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February 2023

PSG Asset ManagementNewslettersAngles & Perspectives

Why global investment capability is going to be critical for local portfolios - Angles & Perspectives

Shaun le Roux, Fund Manager

Asset Management

Gavin Rabbolini, Analyst

PSG Asset Management

Greg Hopkins, Deputy-Chief Investment Officer

2022 was the most challenging year in over a decade for most global investors. Strategies that had been hugely successful for many years stopped working. It suddenly got even harder to be above average. We have been arguing for some time that global financial markets have passed a major inflection point and that the outperforming asset classes of the future will look very different to the winners of the post-Global Financial Crisis (GFC) decade. This backdrop amplifies the importance of having a broad universe within which to pick what is likely to work in the future. More choice and good selection will dramatically improve the likelihood of producing good returns at acceptable levels of risk.

“ Our globally-integrated bottom-up value-based 3M process will find the best long-term opportunities even when they are not popular. ”

Why global investment capability is going to be critical for local portfolios

Global investing will be a key contributor to future portfolio outcomes and a key differentiator between funds

PSG Asset Management is a global investment manager that runs a global process (more on our global capability below). Success requires an experienced team and a credible process in this very competitive industry. Pleasingly, our clients have enjoyed the benefits of a solid long-term global track record.

SA investors will be aware of the amendments to offshore limits for domestic funds in last year’s Budget. Local unit trusts can now invest 45% of their assets outside of SA. This represents a 50% increase in the global allowance and is a big deal for asset allocation and future fund outcomes. This is a very positive development for local managers with proven global capability. The increased limit will benefit local clients in two key areas:

Risk management: More opportunities arise to diversify portfolios across geographies, sectors and currencies so that they can deliver in a wider range of scenarios. The JSE is a highly concentrated market with relatively narrow dependence on a handful of drivers. These include the value of the rand, commodity prices and sentiment towards domestic stocks. A domestic-only mandate requires strong bets on these drivers. This means that unforeseeable events (like the Covid pandemic) can have a more pronounced impact on returns (either positive or negative).
Better returns: A broader universe for security selection significantly improves the return possibilities for skilled managers.

The amended offshore limit is likely to lead to wider divergence in future fund performances
Generally, asset allocators can adopt one of three strategies:

A building block approach: Many top-down asset allocators favour this approach. They will decide on a global-domestic split and select domestic-only and foreign-only building blocks (typically, funds or exchange traded funds (ETFs)) on this basis. They will often dynamically overlay sectoral tilts and allow underlying managers to select securities.
Outsourced global capability: Some local managers have chosen to outsource global asset allocation and stockpicking. Presumably, they do not feel that they have the experience or capability.
Integrated bottom-up portfolios: Here, managers will select securities on a bottom-up basis with careful consideration of risk management when constructing portfolios.

We employ an integrated bottom-up approach
This allows us to take a balanced view between risk and return using a wide global universe. Our global process produces buy lists of domestic and global stocks, bonds and other instruments. When portfolios are constructed, the fund manager compares different securities (domestic and global) and considers blending them in a way that will deliver the best risk-adjusted expected returns. We believe this strategy has several advantages. Primarily, the portfolio comprises our best ideas (whether domestic or global) also giving considered thought to how these different ideas correlate. Furthermore, we derive significant benefit from being able to compare local stocks to their global equivalents in terms of quality and valuation. For example, PSG has identified good opportunities in the global energy markets but prefers direct global stocks like Shell, BP and Noble to JSE-listed Sasol. Also, we often observe patterns or cycles that replicate in different markets with a lag. Furthermore, exposures can be adjusted real time providing a great deal of flexibility in times of market volatility.

Risks may arise when outsourcing to building block or external global managers. Portfolio construction and security selection performed by different people can result in inconsistent philosophies and processes. In addition, outsourcing global stockpicking may require diluting your best local ideas when you manage aggregate risk. There is also less flexibility to respond to market dynamics at a security level when selection is outsourced to other managers.

The environment favours active stock pickers and our agile approach will serve clients well
The market backdrop is one of very divergent valuations and significant crowding in US indices and large cap stocks. This should favour active stock pickers in the future. Our integrated global bottom-up approach gives our clients exposure to our best global ideas, which can then be used to construct portfolios that are fit for the current investment cycle. Having sight of the investment case, risk and interrelationship of all the underlying securities allows us to blend balanced portfolios that can be adjusted on a real-time basis. This enables us to be agile in a very uncertain world. These factors should serve our clients well in the long run, as global capability becomes critical for local portfolios.

A case study of an integrated global process

Investing in global shipping – exploiting the capital cycle
The shipping industry is an excellent example of how the PSG process works in practice. It shows how we generate contrarian ideas and leverage our analytical expertise within a global universe.

A supply side-led process tilts the odds to exploit the capital cycle in our favour
Industries with favourable supply side dynamics have typically been a rich hunting ground for a long-term, countercyclical investment process. Capital cycles play out over several years, are inevitably painful, but result in multi-year inflections in pricing power and returns on capital of industries. The shipping industry is no exception.

We prefer to invest at the stage of the capital cycle when low returns on capital give rise to constrained supply. Profits will then be low and share prices depressed (making it psychologically difficult to buy). To get the odds in our favour, we’ll spend most of our analysis time understanding the characteristics of the industry and building conviction in both the direction and inflection of the key underlying fundamentals in real time. Unfortunately, this journey is never as elegant as set out on paper and it is important to have the ability to withstand volatility and take a longer-term view. Often, demand-led volatility results in excellent buying opportunities, as you have an undisturbed supply side thesis.

There are few industries that characterise a capital cycle quite like shipping
In general, the lack of supply of ships is probably the most important (and overlooked) factor in our investment thesis. Returns are high when the supply of ships is tight, in turn leading to increased ship values (your whole fleet is worth more). A sustained period of attractive returns typically incentivises over-ordering of new ships which, when they hit the water, suppress returns and deflate ship values. The previous cycle saw the emergence of the Chinese economy in the early 2000s, which resulted in a dramatic increase in tonne-mile demand across all forms of shipping (especially dry bulks that transport commodities). Shipping rates exploded between 2003 and 2008 in a supply-constrained market. A surge in orders for new ships followed, resulting in expanded supply just as demand was slowing. This resulted in a decade-long bear market which saw cash losses, bankruptcies and rationalisation (scrapping of ships) as overcapacity was worked away. In turn, this recreated the setup for a future multi-year investment opportunity.

Our shipping journey started locally but our global process led us to profit from multiple global opportunities within the shipping cycle
We have analysed locally listed logistics company Grindrod Limited for more than two decades and added the stock to our portfolios around six years ago. This investment was largely premised on our appraisal of the value of their port and terminal operations. However, it did require an understanding of Grindrod’s shipping subsidiary (Grindrod Shipping), which experienced a dramatic decline in profitability after the superprofits of 2003 to 2008.

Our deep dive into the dry bulk shipping industry indicated that a favourable multi-year capital cycle was building, as the supply of ships had collapsed towards 20-year lows and there were several barriers emerging which would likely enforce capital discipline and keep new supply out (this was unique compared to previous cycles).

After detailed company analysis, we elected to start adding Star Bulk, a US-listed dry bulk carrier, in both our local and global portfolios in 2016. When Grindrod Shipping was unbundled from Grindrod Limited in 2018, we already had sufficient conviction in its long-term prospects and valuation range of outcomes, and we could demonstrate sufficient asymmetry to remain shareholders.

We also did work on other shipping segments and observed similar supply side dynamics in the container shipping industry. We started to invest in Maersk in 2018.

Our investments have not been without their challenges
It is never plain sailing in the shipping industry (excuse the pun) and our patience has been tested. Share prices remained depressed between 2016 and 2020. But in the background, fundamentals continued to improve as fleet growth slowed, scrapping increased, and emission regulations caused inefficiencies. Then the pandemic hit and an unprecedented collapse in demand – and hence freight rates – hit these cyclical business models (and share prices) hard. However, levels reached in March of 2020 are likely to prove to be cyclical lows and share prices have performed very strongly since.

As a rule of thumb, trade inefficiencies drive tonne-miles (increased distances cargo needs to travel), and the pandemic was a key inflection point. Container shippers performed very well in 2020 and 2021 and led the charge in the broader industry, as supply chain constraints (in a tight market) saw a surge in container rates – the Maersk share price increased fourfold over the period. As expected, this has led to a surge in orders for new ships, and shipyard capacity is now filled with orders for new container (and LNG) ships out to 2025. Accordingly, we could no longer find a margin of safety in our Maersk investment and our funds exited the position entirely in 2021.

Despite relatively strong share price performance (and chunky dividends) since the Covid lows, we have elected to maintain a healthy exposure to the broader shipping basket. This is for three reasons: firstly, the supply side thesis for other shipping segments remained compelling. The lack of yard capacity and upcoming environmental regulations eliminating older ships collectively extended our assessment of the duration of the capital cycle by delaying a supply growth inflection.

Secondly, companies have pivoted to very shareholder-friendly capital allocation policies. For example, Star Bulk is returning all excess cash to shareholders and 2022 dividends represent 35% of its current share price.

And thirdly, we are still able to demonstrate attractive asymmetry in the valuation range of outcomes of the companies our clients own. Importantly, these companies’ valuations are heavily weighted to cash returns to shareholders over the next three years.

The composition of our exposure to the shipping industry has changed over the past two years
In early 2022, we added meaningful exposure to crude and product tanker stocks that made it through our process in accordance with the criteria discussed above. Again, the supply side was the main attraction and the disruption to global energy markets from Russian sanctions proved to be a key inflection, as it introduced material inefficiencies to trade routes and strong tonne-mile demand, easily outpacing constrained fleet growth. 2022 was a record year for our tanker positions, and core holdings such as Scorpio Tankers and Euronav saw their share prices increase by 319% and 104% respectively. Despite strong short-term performance, we are maintaining a healthy exposure to the sector, as the fundamental direction of travel still points towards a multi-year opportunity and we expect to participate through healthy cash returns to shareholders. Most importantly, defying historical trends, market strength has not been accompanied by a high level of new ordering.

2022 also marked the end of our journey with Grindrod Shipping. It had contributed materially to our client outcomes between 2020 and 2022, but amidst weak markets in mid-2022, a competitor with similar views on the medium-term prospects for dry bulkers made a bid for the company. We used the opportunity to exit our position at what we thought was a reasonable level given liquidity constraints, and we reallocated capital towards the abundance of other opportunities in weak equity markets.

Our shipping journey demonstrates the value of a full global capability
Our shipping journey has been very profitable for our clients. Equally important is that it demonstrates the value of a full global capability. After getting to know the fundamentals of an industry well, one can then look left and right at adjacent (or similar) stocks, sectors or geographies for similar or better ideas. We remain positive about existing portfolio holdings for the reasons discussed above. It is worth remembering that this is a very volatile market, and taking a longer-term view is essential.

About our global capability

PSG employs one global investment process.
We have been investing globally since 2008.
Our team is well resourced, comprising 20 investment professionals with over 200 years of cumulative experience (much of that including global).
We manage direct global assets in excess of
R13 billion.
Our integrated global capability has produced excellent absolute and relative returns for clients in our local funds: for example, the global portion of the PSG Equity Fund has beaten the MSCI World Index in US dollars since 2011 (when this fund started investing globally).

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

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