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Renier de Bruyn
Head of Asset Allocation
Nov 28, 2018
JSE behemoth Naspers has undoubtedly been the share with the largest impact on our local equity market over the past two decades. Its weighting in the FTSE/JSE All Share Index has increased from 1% in 2004 to 17% currently – indicating the extent of its outperformance compared to the rest of the market. The big game changer for the group has of course been its investment in 2001 in Chinese internet conglomerate Tencent.
Following a 76% rise in 2017, this year has proved to be much more challenging for the Naspers share price, which has slumped by 21% year-to-date at the time of writing (or 33% at its low in October). The decline has come mostly on the back of the dwindling price of Tencent, which constitutes around 80% of the fair value of Naspers’ net assets.
Emotional forces naturally result in the view of both investors and market commentators to ebb and flow along with a company’s share price, which can in turn aggravate the movement of the latter, either up or down. At any given time, one can objectively identify a number of potential risks and opportunities for any company, although it isn’t always possible to predict with certainty which of these will actually play out. This is why an analyst will assign probabilities to different outcomes when valuing a company.
The market, however, tends to dramatically change its narrative on a company – either over-emphasising the opportunities or the risks – based on recent share price movements. The mechanism is straightforward: people tend to seek reasons why a share has moved in a particular direction, which media houses will eagerly provide. The news flow then reinforces investor bias.
This may lead to temporary share mispricing, driven by fear or greed, which a prudent investor with a longer investment horizon may try to exploit. However, it’s crucial to be able to translate all the relevant news on a company into the correct perspective – which is one of the three pillars of our investment philosophy at Sanlam Private Wealth.
Tencent’s share price has declined by 38% from its high in January, following a nearly 67 000% return since its listing in 2004. After 2017, a year in which Tencent seemed unable to put a foot wrong, the news flow has predictably turned negative as the share price has declined.
The most significant negative news around Tencent this year has related to the restructuring of certain Chinese government departments, resulting in no new online games being approved for monetisation since March. Chinese online game publishers (of which Tencent is the largest) have suffered large share price declines as a consequence, highlighting the regulatory risks associated with operating in this market.
Furthermore, Chinese officials have stated that they’re planning to introduce time limits on gaming for minors to prevent the onset of myopia caused by too much screen time. Negative news flow has also emanated from the noise around the so-called US-China trade war, which could potentially disrupt global trade flows.
When assessing all the relevant information to arrive at the correct perspective on the news flow around Tencent, the appropriate question to ask is: how does it influence the fundamental valuation of the group? This in turn depends on the impact on its long-term expected cash flow. If it’s not significant, the information is simply noise and likely to have only a temporary impact on the share price.
In determining this perspective, it makes sense to first look at the group’s starting valuation, as well as the share price movement of the general market over the same period. Tencent’s valuation at the start of 2018 was high following a number of years of strong operating results. Consequently, some normalisation in the share price shouldn’t be surprising.
However, the 40% discount to its net asset value that Naspers was trading at the time, ensured the effective valuation of Tencent (indirectly through Naspers) was still palatable. We did trim the Naspers weight marginally in our house view equity portfolio in February, but we added again in October following the share sell-off.
Tencent’s share price slump should also be seen in the context of a broader sentiment-driven sector decline. For example, Alibaba and JD.com, which wouldn’t have been impacted by the freeze in game approvals, also suffered share price drops this year. US tech companies such as Google, Facebook and Apple initially held up better than their Chinese counterparts, but came under pressure in the second half of 2018. Since the start of 2017, Tencent’s share price performance (in US dollar terms) hasn’t been out of line with the likes of Google.
The freeze in monetisation approval of new games has had a material negative impact on Tencent’s results over the past six months. It is the group’s view that this is a temporary issue, which should be resolved in due course once the restructured government departments have found their feet. This has also impacted competitors, which may be worse off without the large existing game portfolio and list of pre-approved titles that Tencent had in place.
The proposed limits on gaming time for minors in China is arguably a good thing for society, while the revenue impact on Tencent isn’t estimated to be material. Minors make up less than 20% of online gamers in China, but they’re also low revenue payers, resulting in less than 5% of gaming revenue being derived from this age group. Tencent has itself been proactive in establishing measures to restrict game time for minors on its platform.
While the issues around online gaming presented some challenges for Tencent this year, our investment case for the group – which is focused on the power and potential of its WeChat social network – remains intact. Launched in 2011, WeChat has a highly engaged user base of more than one billion. The basic service is free, and consumers are unlikely to leave the platform given its strong social network effect. However, the large user base has created a number of business opportunities for Tencent and its partners in the fields of advertising, music and video streaming, and business and financial services.
While gaming remains an important profit contributor, Tencent has been rapidly diversifying its revenue streams. For example, advertising revenue, where Tencent’s platforms remain materially under-monetised relative to user time spent, has grown by 47% year-on-year over the past quarter, contributing 20% to group revenue. Other revenue, which includes payment and cloud computing services, increased by 69%, contributing 25% of revenue. Online games have reduced their contribution to revenue from 55% in 2015 to 32% at present.
Over the years, Tencent has reinvested most of its profits in ‘partner’ companies, which we currently value at more than US$70 billion, or 20% of Tencent’s market cap. Tencent’s large user base has made it an investor of choice for these companies, which have benefited materially from access to these consumers. Despite the material underlying value of these investments, they’ve enjoyed little recognition in Tencent’s reported income statement to date. This makes them easy for investors to miss when using simple measures such as a price-to-earnings multiple to assess Tencent’s valuation.
Despite the share price volatility, our investment view on Naspers hasn’t changed much since we last wroteabout the group in June this year. We expected that Multichoice would be unbundled, and it’s now been confirmed that this will happen in 2019. The significant growth of OLX has also made this company increasingly ripe for a listing. The value of the Naspers rump will therefore become much more transparent over the next year or two. Looking beyond the current market turmoil, we remain constructive on the outlook for Naspers over the longer term.
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