Assessing our investment approach

Assessing our investment approach

The best years of our investment value proposition lie ahead
As we are differentiated managers, our performance can be out of step with that of the market from time to time. The most recent drawdown, which culminated in early 2020, lasted longer and was deeper than we would have liked.

Looking ahead, however, we remain convinced of the value our approach can add to client portfolios. We are encouraged by the differentiated and attractive positioning our portfolios offer clients and believe this unique outlook will become increasingly valuable to investors looking to navigate the deep (and sometimes lovely) forests of investment markets going forward.

Buying good businesses for less than they are worth is at the heart of what we do
Our 3M investment philosophy provides a shared basis for the consistent and repeatable approach our investment team employs. The focus of our process is on buying businesses at prices below the value implied by the quality of their cash flow (moat) and the management responsible for stewarding it.

While simple, our approach has some notable characteristics:

• Our focus on margin of safety means that we believe price eventually always matters. As a result, our portfolios can underperform in periods where the market shuns valuation as a pricing
• Our focus on price and undervaluation attracts us to situations where fear or uncertainty obscures the underlying quality or growth of cash flows (perhaps due to temporary challenges). As a result, we tend to allocate capital counter-cyclically and can sometimes appear contrarian.
• We don’t reference market indices or benchmarks when constructing portfolios and so our portfolios can look very different to others. We believe this benchmark agnostic approach is a necessary, but not sufficient, criterion for the long-term outperformance objectives we set ourselves.
• We employ a long-term approach and patiently wait for underlying attributes to be recognised by the market.
• Our moat and management focus are the bedrock of our environmental, social and governance (ESG) philosophy and we strive to take a balanced and responsible approach to evaluating ESG.

Our multi-asset funds have a cash-first approach to portfolio construction and we believe cash can play a valuable role in portfolios under most conditions (see Dirk Jooste’s article Blending our best ideas: Lifting the lid on the asset allocation of our multi-asset portfolios).

Importantly, we do not self-identify as deep value managers. We would describe our approach as a bottom-up focus on buying slices of businesses. Some of our best past and current ideas seek to identify quality and growth before they become visible in the market (and are priced accordingly). This approach has worked well for long periods of time (see chart below). Note the MDD for the PSG Balanced Fund is available here.

Our approach impacts the performance of our portfolios
Disciplined and patient application of our investment process has resulted in significant outperformance since inception. Notably, this performance does not come in a straight line, with several notable periods where the fund underperformed (2009, 2012, 2016 and 2020), indicated in grey in the chart above.

While occasional episodes of underperformance are to be expected for a differentiated, high-conviction process such as ours, the most recent period of underperformance was particularly severe, both in extent and duration (it lasted approximately 18 months). It is therefore understandable and appropriate that many of our investors are asking if our investment approach is still relevant or whether it is ‘broken’.

Unpacking the recent episode of underperformance
We believe the following factors, which were all manageable in isolation, had an unusually severe impact on our style of investing and our client portfolio performance when combined.

Global and local investment environment:

• An extended period of low global interest rates, driven by a combination of persistently low inflation and sustained monetary accommodation, has contributed to dampening the rewards usually evident in seeking out undervalued securities.
• The rising trend (particularly globally) of passive investing had a profound impact on market structure (including contributing to ongoing momentum in large cap shares).
• The largest divergence in recorded history between expensive (large cap quality and growth equities) and cheaper parts of the market. Price became a lot less relevant as a contributor to future performance.
• The most severe and extended emerging market and SA-specific economic downturn on record.

Our portfolio actions:

• A material contributor to a disappointing outcome in recent years was that we were too early to sell out of some large cap US shares (e.g. Microsoft and Apple were significant holdings a few years ago) and
  resources companies. The areas where we found value instead (for example, out-of-favour global cyclical shares and SA financials and industrials) were cheap, but continued getting cheaper. While our positioning is now starting to pay off handsomely, we were far too early in our positioning.
• We got a few isolated stock selections wrong (our 2018 and 2019 investments in Tongaat and EOH were notable examples we have written about previously), which was especially disappointing given we had successfully avoided some of the market fall-out from counters such as Steinhoff, Resilient and Aspen prior to that.

Covid-19 itself:
The radical government-mandated lockdowns and suppression of normal human interactions severely impacted some companies, especially those reliant on social and physical operating modes, while it benefited others (typically more digitally enabled ones). This divergence was in many cases made worse by poor liquidity conditions, resulting in abnormal divergences between price and underlying business volatility.

As the stewards responsible for our clients’ capital, we were disappointed by the extent of the recent underperformance. We expect portfolio and process enhancements to contribute to a smoother client journey in the future, while jealously guarding the essence of our differentiated approach to generating outperformance.

We believe our investment proposition will become increasingly valuable
The market crash of 2020 has been followed by a substantial recovery in asset prices and our investment positioning has started to be rewarded. We have seen encouraging progress over the last year, and we believe our investment approach will become increasingly valuable and relevant for investors in the year ahead as well.

In particular, the following supporting points are worth noting:

• Our investment team has been stable through the challenges of 2019 and 2020, and we have applied our investment philosophy consistently, setting aside emotion to buy undervalued businesses and taking a patient approach.
• Early 2020 offered a once-in-a-generation opportunity to deploy capital into high-quality businesses at exceptional prices. Our investment process is extremely well suited to exploiting such an opportunity. The chart below shows the areas we allocated capital to during 2020, and the returns that followed. Opportunities were ruthlessly and unemotionally assessed, and the portfolios came out of the crisis in much better shape than they went in.

• Our portfolios offer a unique component of differentiation relative to large peers and benchmark indices that are broadly invested in very narrow and crowded areas. Many of our best mid-cap ideas simply cannot be exploited by large managers. We expect our portfolios to play an important role within a well- blended solution.
• Historical experience demonstrates that periods of underperformance are always followed by strong and sustained recoveries in absolute and relative performance (see chart below). A defining feature of
  our investment process is that our best years typically follow periods of disappointment. We have no reason to believe this time will be any different.

Our investment approach makes a powerful addition to client portfolios
2020 was a challenging year with an unusual number of surprises and uncertainties. Throughout this period, it was critical to put emotions aside and make good decisions, guided by a sensible and tested investment approach.

This is exactly what our team aimed to do, and we believe it has enabled us to exploit once-in-a-generation opportunities many other managers may have missed. We believe our investment approach presents a particularly valuable proposition for investors at present.