Introduction

The South African economy remained under severe pressure from persisting loadshedding during the first quarter of 2023. Different sectors, including manufacturing, mining, agriculture as well as small businesses, are being negatively impacted by loadshedding. Inflation has peaked during the last few months and is expected to fall within the target of 3-6% in the coming months. The South African Reserve Bank (SARB) announced a surprise 50 basis points interest rate hike, despite the economy operating at recessionary levels. It is expected that the economy will continue to operate at poor levels for the coming months. Markets are also expecting the rand (ZAR) to remain under pressure.

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Introduction

Global equities rose 2.8% over the month, with the US outperforming non-US and emerging markets. Growth stocks did particularly well, with IT up 10%. China, however, outperformed with 4.5%. South African equities were down -2.8%, largely due to financials and retailers, but resources were up 2.9%. Global bonds rose 3.2%, and South African local debt rose 1.3%. Tighter financial conditions, slow growth and high policy uncertainty should weigh on valuations, profit margins and earnings. Valuations and earnings estimates remain somewhat elevated.

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Introduction

Tighter financial conditions, slow growth and high policy uncertainty should weigh on valuations, profit margins and earnings. Valuations and earnings estimates remain somewhat elevated. Global equities rose 7%, led by non-US equities, up 8.1%. Emerging markets rose 7.9%, with China leading the way, up 12.3%. South African equities rose 6.8%, while global bonds rose 3.3% and South African local debt rose 2.9%.

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An Introduction to Precision Fermentation

One of the emerging areas in nutrition that we have some interest in exploring, and have spent some time developing deal pipeline in, is in the area of Precision Fermentation. Precision Fermentation is in pricinple not new. It is the process of using micro-organisms (typically specialized yeast or bacteria) to convert a feedstock (typically a carbohydrate heavy one such as sugar) into other ingredients (such as proteins or lipids/fats/oils) in a bio-reactor or fermenter. As an example, it should soon be possible to, at scale, produce milk that is bio similar to milk from a cow, through a Precision Fermentation process, using grains such corn or sugar beets.

Beer production is of course a wide and well-established use of traditional fermentation processes at industrial scale to convert carbohydrates into alcohol, and bacterial fermentation is used to produce amino acids such as lysine for animal feed. What is new in Precision Fermentation is the evolution of these processes, selecting and modifying micro-organisms to create an ability to produce specific, highly complex ingredients on demand, and on-site. A significant breakthrough was achieved 40 years ago in the production of human insulin from modified yeast, dramatically disrupting the market (which historically sourced insulin from animals) and rapidly generating share of over 80% of the market within 10 years, and 99% today.

However today Precision Fermentation is being shaped by 3 emerging trends:

• Novel organisms are being created and optimised for food-grade components as a result of Crispr engineering and the rapidly reducing cost of Crispr is driving down development costs and speeding up innovation.
• The potential to achieve cost parity / advantages vs. crop or animal derived production is now foreseeable in the short-term which opens up tremendous and rapid switching opportunities.
• Industry pain-points as a result of environmental impact concerns and animal-free consumer demands are creating substantial B2B and B2C market demand.

The cost of production from Precision Fermentation is dropping on a log curve basis. Where Precision Fermentation was previously only cost effective in the production of higher value medicines, and then more recently cosmetics, the cost point is beginning to shift into applicability in food: “The cost of producing a single molecule by PF has fallen from $1m/kg in 2000 to about $100/kg today. We expect the cost to fall below $10/kg by 2025.” – RethinkX. At below $10/kg, production begins to become competitive with traditional animal-based and even some premium plant-based food production. E.g. today casein protein (dairy proteins in milk used for cheese production) trade for $11-$13/kg.

Consequently, we see emerging applications in a wide range of food substrates in proteins, lipids (fats and oils) and amino acids. High price point products are the most interesting as they remain the most vulnerable to switching. Both B2C and B2B applications exist, but we are most interested in B2B propositions as being highly scalable with little consumer education or adoption required. There are a wide range of propositions in early-stage development, with a number of them in Europe: from various proteins such as dairy proteins, to oils such as palm oil replacements, to chocolates. We also expect  to see a rise in various supporting industries to the sector, across software, cell lines, hardware and ingredients.

The application of Precision Fermentation potentially solves a number of industry challenges, and has the potential to be extremely disruptive to legacy farming and production processes. Firstly, the efficiency of production, and the ability to produce locally, has the potential to significantly reduce space requirements and CO₂ emissions from the production and logistics supply chain. Precision Fermentation has a feedstock conversion to protein efficiency of 10x – 20x that of dairy cows for example. As a result, significant productive land used for the cattle, as well as the crops used to feed them, can be released for other uses. The CO₂ and methane impact from cattle, and the transport and logistics of feedstock and final products can be significantly reduced with this higher efficiency, with Precision Fermentation also allowing for the production of the relevant proteins directly at points of production and sale.  Today concerns regarding nitrogen concentrations in waterways from farm manure, as well as the high carbon emissions, are placing significant constraints on traditional dairy production in Europe through regulation and compliance costs, with some cooperatives expecting a 30% reduction in output over the coming 5-10 years. Precision Fermentation offers an alternative path to provide the food ingredients required by society. Lastly Precision Fermentation provides high flexibility in customizing products (such as lactose-free milk), or creating new functional ingredients, to cater for a wide variety of consumer demands.

There is still significant work to be done to bring many Precision Fermentation applications to market. Principally the cost of production is the most critical driver, and solving that requires identifying, modifying and successfully cultivating the most efficient micro-organism candidates in laboratory environments, and then scaling that successfully into industrial scale processes, with the most cost-effective feedstock and operating conditions. These are living systems that can be temperamental, and often downstream extraction processes can be challenging to extract the target ingredient from a biological “soup”. Regulatory approval is required to take Precision Fermentation products to market for human consumption – globally this process is still slow, with different requirements in the US and Europe, but it is improving. There is also limited contract manufacturing capacity currently available for Precision Fermentation, so pioneers in this space often need to build their own capacity, or seek to partner with a large customer. This is leading to some large raises at early-stage companies in the sector.  Lastly there is a relatively small pool of talent able to scale and operate plants, and for the industry to grow the talent pool will need to expand.

Overall there is significant IP to be created in this space. We have also seen significant demand from large food groups who are looking to source suppliers, or acquire, solutions in this space. Winning propositions that can solve the full package have the potential to massively disrupt very large markets.

Introduction

The South African medium-term budget during October received a positive reaction from markets. This was mainly due to expected strong revenue over runs along with fiscal discipline. The South African debt to GDP is expected to peak around 71%, instead of the 75% as previously announced. The South African Reserve Bank (SARB) stated that they will likely remain hawkish, until inflation slows down and political risks fade towards the end of the fourth quarter. South Africa saw President Cyril Ramaphosa further strengthen his hold as leader of the ANC, after their National Congress in December. A cabinet reshuffle is on the cards early in 2023. Loadshedding continued to grapple South Africa during the fourth quarter, as Eskom CEO Andre de Ruyter, announced his resignation in December.

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Introduction

The last quarter of the year saw global equity markets fall in December, but still managed to end the quarter in positive territory. Volatility remained high as the outlook for developed market economic growth deteriorated further, while central banks continued to adopt a hawkish tone. Global inflation pressures remained high, but there were signs that inflation has peaked in the US and across Europe. Although inflation remains above central bank target levels, markets have started to anticipate a deceleration, pause and potential cuts of interest rates.

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Flexibility key to the Balanced Prescient Fund.

Managing a balanced fund means finding the right balance between cyclicals, yield, high or low quality, defensive, value and earnings growth.

Having a flexible approach to these and other variables, and being style-agnostic, are some of the ways portfolio managers and analysts work to ensure that the Fairtree Balanced Prescient Fund is managed optimally.

“We find the SA equity space really exciting and there are a lot of opportunities,” says Chantelle Baptiste, an equity analyst at Fairtree.

SA equity market offers much opportunity, regardless of how SA Inc is performing

“Many people make the mistake of thinking that SA equity means investing in South Africa, but our market is very externalised, with approximately 70% of the revenue of the top 50 companies generated from sources outside South Africa,” she says. This gives the fund access to companies like Naspers, with its exposure to Chinese consumers, and resources companies selling commodities to the US and China in hard currencies.

The fund is exposed to all the major equity sectors ranging from resources (from base metals to paper, oil and gas, and precious metals), offshore defensive (offering dividend yield and safety such as alcohol and cigarettes counters), offshore consumer growth (through companies like Naspers and Richemont) and ‘SA Inc’ (locally oriented companies exposed predominately to the SA macro environment).

“We rotate within these four broad sectors, depending on where we see opportunities and this allows us to capture performance no matter how the South African economy is performing,” she says.

Investing directly in offshore companies is a different ball game. “Offshore equities are not our strength. We are not on the ground and we would rather play to our strengths and have exposure to companies that we know and understand.”

Being flexible is our key discipline

One of the fund’s strengths, and the key characteristic differentiating Fairtree, is its flexibility. “The willingness to be flexible has to be inherent; it has be part of your DNA,” Baptiste says.

“If you wake up today and a stock you are positioned in is not the best for your clients – either because it is not generating the performance you anticipated, or something happened in the world that changes the investment case for the stock – then you need to have the discipline to change, potentially cut your losses and put [your] clients’ investment in a better position.”

To achieve this discipline, as far as Fairtree is concerned, an asset manager needs to be exposed to the liquid part of the market being the mid to large caps which allow for the flexibility to move in and out of positions. This is more challenging in the small cap space, which can be less liquid and where an investor may need to be positioned for a longer holding period.

The asset manager also needs to be the right size as this allows for the agility to move in and out of positions when required. With R12 billion in unit trusts and R42 billion in institutional funds, Fairtree is considered boutique.

We are style-agnostic

“Key for us is our flexibility, and we are style-agnostic – we don’t deem ourselves value or growth, which we consider restrictive”.

“Our philosophy and investment style needs to withstand any economic cycle, it needs to stand the test of time. We view the market within seven strategic focus areas – cyclicals, yield, high quality, low quality, defensive, value and earnings growth. These are not mutually exclusive, nor are they exhaustive”.

For example, at the moment growth is low in South Africa and commodity prices are supportive. Growth “is just not here in SA Inc”, and Fairtree does not want to gravitate to value or low quality as that can be a value trap, so it has a preference for higher quality over low quality in the SA Inc space – like FirstRand, which has a strong management team, is still achieving high growth and pays an attractive dividend, rather than a lower quality peer, which is lower quality in terms of its management and is struggling to make earnings although it operates in the same environment as FirstRand.

“Earnings growth is what we value the most – companies that are able to generate high earnings growth in any given environment and convert that into cash, and that have high quality management teams able to allocate capital efficiently and focus on shareholder returns.

“Anyone can identify value, but you need a catalyst for value to be unlocked,” adds Baptiste. “That is one of the reasons we are style-agnostic. We focus on total shareholder return – earnings growth, dividend and rerating, and out of those, the most important is earnings – how this company is going to generate earnings and what its future growth is going to look like.”

How are we currently positioned?

Fairtree remains constructive and exposed to the resource sector.

“Commodity prices are currently supportive; however, the market is pricing in a recession and demand is softening, and this is where the opportunity lies. Since the last global recession, most resource companies have been repairing their balance sheets, paying down debt, spending less maintenance capex and almost nothing on growth capex and generating cash that could come back to shareholders in the form of dividends and share buybacks.

“We keep a close eye on the global macro and we do not anticipate a global recession imminently, we also don’t see a hard landing for China any time soon which is supportive of metal prices.”

She says China is a $12 trillion economy that is still growing at 6%, which is supportive for commodities, and that Fairtree remains overweight in resources.

Locally, Fairtree believes the election outcome was favourable and South Africa has been in a stabilisation phase under the current administration as President Cyril Ramaphosa tries to stop corruption and put the right people in key economic places.

The next phase will be one of reform, where he needs to resolve the Eskom issue, downsize cabinet and ensure investors are comfortable with SA property rights, Baptiste says.

“But investors cannot ignore that GDP is anaemic, below 1%. Consumer and business confidence is lacking. The next growth phase needs to come from the private sector and SA needs foreign investment and confidence to return.

“We think that in the short term there is still some pain to be felt, the 2019 first quarter GDP print will be very poor, although we are close to the bottom of the cycle,” she adds.

Fairtree will remain selective in SA Inc, investing in strong financials such as FirstRand, Sanlam and Capitec, and remaining underexposed, for now, to telcos and hospitals, and with only selective exposure to some retailers.

Baptiste says Fairtree’s position on South Africa is what keeps her awake at night. “When foreign money comes back into our market, it comes quickly,” she says – and this means local asset managers can miss the rally if not positioned well.

Brought to you by Fairtree.

Originally published on Moneyweb.co.za. To view the original, click here.

Introduction

Last month, global equities jumped 6.8%, with US equities underperforming ex-US equities. Emerging markets was up 14.6%, mostly due to China, 28.9%, while South Africa was up 9.5%. Growth stocks and value stocks performed well as bond yield fell. Energy underperformed other cyclical sectors. Global bonds were up 4.7%, while credit spreads tightened. South Africa government bonds were up 3.99%.

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