By Izaan Buys,
Fairtree Equity Analyst
The efficient market hypothesis posits a world of perfectly informed, rational investors. In this world, stock prices should fully reflect all available information, making it difficult to identify undervalued opportunities. This is the theory, but the reality is that when sentiment becomes extreme, arguably even irrational, a fascinating paradox begins to emerge.
Fundamental analysis, a cornerstone of active investing, emphasises a company’s financial performance. Key metrics amongst many include earnings, cash generation, and shareholder returns. By analysing these aspects, we can calculate the company’s intrinsic value thus focusing on the calculated value and reducing the subjective perception of the stock, in other words, blocking out the noise of sentiment.
Case Study: Company A.
For illustrative purposes, let’s look at a real-life example. Company A boasts impressive growth figures, with a compound annual growth rate (CAGR) for both revenues and earnings exceeding 20% over a 10-year period. This is well above the 5% CAGR achieved by the S&P 500 Index in this same time frame, as shown in Graph 1.
Graph 1: Year-on-year earnings growth for Company A relative to the S&P 500 Index
Source: Bloomberg, Fairtree Asset Management
Admittedly, accounting earnings are only one element of the financial performance of any entity and can appear to outperform due to base effects. Additionally, accounting earnings can differ considerably from cash flow, given the overlays of accounting treatments. Free cash* generation is the key to understanding any company because it is the firepower a company has after it has covered all its stay-in-business costs and capital expenditures. This cash can be deployed in a multitude of manners, such as:
- Balance sheet reinforcement through debt reduction and ultimately debt service cost alleviation
- Shareholder returns through ordinary dividends, special dividends or share buybacks
- Futureproofing the business through investment in innovation or research
- Adding revenue streams through mergers and acquisitions activity
In addition to its stellar earnings growth, Company A has developed into a more mature entity, which generated similar free cash flow yields to the S&P 500 Index in recent years, as shown in Graph 2 below.
Graph 2: Free cash flow generation for Company A relative to the S&P 500 Index
Source: Bloomberg, Fairtree Asset Management
The last column of this chart highlights the paradox of Company A. Despite its compelling fundamentals, the share price has been under pressure, resulting in a reduction in its market cap (reminder that free cash flow yield is a function of market cap*).
Graph 3: Shareholder returns through dividends plus buybacks as a percentage of market cap
Source: Bloomberg
Alternatively, this discount can be illustrated through a short-term valuation metric, such as a forward price-to-earnings multiple. Company A is trading at a significant discount to its historical valuation as well as the S&P 500 Index, which we can see by looking at the graph below, which plots the historical price to one-year forward earnings ratios.
Graph 4: Forward price to earnings multiples screens attractive
Source: Bloomberg
This seemingly undervalued state challenges the tenets of the efficient market hypothesis. This paradox serves as a reminder that even in an information-rich environment, inefficiencies can persist. It is through a combination of fundamental analysis, a nuanced understanding of market sentiment, and a dash of healthy scepticism that investors can potentially navigate these discrepancies and uncover hidden gems.
You may have already guessed that Company A is in fact Tencent Holdings Ltd. Tencent is a Chinese tech giant, and among the largest gaming, social media, venture capital, and investment corporations globally.
What has driven the dislocation?
Several explanations could account for this discrepancy between fundamentals and rating. Front of mind would be how much market sentiment towards Chinese equities has soured due to geopolitical tensions and self-imposed regulations, which have decimated many Chinese sectors, such as property and tech. These concerns may weigh heavily in a time of higher global interest rates, which can lead to a more risk-averse investment environment, which impacts emerging markets, including China, more significantly.
The growth target for China this year is anticipated to remain around 5%, with support from specific policies inside and outside of the property sector. China’s growth outlook depends on policymakers’ ability to boost confidence amid tight regulations, especially in the property sector. Infrastructure investment may firm up, and we have already seen much monetary policy easing.
The relationship between the People’s Republic of China (PRC) and the United States of America has been complex, and at times, strenuous. They have close economic ties and are significantly intertwined, yet they also have a global hegemonic power rivalry. China and the USA are the world’s largest single economies by GDP, accounting for 44% of global GDP. Thus, when these behemoths are in tension with each other, the ripples felt globally are immense. The US election will add further complexity this year, given how anti-China the Trump administration had become. Tension has not abated under the Biden administration. Biden has only expanded the US support for Taiwan and recently announced sweeping tariffs on Chinese semiconductor chips, certain minerals and Chinese-made electric vehicles. As the global superpowers race towards tech supremacy, one should not expect this passive-aggressive trade narrative to change.
The announcement made in December 2023 by the National Press and Publication Administration of China relating to gaming regulations betrayed investors and Chinese corporates alike. Not only was the timing completely off, being the Friday of Christmas weekend when liquidity and investor concentration alike is lacking, but it came at a time when the government had begun an amicable approach to large-scale regulation. 22 December 2023 was the third largest single-day market outflow experienced over the last 10 years, including COVID-19. Is China investable, or is this the buying opportunity of a lifetime?
Conclusion.
In addressing the last question, one should not expect a fundamental shift in policy nor an ideological gear change from the Chinese ruling party. But what investors often get wrong about China is that they label everything as socialist when, in fact, the Chinese economy is capitalist at heart and when broken down to its raw form, it behaves in that way. We need to take a harder look at how corporate China responds to this regulatory malaise, how they navigate and if they still can eke out returns. For example, how Tencent has made use of share price reaction to increase its daily buy-back purchases, enhancing shareholder return.
On 14 May 2024, Tencent reported its results for the first quarter of its 2024 financial year, which was stellar and surprised the market to the upside with the strength of its fundamentals and earnings growth, in addition to strong cash generation. As always, risks and their probabilities need to be weighed against returns, and in this case, the fundamentals provide a compelling investment case, which is perhaps more easily recognised without the “Made in China” label attached. The bifurcation between developed markets and emerging markets performance seems extreme but is it justified?
As equity analysts, we are wired to seek out opportunities to create alpha in any market and any macro environment. Occasionally, these neat periods present themselves where valuations dislocate from fundamentals, and this can make for excellent alpha opportunities.
*Definitions:
- Free cash flow: Cash generated from operating activities less capital expenditure required to stay in business as well as items excluded that are costs to shareholders (share-based payment expenses and lease payments).
- Free cash flow yield: Free cash flow divided by the market cap.
Disclaimer:
Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. There is no guarantee in respect of capital or returns in a portfolio. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms, please go to www.fairtree.com
