Capturing the potential upside of shifting cycles - Angles & Perspectives

Capturing the potential upside of shifting cycles

The importance of shifting market cycles should not be underestimated
The run-up to 2022 was marked by many events that seemed unlikely or irrational at the time, such as the market valuing Zoom higher than Exxon or a car maker of questionable integrity like Nikola having gained significant value (at its peak it was valued at more than most of the shares listed on the JSE). Additionally, the trend of low interest rates and the proliferation of technology and special purpose acquisition company (SPAC) IPOs have characterised this era as one of ‘easy money’ and excess.

However, this era appears to have come to a painful end. Years of underinvestment, labour disruptions, massive fiscal and monetary stimulus in the wake of the pandemic, and ongoing geopolitical tensions have unleashed inflationary pressures and led to rising interest rates. This shift in market conditions and the increase in the price of risk have caused some investors to re-evaluate their strategies and seek out new opportunities.

Rising odds of a new (and different) cycle
We believe that we are currently in the early stages of a new cycle, and many market participants have yet to recognise the shift. Kevin Cousin’s article Regime change in markets: a capital cycle perspective provides valuable insight into understanding these changes and identifying opportunities. For example, the energy sector offers a useful case study of the last cycle’s overinvestment and subsequent lost decade. Now, however, signs of underinvestment suggest the supply glut has been worked off and we see considerable potential for a more favourable cycle in the future.

In contrast, we see signs that the capital cycle for the current market darlings, large US technology companies, is close to a peak. Therefore, we argue that market leadership will very likely not flow back to the winners of the past and that opportunities in traditional value sectors look more attractive compared to growth. Furthermore, we believe that opportunities outside of the US, particularly in emerging markets, may offer more potential.

Indeed, it is worth noting the surprising outperformance of emerging market (EM) assets (bonds and equities) last year, in the face of challenging global markets and tightening financial conditions. We think this is pointing to the potential for underlying strength that is common at the start of a new cycle, and that may signal scope for material gains once external conditions turn more favourable. We note better news out of China as being relevant in this regard.

Looking at South Africa specifically, we acknowledge the real and well-known challenges facing the market, but still see opportunities for companies that have demonstrated resilience and pockets of growth. These opportunities may not be glamorous, but they are undervalued, such as companies in the gaming, hotel and construction sectors, as well as AECI, JSE Limited and Kaap Agri.

In addition, domestically, smaller companies offer specific opportunities for investors to achieve alpha which large asset owners will find difficult to replicate, as evidenced by stocks such as Grindrod and HCI’s outsized contribution to our portfolio’s performance in 2022.

In terms of fixed income, domestic bonds are currently available at high yields and offer potential for income and diversification. When yields are this high, they act like reverse gravity, generating decent returns even in the face of tough headlines. This asset class has the potential to surprise to the upside if the environment normalises and EM assets have a more favourable cycle again. Overall, as we navigate the shifts in the market and anticipate future trends, we believe that a value-oriented, diversified approach will be key to achieving success for our investors.

How we position our funds to take advantage of the opportunities we see ahead
PSG Asset Management offers a diverse range of investment products, including portfolios of local equities, offshore assets and fixed income. As noted in the article Why global investment capability is going to be critical for local portfolios, having an integrated global approach is a key advantage in today’s market. The market has moved largely in line with our investment thesis over the past 24 months, and we are pleased to report that our investors have been rewarded with strong performance, even during the difficult time we have experienced recently. Despite a strong run to date, we believe there remains significant scope for future returns from the securities we hold, given the diverse nature of the counters in our portfolios, and we consider fixed income as a valuable underpin to delivering on client objectives over the medium to longer term.

Looking into the PSG Balanced Fund, we can segment its holdings into five key buckets:

While we remain positive on the opportunity for selected local shares that meet our 3M criteria, we have seen a natural reduction in our local equity holdings since 2019, as some of our investment theses have played out (e.g. sales in HCI and Grindrod) or the companies have been bought and delisted (Imperial, Grindrod Shipping, Long For Life, Massmart). We have been redeploying the proceeds from the reduction in holdings as mentioned into areas like resources, some of our global shares, and bonds.

As a result, our current asset allocations show that we are slightly under historical averages in local shares, slightly over in global assets, and have a healthy position in bonds. Additionally, put options are used to moderate aggregate portfolio risk. Our portfolio is well balanced across different types of opportunities, and while we still retain a healthy exposure to SA Inc and mid-caps, it is smaller than it was at the peak.

We continue to apply our 3M investment philosophy to our clients’ advantage
We believe that investors should not assume that the trends and themes of the last decade will continue unchanged, but should rather seek out opportunities outside of the US and in sectors with more favourable capital cycles. Furthermore, relative prices are in favour of such a strategy. We believe our proven 3M investment philosophy underpins our unique, differentiated investment approach and enables us to look beyond conventional wisdom and prevailing narratives. Ultimately, this allows us to identify the opportunities associated with changing market cycles to our clients’ advantage.

PSG Asset Management is a wholly owned subsidiary of PSG Konsult Group.