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CORONAVIRUS: A SENSIBLE
Sanlam Active UK Fund
Mar 04, 2020
Also see comments by our Director of Investments, Alwyn van der Merwe,
below the article.
As the world struggles to get to grips with the coronavirus epidemic, what should investors make of the daily bombardment of negative news – with the outbreak currently showing no signs of abating? The reaction of global financial markets has been mixed: after an initial negative response, markets generally bounced back for a few weeks, but then plunged sharply over the past few days as the number of cases outside China surged.
While history has shown that stock market concern around epidemics tends to fizzle out after a few months, no one can predict how events will unfold this time round. How does this impact the investment decisions we make on behalf of our clients? What does it mean for our valuation of the companies we hold in our Sanlam Active UK Fund?
The strategy of our fund is to buy a concentrated portfolio of high-quality businesses at attractive valuations, and then own them for long holding periods, benefiting over time from their attractive underlying economics. When we invest, we have a view on what the shares will do over three to five years or longer, even though we don’t know what may happen to share prices over the next few months or even the next year or two. While sliding share prices are of course never comfortable, our approach of owning better businesses generally allows us to view this as an opportunity to buy more, rather than panicking and trying to trade out of a position.
For us, buying a stock for inclusion in the Sanlam Active UK Fund means becoming a part owner in a real business. While successful investors like Warren Buffett have a huge following and have spawned thousands of books, how many people truly follow his advice to buy and hold good companies? An entrepreneur building a business wouldn’t dream of selling up just because there was some short-term news item scaring the stock markets. If you owned the best hotel in the middle of a growing town, or owned a long-established profitable family business in that same town, you would likely take little notice of the talking heads on CNBC, or the latest monthly global economic and trade news. In our fund, we invest in stocks with the same ownership mentality.
At the risk of becoming a little technical, the true value of a business (known as its ‘intrinsic value’) is the present value of all free cash flows it will produce in the future, not just the cash it will produce in the next year or two. For a business that has long-term potential to grow its cash flows, what happens in the next year or two has only a small impact on its intrinsic value.
To demonstrate this, take a company with 3% growth into perpetuity, and a cost of equity of 10%, which produces US$100 in cash flow in the first year. The intrinsic fair value of this company is US$1 428. Stress testing the impact on value of short-term disruption, by halving the cash flows expected for the first two years, but leaving all other cash flows into perpetuity the same, reduces the intrinsic value of the company by roughly 6% – not insignificant, but not hugely destructive. Share price reactions often ignore this and move far more than the underlying intrinsic value of a company. This clearly shows that the short term is not very important if the long term remains attractive.
A good example of our strategy in the real world is our current portfolio holding Intercontinental Hotels Group (IHG), which we’ve owned since March last year. IHG is a hotel franchise business with a high return on capital. It has more than 5 000 branded hotels with 883 000 rooms around the world. Franchisees own and operate the hotel properties, and they pay IHG a royalty on each room night for using one of IHG’s 13 hotel brands – including Holiday Inn, Intercontinental Hotels, Crowne Plaza, Kimpton and Regent. Most of IHG’s business is derived from the US, but it’s growing rapidly around the world, especially in China. The shares of travel companies are particularly sensitive to an event such as the spread of the coronavirus.
IHG earns a return on capital of over 100%, which is exceptionally high, because the capital of putting up a new hotel is provided by the franchisee, and IHG just collects cash royalties from each guest night sold. Had you invested in IHG 15 years ago, you would have earned 14% a year in US dollars, compared to 9% a year in the S&P500 Index. This is the past, but we think the opportunities to grow and provide exceptional returns to investors over the next 15 years are just as exciting. IHG allows investors the chance to benefit from the growth in the emerging middle class in Asia and around the world, in a vehicle that is very cash-generative.
What impact is the coronavirus epidemic likely to have on IHG? Only 15% of IHG’s current room base is in China, but China comprises 30% of its total future pipeline. The company wants China to be its second ‘home market’ after the US. Although the group earns less than 10% of its profits in China, its exposure to this country is higher than that of other global hotel companies. This led to a sell-off in IHG’s shares in January – the shares were down 12% at one point, at which time we topped up for the fund.
Our current fair valuation for IHG shares is around US$74 a share, or £57. We’ve run a basic ‘stress test’ for a severe coronavirus impact – in this case we assume significant falls in room occupancies worldwide for the next two years, as well as a significant reduction in the daily room rate. This stress test results in drops in revenues not far off those during the 2008/09 financial crisis, and we also assume profits fall more than do revenues. In this two-year stress test, our free cash flow to the firm (FCFF) estimates fall in 2020 and 2021 by around 20%.
The intrinsic value for IHG on this stress scenario falls from US$74 to US$71 per share, compared to the current share price of US$54. This is a minimal and manageable fall in the valuation of the company for what is a severe short-term hit to profitability. As such, we think there is a significant margin of safety at the current share price and the shares remain undervalued.
Let’s not pretend otherwise: humility is important. We don’t know what course this alarming and escalating health crisis will take. We know travel companies are being disproportionately impacted by the virus. While the share price has been down significantly since December, it could very well sell down more.
However, what we can say with confidence is that we believe the business remains very well positioned for the future. IHG continues to grow its room count by about 5% a year, is still expanding in areas of the world with emerging middle classes and a need for good hotels, and the company continues to generate very good cash flow. IHG has the potential to contribute meaningfully to the performance of the Sanlam Active UK Fund over the medium to longer term.
A GRIM PICTURE
Comments by Alwyn van der Merwe, Director of Investments
The economic and social disruption caused by the coronavirus will continue for many months. It can’t be dismissed as an aberration. It will result in weak world economic data for at least the first half of 2020. Concerns that major international events could be cancelled (such as the Olympics, due to start in Tokyo on 24 July), that international tourism will decline sharply, and that manufacturing supply lines are becoming frozen, are all very real and paint a grim picture over the short term.
These concerns are, however, obvious and the prices of financial assets have responded aggressively to the external shock. Global equities have lost 11.5% of their value, US share prices as measured by the S&P 500 are down 12.4% from their peak and the FTSE/JSE All Share Index has traded 12.2% lower.
Of course, the averages mask extreme declines in individual shares, particularly those perceived to be more sensitive to the potentially negative spill-over of the virus. As Andrew explains in his article above, if the impact of the virus isn’t permanent in nature and normality is restored in the economic cycle, the valuation of shares should decline, but not in a ‘destructive’ fashion.
The severe decline in prices would imply one of three scenarios:
Our view is that the decline is a function of a combination of all three these scenarios. Despite the potentially negative impact of the virus on current economic activity, we believe the sudden sell-off suggests panic selling. Since we’ve been cautious regarding the prospective returns of global equities in particular, we believe that in certain equity sectors, the sell-off came from elevated valuations. As long-term active investors, these extreme price movements as a result of emotional selling create opportunities for us to take advantage of on behalf of our clients.
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