover and prices return to more normal levels. Tongaat continues to monetise its extensive land portfolio successfully, and will likely generate more than R800 million per annum of operating profit over the next two years.
Three years of declining sugar earnings have set the share price back to 2012 levels, but recovering earnings mean the company now trades at a 9.4 times multiple on the expected earnings for the next 12 months. Over the next three years, we expect headline earnings per share (HEPS) growth of 35% per annum from the low 2017 base to R16 per share in the 2020 financial year. The stock is also cheap on a sum-of-the-parts basis, with the land business alone worth around R55 per share (versus a share price of R106). We have a fair value of R134 per share.
EOH: EOH is a market darling that has fallen from grace. The group’s 17-year history of reporting earnings growth in excess of 20% came to an end in the 2017 financial year (FY17), when growth fell to 16%. In light of this slowdown, multiple concerns around the business’s stability have arisen – from the retirement of founding CEO Asher Bohbot to unproven (and subsequently retracted) media allegations of impropriety in winning government business. But most concerning is that working capital has risen ahead of revenue recently, creating a gap between accounting profits and cash flows. This should begin to reverse in FY18.
In our view, the market has punished the share price far too severely for the above issues. We expect HEPS growth of 15% compound annual growth rate (CAGR) for the next three years – yet the share trades at a rolled forward earnings multiple of only 8.2 times, with a 3% dividend yield and a 10% free cash flow yield. The share price already discounts a decline in earnings, which provides investors with a wide margin of safety. We have a fair value of R115 per share based on a conservative 11.5 time forward price/earnings (P/E) multiple. When we value the share on a discounted cash flow basis, we put a value of a R120 on the share.
Metair: This share also featured on our 2017 list, but the share price performance was disappointing. Our investment thesis, however, hasn’t changed. The one-off retooling of Metair’s South African manufacturing facility and struggling European operations, largely on the back of deteriorating political relations between Turkey and Russia, continued to weigh on the share price. Metair delivered a better-than-expected earnings result in first-half 2017, yet the share price did not respond.
The company remains on a path to rebalance the business towards batteries, which are higher margin and less cyclical than auto components. It is, however, exposed to a number of negative factors from a news perspective, including South African manufacturing exposure, a business in Turkey, and a narrative that lead acid batteries are being displaced by electric vehicles. Ultimately, cash flows generated and dividends paid out will overrule sentiment on the former concerns. We believe investors will change their minds on these factors over time, or when the results prove these concerns unfounded. Uncertainty regarding the impact of electric vehicles and the demand for lead acid batteries is likely to linger longer, however.
The company trades on a seven times forward multiple, with decent growth prospects in our view. While the market has been brutal toward smaller companies over the past few years, we don’t buy the argument that big companies will continue to get bigger into perpetuity – the maths doesn’t add up.
Invicta: As an importer and distributor of agricultural and construction equipment, and a leading distributor of engineering consumables and provider of engineering solutions, Invicta is often at the mercy of the strength of general economic activity, particularly activity within the primary sectors of mining and agriculture. One can therefore understand investors’ current scepticism when ‘rating’ the company. As is common practice, investors are unlikely to give a company the benefit of the doubt when operations have been under pressure for a sustained period, as has been the case with Invicta.
The company has a strong balance sheet, which would allow acquisitions at a time when prices are low. Despite modest earnings growth expectations, the share is currently trading on a 12-month forward earnings multiple of just over eight times. In our view, investors are being overly cautious, and patient investors are likely to be rewarded for the risk they take to invest in this share.
Coronation Fund Managers: Coronation’s profitability is mainly driven by two factors – assets under management (AUM) and its fee margin. Both of these were under pressure over the past three years, but are expected to improve over the next year.
AUM are driven by the markets and the net in- or outflows from clients. The recent rise in the South African equity market after a three-year consolidation should start having a positive impact on Coronation’s earnings in the new financial year. Despite suffering large investment outflows over the past three years, the momentum seems to be turning, driven by the reopening of a few of its key institutional mandates and a recovery in its relative investment performance.
The improved relative investment performance is also expected to lead to a recovery in investment performance fees – despite pressure on fees in the industry – over the next year, from a low base. The share is trading on a very undemanding one-year expected dividend yield of 7.1%. This compares favourably to the JSE All Share Index of 3.2%. In our view, Coronation is a cheap proxy for those who believe local shares will continue to outperform other local asset classes.
Altaf Rooknoodeen, Portfolio Manager SPW Johannesburg, and Emile Fourie, Portfolio Manager SPW Pretoria
BHP Billiton: The BHP Billiton share price doesn’t fully reflect the recent rally in commodity prices. This important point, along with the knowledge that you’re buying into high-quality assets with strong margins, should provide investors with comfort when investing in this cyclical stock.
The stubbornly high iron ore price and the recent resurgence in the oil price due to production cuts and tensions in the Middle East, both bode well for the company. Net debt has been reduced significantly to June 2017 due to strong cash flows – net debt was down 38% in 2017 to US$16 billion – and the company recently announced plans to dispose of its low-margin shale assets. Capital spend continues in copper and petroleum. BHP trades at a forward P/E of 12.9 times and has a dividend yield of 5.2%.
Woolworths: Woolworths is a unique South African retailer. With its successful high-end food offering (26% of operating profit) and strong Australian presence through Country Road and David Jones (41% of operating profit), it’s difficult to compare Woolies with other local retailers. The company’s two primary markets, South Africa and Australia, have both experienced tough economic conditions mainly as a result of political dysfunction. Australia has switched prime ministers five times over the past decade, which has impacted the economy negatively over the past few years.
While the near-term environment is expected to remain tough for consumers in both South Africa and Australia, we see this as an opportune time to invest in a quality company with a highly respected management team. Woolies trades at a forward P/E of 12.7 times, at an attractive dividend yield of 5.5%. Recent investments made by the company should bear fruit when the cycle starts to improve. These include IT system overhauls to improve inventory management, the introduction of high-end food concepts in Australian stores, and optimisation of the real estate portfolio.
Remgro: Locally orientated stocks have performed poorly as a result of the economic and political environment in South Africa. Investor pessimism can, however, lead to buying opportunities. Remgro has underperformed over the past few years as a result of its investment in Mediclinic (down 52% from its high price), and exposure to locally based businesses such as First Rand and Rand Merchant Insurance (RMI).
We believe Mediclinic’s Al Noor business in the Middle East is turning the corner and will be able to grow earnings longer term off the current low base. It will therefore start to contribute to the South African and Swiss businesses. Additionally, First Rand and RMI look attractive at current price levels.
Remgro is currently trading at a 15% discount to intrinsic value. At the current price, one is buying a basket of above-average quality assets at an attractive level.
Impala Platinum: As with other mining industries, the platinum industry is cyclical. Platinum-group metals (PGM) prices are currently very low and below what we’d consider to be the normal prices required to sustain the industry. Competitors in the PGM sector will find it increasingly difficult to survive this trying period. Impala Platinum (Implats) has the important advantage of a strong balance sheet to operate through the low-price environment. Additionally, the company has responded by concentrating on controlling costs and improving productivity.
Implats is currently trading at 90% below its peak price reached in 2008 and at a 0.6 price-to-book value. We believe the company is worth around R55 per share, and is therefore attractively priced at R40 per share.
Carl Schoeman, Wealth Manager SPW Claremont
Sasol: With its sales priced in US dollars, Sasol offers investors an attractive hedge against a depreciating rand and a rising oil price. The stock currently trades at a discount to intrinsic value due to a depressed global oil price and massive capex (hitting a peak in FY17 of R60 billion and R59 billion in FY18 before declining by about 50% in FY19). There are also questions about management’s ability to allocate capital (specifically around the Lake Charles project) and its strategy to hedge 82% of the company’s energy and 70% of the US dollar exposure (which could be viewed positively in the face of massive capex commitments, as it could provide revenue certainty).
At its current price of R428, the stock is on a historic P/E of 12.89 times and a dividend yield of 2.94%, while still ascribing a value of zero to Lake Charles, which is currently estimated to be worth around R50 per share. There is thus a sufficient margin of safety at current share price levels.
Positive catalysts for the share price to close the discount between current levels and its intrinsic value include a depreciating rand and firming global oil prices, Lake Charles starting to produce revenue in second-half 2018 and the decline in capex. All these factors should have a positive impact on earnings in FY18 and into FY19.
PPC: In addition to the construction slowdown in South Africa, PPC has faced several headwinds, including a downgrade of its debt by S&P Global Ratings, which resulted in a rights issue. Other challenges have been a public spat between the company’s former CEO and its board, falling cement prices, and concerns over the economic viability of operations in the Democratic Republic of the Congo (DRC). Earnings fell by 83% in FY17 and the share price fell to a low of R3.44. The company was also subject to a merger offer in September that would have valued the business at R5.75 per share, only slightly ahead of the book value of R5.33 a share.
PPC’s share price has reacted to the offer, almost doubling from its lows (which were simply too cheap). However, we believe there’s still some headroom for the price to appreciate. If you value the company on a normalised ‘through-the-cycle approach’, its intrinsic value is closer to R10 per share, despite the book value of assets being just over R5 per share. This doesn’t truly reflect reality. Because of management’s continuous writing down of assets, the replacement cost would be closer to R17 per share.
Potential positive earning catalysts include PPC’s DRC and Ethiopia projects becoming cash generative, and the fact that import duties in South Africa have resulted in a decrease in imports, resulting in local cement prices stabilising in the face of declining supply. Capex is declining, so debt reduction and resultant increase in cash flow should follow suit along with improved operational performance associated with the capex. Consensus is for earnings growth of around 430% for FY18 and a further 53% in FY19 putting the stock on a forward P/E+1 of 17.5 times and P/E+2 of 11.5 times. There is potential for earnings to surprise on the upside.
Pieter Fourie, Head of Global Equities at Sanlam Private Wealth UK
Reckitt Benckiser: As the world’s leading consumer health and hygiene company, Reckitt Benckiser has operations in more than 60 countries. The company’s products include fabric treatments, air fresheners, detergent, personal care and over-the-counter drugs such as painkillers and flu remedies. Reckitt Benckiser is a high-quality business with high margins, free cash flow, a robust financial position and low capital requirements, rewarding shareholders with phenomenal returns and earning a reputation for its strong cash generation.
Reckitt Benckiser has a free cash flow yield of 5.3% and a free cash flow conversion ratio in excess of 90% over the past five years. It’s been able to deliver a decade of superior earnings growth with best-in-class working capital and margins. We like the positioning of the portfolio to participate in the faster growth dynamics of the health and hygiene categories, and the Mead Johnson acquisition should provide another leg of growth for years to come.
Medtronic: A global leader in medical technology, Medtronic develops therapeutic and diagnostic medical products. We believe Medtronic is competitively well placed, as it holds the number one position in almost every product category it is in, and has a leading distribution footprint, deep clinical expertise and a strong pipeline programme. We’re attracted to the company’s emphasis on gross margin stability, operational leverage and its long-term financial goals. Management has a disciplined approach to allocating capital, with a focus on creating shareholder value and delivering long-term dividend growth.
The company has a solid track record, having consistently achieved appealing cash returns on invested capital, which have averaged over 50% over the past 10 years. Medtronic has a prolific track record of generating free cash flow, having achieved an impressive conversion rate averaging more than 110% over the past decade, excluding the Covidien acquisition. We see this trend continuing, with Medtronic on an implied enterprise value to free cash flow yield of over 6% three years out.
Philip Morris: Philip Morris is a high-quality business with exposure to a good mixture of markets in the European Union, Eastern Europe, Middle East and Africa (EEMA), Latin America and Canada. It’s the market leader in the tobacco industry with seven of the world’s top 15 international brands, and the capability to pass on costs to the end consumer.
We believe dividends should continue to grow steadily in the near future, even when earnings momentum will remain under pressure, with negative foreign-exchange impacts from all the regions in which Philip Morris operates. In Japan, IQOS (heat non-burn technology) has gone from 1.6% market share of total tobacco products to 4.9% in just six months to end-December 2016. This sets the scene for the company’s ability to compound earnings per share at double digits over the next three or four years – twice the rate of competitors, and hence the premium valuation.
Priceline: Priceline is a high-quality company that’s perfectly positioned to take advantage of the migration of travel bookings from offline outlets to online operations. Thanks to its end-markets being highly fragmented, the company provides much-needed scale to customers who would otherwise be unable to advertise and market in an efficient and successful manner.
Priceline is better positioned than its main competitor, Expedia, as it has greater exposure to more profitable markets: Europe and accommodation. It has also managed to grow revenues at an extraordinary rate over the past few years, while at the same time keeping the cost of revenues and operating expenses under control.
The travel market is currently valued at around US$1.3 trillion and is growing at 5% per annum. With only mid-single digit market share, Priceline has a large runway for growth.