Every December our analysts choose the stocks they expect to offer the most value to our investors in the coming year.
Combining value and momentum
Over the years we’ve learnt that the one-year investment outcome of a limited list of shares can be very random. Sometimes the selected shares might have a good start, only to fade towards the end of the period. Sometimes a share that looks attractive on valuation grounds might be a non-starter as investors take longer to recognise the value.
Because of these uncertainties I follow a particular approach to ensure we can at least explain the methodology in picking these shares. Last year I followed an approach where I picked shares on valuation criteria in combination with so-called momentum criteria – price momentum and earnings revision. I’ve followed a similar approach to select shares for 2016.
Alwyn van der Merwe, Director of Investments
[DATA SAP: Sappi]
This share trades at the same price it did in 1989! It was a company that operated in a very competitive industry where it had little influence on the price of the products it sold and where the returns on the assets were particularly small. However, the valuation looks attractive as the share trades on a 9.5 times forward earnings multiple, which is a steep discount to the rest of the market.
The company has been on an efficiency drive, with a number of initiatives to improve in areas where the business was poorly run. These improved efficiencies are likely to provide impetus to improved earnings performance. The latter should lead to a higher rating from investors and therefore outperformance for those who believe management will deliver on its promises.
[DATA KAP: KAP]
Since the lows recorded in 2009 the share price has displayed a clear bull pattern. The risk is always that one is too late into the action as the share trades on quite an elevated earnings multiple of 17 times.
However, this is a classic case of the management team transforming a company. Management has focused on the businesses it is good at and divested from the rest. The result has been a business with higher margins and a better return on capital. We assume that although the low-hanging fruit has been harvested, management can still squeeze out further efficiencies, which is likely to support the share price.
[DATA BAW: Barloworld]
This company screens very well on value but not on momentum as it struggles with substantial headwinds in the industries in which it operates. As it is largely exposed to resources markets, the earnings stream is more cyclical and, of course, given the current slump in commodity prices, new orders are significantly down. In addition, Barloworld’s operations in Russia will do little to boost investment confidence.
Management, however, has divested from some non-performing businesses like its European logistics and Australian vehicle retailers. The increased focus and the limited downside of the operations in the resources area should turn the fortunes for the share price from very depressed levels.
[DATA NED: Nedbank]
Nedbank is another share selected largely on valuation criteria. The share trades at an attractive earnings multiple of 9.7 times and on a price to tangible book value of 1.6 times. The share has delivered steady earnings yet the share price has lagged the sector average. Investors question the bank’s provision policy and are clearly concerned about the ‘lazy’ capital following the latest Basel capital requirements for SA banks.
Nedbank might be boring but we’re comfortable with a bank that doesn’t produce negative surprises. It recently bought into Ecobank – operating in Africa – which should also be earnings accretive. With no negative surprises and a low rating, this one is likely to provide a good return relative to the risk one takes on board when investing in this bank.
William Ball, Senior Equity Analyst, Sanlam Private Wealth UK
We believe Medtronic is competitively well placed. It holds the number one position in almost every product category it’s in, has a leading distribution footprint, deep clinical expertise and a strong pipeline programme. We are 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 of allocating capital. Once the recent Covidien transaction has been fully integrated into the business, we expect returns on capital over the cost of capital will be at least 3.5 times.
The company has a prolific track record of generating free cash flow, having achieved an impressive conversion rate averaging more than 110% over the past 10 years, excluding the Covidien acquisition. We see this trend continuing, with Medtronic aiming to generate ~$40 billion in free cash flow over the next five years. This is from a starting market capitalisation of $100 billion – equivalent to an 8% free cash flow yield.
Our investment case is based on the premise that Roche is a scientific leader, enabling it to develop and spearhead many new and exciting therapies. This is a business that has a wide economic moat, driven by its impressive portfolio of biologics and leading position in diagnostics. Its hugely successful and clinically effective oncology drugs continue to grow and gain further approvals in emerging markets, providing relatively inelastic demand. Unlike the traditional small molecule drugs, which are subject to generic competition, biologics are made using specialist materials, have far more complex structures and require specialist manufacturing.
Roche has been developing a large number of biologics through phase III trials during the past few years in fields such as oncology, immunology, haematology and cancer immunotherapy. The immunotherapy pipeline looks exciting to us, with impressive data at the American Society of Clinical Oncology 2015.
American Express (Amex)
American Express operates a powerful closed-loop network that enables it to generate excess economic profit backed by valuable intangible assets in the form of its brands. The secular opportunity for Amex and the other two networks (MasterCard and Visa) is significant, with high global cash penetration rates and personal consumer spending growth expected to be at least in the low single digits for the foreseeable future. While the overall market is set to become more competitive, we find the company’s differentiated and balanced business segment economics an advantage that should provide growth opportunities and protect against competitive threats.
Since the financial crisis, Amex has significantly reduced its dependency on securitisation and unsecured term debt, providing greater assurance that the funding mix is less aggressive. We currently do not have any concerns about its liquidity profile.
This is a business that has produced an impressive $40 billion in free cash flow since 2010, providing management with the opportunity to invest in growth opportunities and return cash flow to shareholders. This name has appealing long-term targets to grow revenue by at least 8%, achieve EPS growth of 12-15% and maintain a minimum return on equity of 25%.
Having enjoyed a stellar stock price performance in the first half of 2015, Yum! Brands significantly rerated to the downside after a poor set of Q3 results. This prompted a managerial rethink, followed by an announcement that the company would spin off the China business into a separate entity.
We feel this sets up Yum nicely for a structure that will let the business focus more on long-term value creation. There has been a sense for quite some time that a specialist management team is needed in China in order to refocus on sales growth, and rid the brand of a poor image acquired on the back of various ‘health scare’ scandals.
With a 2016 normalised return on equity estimate of 140%, and a blended forward price to earnings ratio of 21 times, we see attractive returns for the long-term investor.
Keeping it local
Emile Fourie, Portfolio Manager
[DATA SOL: Sasol]
Sasol’s earnings remain very sensitive to both the rand-dollar exchange rate and the oil price. According to the company, a $1 movement in the oil price impacts operating profit by R811 million (assuming an average rand-dollar exchange rate of R12.65), while a 10 cents movement in the exchange rate impacts operating profit by R650 million (assuming an average oil price of $60 a barrel). While the rand has weakened considerably, Sasol’s share price remains under pressure as the oil price continues its downward momentum. At $44 the oil price is more than 60% down over the past 16 months.
We view the current low oil price as unsustainable over the longer term. Our long-term normal estimate for the oil price is $85. Additionally, the oil price is likely less susceptible to a Chinese economic slowdown as China only accounts for about 10% of global oil demand compared to the 30–40% of most base metals.
Sasol’s balance sheet remains very strong, with a net cash position. At consensus earnings of R38, it trades on an 11 price to earnings – undemanding when compared to the market’s 19 P/E on arguably higher earnings.
[DATA IMP: Impala Platinum]
Like other mining industries, the platinum industry is cyclical. Platinum-group metal (PGM) prices are currently very low and below what we would consider to be normal prices required to sustain the industry. The near-perfect storm that has hit the platinum industry has forced companies to follow various strategies.
Implats’ strategy has been to raise a further R4 billion by way of an accelerated book build. The money will allow it to continue its strategy of replacing older, costlier shafts in the Implats lease area with newer, more efficient ones. CEO Terence Goodlace has said the company wants to finish its number 16 and 20 shafts, as this is crucial for it to move production to safer, more efficient methods. It’s important for a cyclical business such as Implats to invest through the cycle – it will allow the company to deliver lower-cost ounces when PGM prices recover one day.
Implats, trading 90% below its 2008 peak price, has quality assets and a balance sheet to see it through until the tide turns.
[DATA SBK: Standard Bank]
Over the past few years Standard Bank’s Global Markets business outside Africa has suffered heavy losses and tied up capital, which has hurt the group’s profitability. After a majority stake was sold to ICBC in 2015, the goal now is to focus on clients in Africa. After heavily investing in Africa over the past decade, and several years of strong increases in earnings, the group’s growth has slowed. The African franchise remains in good shape, however, despite lower oil prices and difficult operating environments in West African countries.
Over the longer term, our expectation is that economic growth will recover and continue to exceed the economic growth rate in South Africa, which will be good for Standard Bank. The bank is currently trading on a forward P/E of 9.2 and a dividend yield of 4.69%, and has historically been an excellent dividend payer.
Backing a winner
We’re all looking forward to a jolly good festive season stocking after 2015, which can only be described as tough. Here are my three stock picks for the new year.
Humphrey Price, Portfolio Manager
[DATA SUI: Sun International]
With a major weakening in our currency this year, the first thought that comes to mind is tourism. It’s simply too expensive to travel, so expect inbound and inland tourism to benefit. One company that should benefit is Sun International. This business underwent major restructuring in 2014/15. It has streamlined its African operations, taken control of catering, refurbished hotels and focused on its South American operations.
The company trades on a reasonable price to earnings ratio (PE) of 13, EBITDA margin of 30%, and dividend yield (DY) of 2%. But the balance sheet gearing levels are stretched after all these deals, including the latest Peermont merger. Expect solid growth in time from all the significant strategic transactions.
[DATA OLG: Onelogix]
I’ve always liked this little winner. With the recent sale of PostNet and acquisition of core logistics businesses I expect a rerating in due course. Here’s why …
The company is now fixated on what it does best – logistics. Onelogix’s three segments are abnormal logistics (vehicle delivery services), where it’s a market leader, primary products, and other logistics. Onelogix is well entrenched as a niche business. It has a sound delivery track record and management under Ian Lourens is solid. The company trades on a PE of 14 and DY of 3%. Keep an eye out for all those Onelogix delivery trucks on the road.
This one is a perennial favourite for many reasons. Berkshire Hathaway is composed of two distinct units – companies it owns and controls, and investments in non-controlled publicly traded companies.
The share has performed poorly this year due to the company’s large investments, IBM and American Express Co. With Berkshire Hathaway trading at a price/book of 1.4 times and no value assigned to its ($5 billion) Bank of America holding, I expect it will only be a matter of time before the market takes note again. It has so many solid characteristics and really is a proxy for US investment. Having attended the 50th AGM this year, I came away more convinced than ever that this investment is for the bottom drawer.
Johan Strydom, Head of SA Equities
[DATA SBK: Standard Bank]
This long-time stalwart of the local market has underperformed over the last number of months, with the weak returns achieved in some of its offshore ventures counting against the company. Now the company has sold off a number of the underperforming assets and is investing the capital in higher-returning assets. We expect relatively strong earnings growth in the next 12 months and an improving return on equity in the coming years. Trading on a historic price earnings ratio (P/E) of 11.4 times, dividend yield of 4.7% and a price-to-book ratio of 1.5 times, the company offers good longer-term value.
[DATA MDC: Mediclinic]
For the last few years, this company has continued to expand and enhance its global platform. As far as the offshore operations go, Mediclinic now has exposure to the Swiss, United Arab Emirates (UAE) and UK private hospital markets. The global division’s contribution to revenue currently amounts to 70%. This diversification strategy has been driven further with the recent reverse takeover of Al Noor, a meaningful player in the private hospital space in the UAE. The transaction will lead to the ultimate listing of Mediclinic on the UK stock market.
The benefits from an international listing – cheaper access to funding – as well as the increased exposure to the fast-growing private hospital industry in the UAE should lead to attractive earnings growth over the coming years. Although the share price is not cheap at current levels, we believe the earnings growth potential will result in share price outperformance.
[DATA MRP: Mr Price]
This winning clothing retailer’s share price has been under pressure over the last couple of months as the market was disappointed with the latest earnings growth produced relative to the company’s high P/E. Its PE ratio has come down and now looks more attractive relative to the market. We believe the company is well placed to continue delivering above average earnings growth from both the local and African operations. The current weakness in the share price is giving long-term investors a buying opportunity.