Our investment philosophy is our North Star

We believe that understanding why we think about companies and investments the way we do, would help explain why we have a preference for certain businesses and industries above others.

The importance of having a properly defined investment philosophy and process can never be overstated.

We have very little exposure to commodity companies and we are okay with that
This is particularly relevant for our stance on commodity producers. We have very little exposure to commodity companies, which is primarily explained by the capital intensity of their business models, the unpredictability of profit cycles, and the cyclical nature of their cash flows. The industry is a large constituent of the JSE All Share Index, but we do not believe that having exposure to a business or an industry just because it is held in an index is always in the best interest of our clients.

While we do have some relatively small positions in a diversified mining company across our local portfolios, we have largely avoided the industry for reasons rationalised by our investment philosophy, which underscores the characteristics we apply to our investee companies.

Commodity prices have been on a tear
Commodity producers have performed extremely well recently, on the back of a spectacular rally across the commodity complex that ensued amidst the pandemic in 2020. The Economist Metals Price Index rose 118% in US dollar terms from March 2020 to April 2021. By April 2021, we were watching 12-month commodity price returns that were even stronger than the post-2008 Global Financial Crisis recovery.

While commodity prices (in many instances) have since retraced some of their gains, they remain at lofty levels and there is a broadly held view that we are in a commodity super-cycle.

Against this background it is not surprising that we are often questioned about our lack of commodity exposure. We believe the best businesses to own in the long run are resilient businesses of which operational performance is mostly stable and compounds over time, irrespective of share price volatility that is driven by short-term market sentiment. Commodity producers, generally, do not fall into this category. Share price fluctuations are often exacerbated by the volatile nature of the underlying profit and cash flow drivers.

Admittedly, commodity producers are currently drowning in cash and dividend payments are indeed at levels that shareholders have not seen in years. When evaluating these businesses from an investment perspective, though, it is important to incorporate a normalised operating environment, assuming prices that can be sustained over the long term. These prices are closer to the marginal cost of production.

Why the scepticism?
The mobilisation of China’s rural labour force under Deng Xiaoping’s leadership since the late seventies saw an explosion in the rate of urbanisation from roughly 20% in the 1980s to an estimated 64% in 2020.

China’s lop-sided growth over the past four decades can be traced back to this rapid pace of urbanisation that has fuelled a development and an infrastructure boom of unprecedented proportions – to the extent that China’s residential investment spending (Residential Gross Fixed Capital Formation), at almost 17% of GDP, is a multiple of those of some developed market peers, despite per capita income levels being significantly lower. China’s dependence on land sales to property developers as a government revenue source has resulted in a warped incentive that has fuelled unproductive investment-led growth at the expense of the consumer. As a result, China is now the dominant demand source for most commodities.

While the Chinese economy consequently grew into a powerhouse that is currently ranked as the second largest economy in the world, the benefit of this urbanisation accrued mostly to capital providers rather than the Chinese consumer.

The Chinese Communist Party (CCP), under the leadership of Xi Jinping, has actively been trying to rectify this economic imbalance through aggressive reforms over the past few years, ranging from gearing limitations for property developers to the more recent calls for “excessively high income regulation”.

Under the CCP’s new mantra of ‘Common Prosperity’, Chinese economic growth over the next decade, is likely to be significantly less commodity intensive.

Considering the proposition of tapering demand from the world’s foremost commodity consumer, requires a conservative approach to the long-term commodity prices being incorporated into the valuation of commodity producers.

Any assumptions regarding these businesses are likely to be wrong
Our key concern with commodity producers, especially those with the bulk of their productive assets domiciled in South Africa, is the fact that input cost pressures are almost a given (mainly as a result of unionised labour), while revenue drivers are generally out of management’s control. In an environment of normalising commodity prices, margins can quite quickly revert to levels where these companies struggle to generate returns on capital that add economic value to shareholders.

The ratings of these companies over long periods should therefore reflect returns that are reasonably sustainable on the capital base, which we believe (in most instances) to be significantly lower than current levels.

Some might argue that the ratings of many of these commodity producers were attractive enough in 2016/2017 that buying them, surely was a no-brainer. Proponents of this view need to remind themselves, though, of the financial predicament that many of these companies found themselves in, at the time. Even Anglo American, under its new and highly respected CEO Mark Cutifani, was forced to suspend dividend payments at the end of 2015 due to high debt levels and deteriorating operating conditions – the second time since 2008. While Anglo American is currently a rejuvenated business under Cutifani’s leadership, things looked rather less rosy at the time.

The commodity price recovery since 2016 indeed provided producers with a golden opportunity to stabilise balance sheets that have positioned them for the dividend flows shareholders are currently seeing. Sustaining these dividend payments, however, requires commodity prices to remain at elevated levels. Basing investment decisions on assumptions regarding unpredictable variables such as short-term commodity price levels, though, is a very dangerous exercise.

We prefer businesses with some predictability
Our investment philosophy deliberately steers us away from highly cyclical, commodity-type businesses towards those that consistently generate high returns on reinvested profits that translate into consistent cash generation. Commodity businesses indeed currently generate high returns on capital, but can these returns be sustained? The ability of a business to maintain high returns, and hence cash flows, is encapsulated in its long-term competitive advantage that has evolved over many years, or even decades.

There is indeed no guarantee that the share prices of high-quality companies will perform better than the broader market, or even according to investor expectations in the short term. We are well aware that some of the domestic companies that fall into this category and that we have owned on this premise, have indeed underperformed against the market over the past few years, despite having compounded cash flows at an attractive rate. However, we remain of the view that the cash flows generated by these businesses (after capital expenditure) will eventually translate into higher share prices. This gravitational attraction of share prices towards cash flows over long periods is one of the strongest forces in financial markets. Unfortunately, with cyclical companies this force is exerted in both directions.

Therefore, owning highly cyclical commodity businesses at current ratings, with earnings and cash flows at peak levels last seen in 2007 and 2008, to us assumes unwarranted downside risk. This stands in stark contrast to the attractiveness of some highly resilient compounders of which share prices are not yet reflecting the long-term sustainable cash flow that these businesses have generated, and will continue to generate over the next five to ten years.

Having a well-defined investment philosophy facilitates an understanding of why you own particular types of businesses and why you avoid others; it should be your North Star. Being married to a particular business, as an investor, can be extremely dangerous. Being married to your investment philosophy, though, should be non-negotiable.

The opinions expressed in this article are the opinions of the writer and not necessarily those of PSG. The information in this zarticle is provided as general information. It does not constitute financial, tax, legal or investment advice and the PSG Konsult Group of Companies does not guarantee its suitability or potential value. Since individual needs and risk profiles differ, we suggest you consult your qualified financial adviser, if needed. PSG Wealth Financial Planning (Pty) Ltd is an authorised financial services provider. FSP 728