Why our funds remain offensively positioned when equity markets are high

Why our funds remain offensively positioned when equity markets are high

We anticipate very divergent future returns from stock markets. A strong case can be made for excellent long-term returns from a carefully selected active portfolio.
We recently marked the one-year anniversary of the lows reached during the pandemic-induced panic of March 2020. If you had predicted at the time that the S&P 500 would be 78% higher a year later, psychiatric observation would have been suggested. With markets hitting all-time highs in recent weeks and many prominent examples of the frothiness, manias and bubbles that we associate with late-cycle bull markets on display, caution is justified. There have recently been many examples of very speculative or aggressive market behaviour and the likes of Tesla, Dogecoin, Archegos, special-purpose acquisition vehicles (SPACs), non-fungible tokens (NFTs), Gamestop and ARK have offered telling insights into market temperature. Clients will be familiar with our tendency to hold high levels of cash when markets are expensive and risk appetite is high – a case of being fearful when others are greedy. Yet cash levels in our funds are currently low and our funds remain offensively positioned. However, this is entirely in keeping with consistent application of our investment process, which continues to identify very compelling investment prospects.

If you are prepared to look within markets, you should come to a very different conclusion to the building narrative that all stocks are expensive and defensive positioning is warranted.
We argue that the capital cycle has given rise to extremities and distortions in positioning and prices that provide a very favourable environment for bottom-up stock-pickers like ourselves. We focus on the price paid and take a long-term view. Accordingly, we expect stock portfolios that our clients own to both handsomely beat the market and generate strong returns over the next few years.

The broader South African investor base has become very pessimistic. Poor returns from local assets and high levels of emotional stress continue to make offshore investments popular and an easy sell for banks and some financial advisers. While we strongly support portfolio diversification and favour healthy offshore exposure for high net worth individuals, we question the wisdom of the ongoing panic to reduce cheap domestic equities in favour of expensive global stocks (or domestic cash). Further to the scramble offshore, local investors have also been selling equity-heavy local unit trusts and migrating to cash and fixed income. The Association for Savings and Investment (ASISA) statistics (as at 31 December 2020) show that 2020 was a record-breaking year for the local investment industry, taking R213 billion in net annual inflows. SA interest-bearing portfolios continued to attract the bulk of inflows, while the SA equity sector recorded a second year of net outflows. In their bid to avoid volatility, investors have even started shying away from historically popular multi-asset portfolios: the sector only recorded R3 billion in net inflows for 2020.

Domestic equities have endured a triple whammy: foreigners have been multi-year sellers, institutions have dramatically reduced their weightings to multi-decade lows, and retail investors have fled into cash and offshore. This has given rise to extremely depressed prices, especially during the crisis of last year. What worries us most is that this behaviour is persisting and end-investors are likely truncating future portfolio returns by selling very low and buying very high.
What is lost in times of stress and emotion is the fact that investment markets move in cycles, and if capital leaves and prices become depressed, the seeds for high future returns are sown. Conversely, buying expensive assets always reduces the odds of achieving high future returns. At current ultra-low yields, investors may end up paying dearly for the ‘comfort’ of the perceived safety that cash offers, especially in light of the pitiful protection it offers against future inflation – we believe cash is the most expensive it has been in modern times. Yet, SA investors have aggressively moved out of cheap equities into cash. Similarly, the passive or mega-cap offshore investments currently preferred by pessimistic locals are extremely expensive relative to history, making it difficult to argue for favourable future returns. Let the buyer beware.

As is usually the case, panic selling of stocks by both locals and foreigners during last year’s crisis gave rise to a rarely seen buying opportunity. The most acute opportunity arose in the stocks that were already cheap coming into the crisis and which were still dumped during the panic: unloved cyclical industries and out-of-favour geographies like emerging markets, the UK and Japan were severely punished. Market panic within a very unbalanced market has created the most favourable environment for differentiated investing in two decades. We have been able to buy fantastic businesses set for explosive profit growth at depressed prices – a powerful combination. This explains why the PSG Equity Fund is 75% higher than the lows of March 2020.

Despite a strong recovery over the past year, our conviction in the expected long-run returns from the companies that our clients own remains high.
Our 3M process sees us preferring to invest in quality businesses that are being overlooked or under-appreciated by the market. Extreme market conditions of recent years were exacerbated by the turmoil and uncertainty of 2020, dishing up very attractive opportunities to identify cheap stocks where inherent quality was being obscured. Examples include some of our larger fund holdings discussed below. We are confident that these companies will enjoy strong profit growth over the next few years, initially as a result of a post-pandemic recovery and thereafter as a result of their strong market positions. Most importantly, our clients own stocks that are still cheap – particularly when compared to the elevated levels of the well-owned winners of the past few years.

Discovery
2020 was a tough year for life assurers. Discovery put in a strong operational performance and, given the conservative level of Covid-19 provisioning and anticipated decline in investment spend, the company is very well positioned for several years of above-market profit and cash flow growth as its new and emerging businesses begin to reach scale. It is extremely attractively priced, as it appears that the relevance and competitive advantage of its shared-value platform is under-appreciated by the domestic investor base. In short: it’s a local fintech champion with a long global runway.

Remgro
2020 provided an excellent opportunity to acquire this quality share with an ‘SA Inc.’ label. There are several attractive features to this investment case. As an investment company, it trades at a very wide discount (40% plus) to a quality portfolio of underlying investments that are all cheap in their own right: Mediclinic, RMI, Distell, CIVH (the telecoms infrastructure player), RCL Foods, etc. We expect management to take advantage of the opportunity to close the wide discount. The investee companies look well positioned to enjoy strong growth in profits and cash flow from this point in time.

AB InBev
AB InBev is a global brewing champion that owns seven of the world’s ten largest beer brands. The company endured strong headwinds in most of its key markets last year, suppressing earnings and drawing attention to the high levels of debt on the balance sheet. We think this situation has obscured the degree to which the company has sensibly locked in extremely low costs of finance and built a platform that will enjoy strong and sustainable growth as it leverages its competitive advantage in both mature and growth markets. The share is very cheap relative to our assessment of earnings power, which we believe will materialise in a few years to come.

Imperial
Imperial is a logistics company that is undergoing a transformation. It has unbundled Motus, sold its European shipping business and streamlined its domestic consumer business. Imperial is intending to sell its remaining European assets and concentrate on two areas: a mature domestic logistics player with high market share and a growing African market access business. The transformation of the group has coincided with severe Covid-19 disruption in 2020, obscuring the earnings power and return potential of the new-look business. We expect the market to recognise the company’s inherent quality and earnings potential in time. Covid-19 highlighted the essential nature of a logistics network. This is a deeply relevant business, yet the company trades at an extraordinarily low multiple of sustainable cash flow.

AECI
AECI is a good example of the opportunities that lie outside the Top 40 on the JSE. This mid-cap explosives and chemicals manufacturer has generated well above market returns for most of the past two decades. Yet, the lack of interest in local companies and the extra risk premium afforded to ‘lower liquidity’ companies saw this business trade at around six times normalised earnings (and a 10% forward dividend yield) in 2020. Operational performance last year was robust, and we are constructive on the path to higher returns on capital, as the underlying businesses are sound and prospects are favourable. It remains extremely cheap.

The stocks discussed above are excellent case studies of the opportunities that the market is currently providing to buy great businesses at wide margins of safety (or discounts to intrinsic value). These stocks are very cheap relative to the cash flows that we expect them to produce over the next few years – PSG Equity Fund clients are invested in domestic and global stocks that trade at 69% of what we think they are worth. This explains the low levels of cash in our funds. We believe patience will be rewarded for those who can look past the manias and extremities of today. Our clients have always been well rewarded by owning good businesses with solid prospects at cheap prices. This is very fertile ground for a differentiated approach.