While South African industrial companies have shown signs of recovery over the past six months as local macroeconomic conditions have improved, they have significantly underperformed other sectors in the market. Over five years, they have lagged the JSE All Share Index and been marked underperformers compared to resources companies.
South African industrial companies are the largest active exposure in the Northstar SCI* Equity Fund compared to the JSE Capped Swix Index. This article analyses the recent poor performance of industrials, explains why we believe the recent rebound is sustainable and discusses three quality businesses the Fund currently holds that we believe are likely to continue to outperform.
Locally-focused industrials have struggled
Our analysis shows that only 30 of 61 stocks in the industrial index managed to produce positive share price growth over the past five years. While the JSE All Share Index generated a return of 9.8% per annum over the same period, the simple average return of all constituents in the JSE All Share Industrial Index (excluding rand hedges) was close to 0%. This paltry return contains a very large breadth of outcomes with compound annual growth rates (CAGRs) for companies in the index ranging from +23% to -31%. With a few exceptions, large- and mid-cap companies outperformed their smaller counterparts and significant rand weakness over the period assisted locally domiciled companies doing business abroad (rand hedges).
The main reason for this underperformance stems from the general weakness in the South African macroeconomic environment, characterised by muted GDP growth, weak consumer confidence and underinvestment. These factors limited the ability of local industrials to expand production and grow their top line. Across the board, the sector saw returns and margins decline as competition and an inability to pass through costs impacted businesses. Companies with more diversified revenue streams and flexible balance sheets were better positioned to navigate these conditions.
The lack of growth and returns locally prompted several companies to expand operations overseas. Underestimating the competitive landscape in most instances proved disastrous and the past few years have seen significant impairment of assets and loss of capital for numerous listed South African companies. Examples include Shoprite and Tiger Brands in Nigeria, Woolworths in Australia and Imperial in Europe.
Over the past six months, the relative performance of South African industrials has improved significantly with retailers and general industrials benefitting most from a stronger rand and improving consumer conditions after the hard lockdown in the second quarter of 2020.
High quality companies were better positioned for COVID-19
While the recovery has been fairly broad-based, we believe that higher-quality industrials have fundamentally benefitted the most from COVID-19 dynamics and have been able to entrench their competitive advantage further and consolidate their dominant market position. The outlook and sustainability for such businesses in our opinion is far better than highly operationally and financially geared businesses.
Northstar’s investment approach focuses on high quality companies with inherent competitive advantages that enable them to generate good returns on invested capital and free cash flows. The market pullback at the start of the COVID-19 pandemic provided us with an opportunity to buy good businesses that generally trade at a premium to their peers. The section that follows discusses three industrials held in the Northstar SCI Equity Fund – Mr Price, Dis-Chem and Distell – that demonstrate the benefits of good management, effective strategy and strong balance sheets.
All three stocks have recovered to above pre-COVID-19 levels and outperformed the Industrial Index (excluding rand hedges).
Chart 5: Share price return (indexed to 100)
Source: S&P Capital IQ, Northstar Asset Management. Date: May 2021
Mr Price (MRP)
While clothing retailers came under significant pressure during COVID-19, and particularly during the hard lockdown, Mr Price’s strong value proposition and distribution capability allowed it to capture market share (+1.8%) as a result of down-trading in the market. While not acquisitive by nature, the group also smartly used the crisis to acquire Power Fashion, further entrenching their value footprint, and Yuppiechef, which represents a move up the value spectrum and further solidifies their online footprint.
Mr Price also re-thought their strategy and diversified into baby and school wear which is likely to pay dividends in the years ahead.
Northstar acquired a holding in Mr Price when the price pulled back in the second quarter of 2020. While we took some profits during the first quarter of 2021, we still hold a significant position in the company.
Dis-Chem (DCP)
Retail pharmacy group Dis-Chem’s skew towards mall-based stores hurt its performance during hard lockdown as the group lost market share across all categories. The resilience of its business model and financial flexibility allowed it to do well despite the difficult times and it soon recaptured the business lost. Like Mr Price, Dis-Chem took advantage of market distress to make a number of strategic acquisitions, including:
- Baby City (R422 million), which enables them to gain share in the highly profitable baby category;
- Medicare (R282 million), which allows Dis-Chem to expand their footprint of smaller stores; and
- Healthforce (R48 million), which adds a further 50 community-based pharmacies in geographies where Dis-Chem was under-represented.
The Fund acquired shares in Dis-Chem following COVID-19 and realised some of the holding after the price rallied, but still holds a large active position.
Distell (DGH)
Alcoholic beverage producer and marketer Distell has been in the news recently due to Heineken’s interest in acquiring the company. Distell was one of the worst affected businesses in South Africa as the lockdowns impacted both on-site alcohol consumption and direct sales. This resulted in a complete halt of sales for months and cost the company 22% of their trading days in the first half of their 2021 fiscal year (to Dec 2020). Despite this, revenue was only down 0.5% in South Africa, increased 2.5% at a group level and the company managed to grow market share in all operating categories. This performance is largely attributable to panic buying and stocking up before and after the alcohol bans in South Africa, combined with the excellent performance in the rest of Africa, where revenue grew 12%.
This performance highlights the group’s product and geographic diversification, the strength of its brands and the efforts of the management team to improve the route to market of the African operations, which are clearly paying off.
Northstar was a holder of Distell going into COVID-19 and maintains a large position in the company.
Forward valuations and earnings prospects suggest scope for further returns
South African Industrials are currently valued in line with their five-year average on a one-year forward P/E basis. Although the sector has seen something of a recovery in earnings over the past quarter (shown as one-year forward EPS in the chart), it remains 10% to 20% below pre-COVID-19 levels. Normalisation of earnings is only likely to happen over the next two to three years, implying that on a medium-term normalised P/E perspective there is still significant value.
Chart 6: SA industrials (excl. rand hedges)
Source: S&P Capital IQ, Northstar Asset Management. Date June 2021
We recognise that, although improving, the South African macroeconomic recovery will be long and fragile. However, we believe that high-quality domestically-focused companies such as Mr Price, Dis-Chem and Distell, that made the most of the conditions precipitated by COVID-19, will be better positioned to grow.