Following a volatile start to 2019, our investment team responds to some key investor concerns
The market volatility and economic uncertainty that characterised much of 2018 continued into the new year. This has been heightened locally by intensified electioneering in the run-up to the general elections in May and the return of load shedding.
Reflecting on a difficult first quarter, our client-facing team sat down with a few members of our investment team to ask the most pressing questions currently on our investors’ minds.
Q:Over the short term, your funds are underperforming. What can we read into this?
Greg:Short-term underperformance is part and parcel of contrarian investing. To achieve superior returns over the long run, you must be able to bet away from the crowd, and to stomach the short-term drawdowns that may result. That said, we take concerns around short-term underperformance seriously and understand that it’s a difficult experience for investors – we don’t like it either. Looking back over the past three years, our funds have, in fact, outperformed in what was arguably one of the toughest investment environments South Africa has endured since 1994. We believe that this is largely because the quality checklists we apply as part of our investment process helped us avoid most of the corporate landmines that hit the markets in recent years. More recently, however, our funds have lagged our peers, and absolute performance is not what we’d like it to be.
It is important to understand that this is also symptomatic of our process. As we seek to identify quality companies on sale, we often buy what we believe to be good companies that are out of favour. But it’s impossible to predict when the market will start to recognise mispriced quality, and we are often quite early in our positioning. We believe this is currently the case with several of our local and global holdings.
Shaun: When our funds underperform over the short term, we always stop to ask ourselves if this is due to market timing or if we’ve made any mistakes. All investors make mistakes and we acknowledge that there have been instances in which we’ve valued companies incorrectly, either because we’ve subsequently been blindsided by unforeseeable events or due to flaws in our analyses. EOH serves as a recent example. But while we have had specific drags on performance recently, we need to consider how extreme the current market environment is, with poor economic conditions compounded by extremely bearish sentiment. In these environments, short-term pain is often necessary for long-term gain.
Some of our investors will remember similar conditions at the end of 2015 and in early 2016. We experienced significant short-term pain then, but that was part of the reason our funds were subsequently able to outperform. In fact, several of the companies that have made the biggest contribution to three-year outperformance were those that underperformed in the preceding two years.
Most of our funds’ current short-term underperformance can be attributed to their holdings in so-called SA Inc. companies (particularly in the mid-cap space) and unloved global sectors. Although these continue to lag, our investment case holds.
Q:You’ve referred to EOH as a contributor to underperformance. Can you explain what went wrong?
Shaun: In hindsight, we got the intrinsic value and size of the position wrong. While the share performed well for our clients for several years, our research later flagged concerns about the company’s balance sheet, which we didn’t act on soon enough.
Q: Despite recent declines, your funds still own EOH. Why?
Shaun: If we compare EOH now to a year-and-a-half ago, it’s a very different company in several ways. Importantly, it appointed external legal counsel to conduct a thorough governance overview and has overhauled its management and governance structures. This included appointing a new CEO, CFO and head of treasury, along with new board members. The company also has a new investor relations contact, offering improved disclosure to its investor base.
While legacy issues remain a concern, the new management team is committed to rightsizing the business and attending to problem areas. There is a long way to go, but our current view is that the market is ascribing a very low likelihood of a successful turnaround. In our view, the share therefore still offers some margin of safety and we have concluded that it is in our clients' interest to retain their investment.
Q:What risks do investors in PSG’s portfolios currently face?
Greg:Over the longer term, we believe that our portfolios can be characterised as low risk, given how low prices are. Over the short term, however, the risk of poor or volatile performance is relatively high. Many of the companies we hold are out of favour with the market in general. While this is what we believe makes them attractive, it also means that over the shorter term, they are prone to being buffeted around by sentiment. Their share price movements can be unpredictable, and prices may fall further or remain lower for longer than expected.
Q: Given how challenging market conditions are, are you still finding opportunities?
Shaun: As we have noted for some time, there is pervasive fear in certain parts of investment markets. This is in complete contrast to other areas that are well owned and in which investors are inclined to be complacent. We’re finding far more opportunities in those parts where investors are fearful. In fact, our bottom-up analysis is indicating valuations usually seen in deep bear markets.
For longer-term investors who can ride out the storm, the return profile from these low valuation levels is promising. Accordingly, we believe we should be prepared to stomach some short-term volatility in exchange for locking in longer-term returns that increase the likelihood of meeting our clients’ objectives.
Greg:We are finding significant opportunity across most asset classes, which is a rare position to be in. This has allowed us to build diversified portfolios with favourable odds of achieving their mandates under a range of possible outcomes. We are happy to sit in cash when we cannot find opportunities for our clients. The significant deployment of cash in 2018 across all of our multi-asset funds is therefore indicative of how favourably we view this opportunity set. We’re excited both by the opportunities themselves, and by the balanced nature of our funds’ investments. (For more on the current opportunities in our multi-asset funds, please refer to the article by Justin Floor and Dirk Jooste of this edition.)
Q:Is this potential upside realistic, given some of the structural challenges in South Africa?
Shaun: We’re reading the same headlines and share the same concerns as our investors, most notably the significant challenges facing Eskom. However, at a structural level, the assessment of South Africa is more nuanced than most people give credit for – especially when emotions are heightened by economic pressures and political factors. It’s important to keep in mind that governance structures (including at Eskom) have improved substantially. Furthermore, the South African Reserve Bank’s credibility in inflation targeting (with the bank managing to keep inflation within its target band of 3% to 6% since adopting this mandate in 2003) acts as a long-term underpin for local assets. We believe this is far more significant than the potential short-term impact of a possible ratings downgrade that much of the market is fearing.
Greg:If you buy good businesses on low levels of earnings and hold them for long periods, you set yourself up for above-average returns at low levels of risk. We think that the local market currently presents these kinds of opportunities. Furthermore, both corporate and consumer balance sheets are in relatively good shape, which usually offers reasonably good potential for future earnings growth. Of course, the situation at Eskom – and the risks associated with a protracted energy crisis – is troubling, and one we’re monitoring closely. However, we continue to apply our checklists to determine fundamental asset values. If we can acquire assets at large enough margins of safety to compensate for structural challenges, we will continue to capitalise on these opportunities on behalf of our clients.
Q:We are 10 years into a global bull market and valuations are generally high, yet you have been deploying cash globally. Are high valuations not a concern?
Philip: Rising valuations globally over the past few years have indeed made us more circumspect. In fact, cash levels in the PSG Global Flexible Fund were at record levels in early 2018. However, just as in the local market, there continue to be large divergences in the valuations of well-owned, popular stocks and those that are unloved and uncrowded. Consequently, we continue to deploy capital into carefully selected companies from within these areas, which we believe the market is mispricing.
Price moves over the last 12 months have widened our opportunity set, with some high-quality businesses going on sale. We’ve deployed cash into these sell-offs. Importantly, the value of these opportunities may only be unlocked over several years, as sentiment towards the businesses we’re buying or the sectors in which they operate (for example, global real estate and Japanese financials) is currently poor.
For more on our funds and their current positioning, please refer to our fund fact sheets.
Click here to download the article.
Click here to read the next article: Balancing offence and defence to build all-weather portfolios by Dirk Jooste and Justin Floor.