How our market views translate in our portfolios - Angles & Perspectives

How our market views translate in our portfolios

If the first two articles in this edition set the scene for our view on equity markets, investors may well wonder what this means for our portfolios, and where we see the opportunities unfold in the future. Our 3M investment philosophy leads us to hunt for under-appreciated quality at a favourable price, and the current market environment is offering an above-average number of opportunities, many of which are unlikely to be found in more mainstream portfolios. In this article, Head of Equities Justin Floor and Fund Manager Dirk Jooste highlight their current approach to the investment environment.

Q1: Kevin and Shaun’s articles suggest we’re in a world that may look very different from the past decade. What does that mean for our portfolios? Can you unpack the positioning in the PSG Balanced Fund?

Justin responds:

We never position our portfolios with a single macro outcome in mind, and therefore aim to ensure our portfolios are diversified to benefit from multiple growth drivers into the future. Our current equity book can broadly be viewed in three primary buckets, each likely to benefit from different factors and drivers.

These are:

• High-conviction obscured ‘quality and growth’ stock picks such as Discovery, AB Inbev, Liberty Global and Prudential, where temporary factors appear to be obscuring the inherent above-average quality and growth potential in specific companies. These opportunities are more idiosyncratic and therefore less dependent on broader macroeconomic support.
• Real assets, including commodity and related shares, and a healthy energy position, where we emphasise the almost unprecedented level of under-investment in certain sectors. This deep focus on the supply side is a core part of our approach and provides the conviction we need to take long-term views of what have historically been cyclical and demand-sensitive sectors. These opportunities were attractive even before the events in Ukraine, which have added further geopolitical constraints to supply in certain commodities.
• Domestic shares, such as Remgro, Standard Bank, and certain mid-cap opportunities with some nice little differentiators such as the JSE itself, AECI, gaming and leisure positions, and SA construction names.

Our fixed income positioning is concentrated in longer duration government yield (earning equity-like real returns, and we see reasonable signs of an improving fiscal outlook while foreigners are still under-invested in SA bonds) balanced with substantial inflation-linked positions, resulting in a healthy yield profile that also offers protection from inflation pressures.

Perhaps the most telling reflection of our current outlook is in what we do not own, or where we are underweight relative to the rest of the market. We are cautious about the large index shares, and tend to be more cautious on US shares in general, which have performed very well historically and are currently on elevated earnings levels and valuation multiples. We approach Chinese counters with some caution, and try to ensure our commodity exposures are not dependent on heavy Chinese demand (as is the case for iron ore). We also don’t own Chinese technology shares. From a fixed income perspective, we are cautious on developed market government bonds and both local and global credit instruments.

Overall, we seek to ensure our portfolios are robust representations of our best ideas, and the diversity of return drivers is also one reason why we see continued upside potential in our funds.

Q2: The PSG Balanced Fund has a sizeable exposure to listed property. How does that fit in?

Dirk responds:

While we have successfully avoided listed property exposures due to high valuations and debt levels over the last few years, we believe a substantial recalibration has taken place post Covid-19 and that there are a number of attractive opportunities for those who are selective. Most of our current listed property exposure is concentrated in the retail sector, with key holdings in local REIT Resilient, US REITs Tanger Factory Outlets and Simon Property Group, and a more recent investment in Hammerson, which is a more distressed play recovering from a very tough pandemic environment. We view listed property as a classic real asset, with the added benefit that it has been deeply out of favour, especially given narratives regarding e-commerce killing the shopping centre. Underlying cash flows from these businesses are now likely to broadly keep pace with inflation, as they are linked to the nominal sales trajectory of their tenant base, which will be augmented by residual recovery from a tough Covid period. Fixed expenses are reasonably low and finance costs are fixed with very long maturities, resulting in a very favourable outlook for inflation-beating cash flow growth going forward, which bodes well for investors who have bought in at generous yields and valuations.

Q3: If the next decade is going to differ from what we have become used to over the past decade, what attributes do investors require to succeed in this new environment?

Justin responds:

We believe those who are likely to succeed in the new environment will have to be willing to adopt an unconventional approach. Relying on what has worked in the past, and is therefore overly represented in benchmarks and consensus positioning, is unlikely to deliver the necessary returns because there still appears to be a lot of extrapolation and complacency embedded there. For us, this is about a willingness to own assets that are not included in popular benchmarks, rather taking positions in our best ideas, regardless of what everybody else is doing. This approach is unpopular and can often feel lonely, as there is magnified pressure on you if you get it wrong. Such differentiated thinking requires a deep and an independent research ability: if you’re getting your insights from what everyone else is thinking, then you will look like everyone else, and are unlikely to deliver the positive differentiated outcomes to investors.

Q4: Why can size be a differentiator?

Dirk responds:

Over the past few years, we have witnessed enormous crowding into what has been popular, driving up prices for many large index constituents. By comparison, many unpopular counters have become ever cheaper, especially since many of these were in unfashionable short duration assets. Given this disparity, we believe the opportunities are most likely not to be found in the big name index counters, but rather among the unloved gems. Many larger managers are driven to stick close to the index for structural and behavioural reasons, and therefore smaller managers have an opportunity to exploit their wider opportunity set. Smaller, differentiated managers who are not afraid to look different from the crowd, have some significant advantages if it is in fact true (as we suspect it is) that most large pools of capital and indices are not well positioned for the market environment we are heading into.

Q5: The environment seems very uncertain, price indices are high and geopolitical risks are becoming more visible. Why then does the PSG Balanced Fund retain a sizeable exposure to growth assets and low cash levels?

Justin responds:

This does seem to be something of a contradiction, but we believe the key lies in the fact that our clients don’t own ‘the market’. Instead, they own portfolios of shares and instruments that look very different to the popular shares and large index constituents. Consequently, we believe our portfolios to be a lot less risky than popular alternatives by virtue of their lower prices (many stocks are still wildly out of favour) and their potential to benefit from more inflationary conditions.

That said, we acknowledge that we are in a highly uncertain environment and aggregate price levels, particularly in the gargantuan US market, are are still elevated. Therefore, it is certainly appropriate to be thinking about risk and considering scenarios that could prove more painful to our investors.

From a practical perspective, we’ve chosen to remain invested in our best ideas where we have strong reasons to believe that future real returns have a high likelihood of being satisfactory. To control aggregate risk, we augment these core beliefs with pragmatic offsets that reduce risk at a portfolio level. Examples of these would be put option hedging on expensive US equity markets, gold positions, and inclusion of a number of shares that are less dependent on the macro cycle or with unique special defensive characteristics (such as the JSE). Short-dated inflation linkers present a best-of-both proposition by ensuring reasonably stable capital, but also providing positive exposure to an accelerating domestic inflation trajectory.

PSG Asset Management.