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Balancing offence and defence to build all-weather portfolios

30 April 2019

Balancing offence and defence to build all-weather portfolios

We are excited about the opportunity set embedded in our funds
Poor market sentiment locally and elevated economic uncertainty globally have weighed on investors in recent months. For us, the parts of the markets most clouded by fear are those that present the best opportunities. While we know that it will take time to realise mispriced value, we’re excited by the prospects our process is uncovering. They’re what we refer to as coiled springs: opportunities with the potential for significant upside. The fact that these opportunities extend across almost all asset classes is just as encouraging – and very rare. We believe that this has allowed us to build balanced portfolios that are well positioned to deliver on our client mandates.

We construct portfolios with our investors in mind
We build portfolios around our investors’ needs, taking both return requirements and risk appetite into account. We consider the typical client a fund has been designed for and their key objectives: whether it is more important for them to grow or protect their capital, how long they are looking to invest for, and how sensitive they are likely to be to temporary dips in performance. Our aim is to maximise the number of scenarios under which we meet our investors’ objectives, while remaining mindful of the client journey. This requires a balance between offence – capitalising on opportunities to enhance returns even when it might feel uncomfortable – and defence – reducing the risk of permanent capital loss by avoiding any one-way bets. While this may at times result in short-term underperformance (as we reference in the opening article), it helps us deliver the returns our clients require over mandate-appropriate periods.

Our starting point is cash, which we only allocate to individual securities that meet our criteria
Our process sees us defaulting to cash, which we will only allocate if we can identify opportunities that offer the potential for attractive risk-adjusted returns. As bottom-up managers, we do not make broad, bold asset allocation calls and then search for investments to satisfy these. Rather, we evaluate each security based on its own merits. Accordingly, our funds’ cash holdings are the end result of allocations to the individual investments we identify as offering mispriced quality. Current cash exposures are low relative to history, which is indicative of the opportunities we believe markets are presenting.

We select securities from our buy lists and invest across asset classes for diversification
All our fund managers populate portfolios from the buy lists (equity, fixed income and credit) that our investment committees produce. The securities on these buy lists are those that have successfully met our 3 M (Moat, Management and Margin of Safety) criteria and reflect our team’s best ideas. To make their selections, fund managers consider:

  • a fund’s required return hurdle, which largely determines its exposure to growth assets
  • opportunities across the buy lists that could contribute sufficiently to this return to qualify for inclusion

We take a through-the-cycle view (we evaluate the potential range of outcomes over the full recommended investment horizon) and diversify across both asset classes and the individual securities on any single buy list. As a final risk overlay, we check for and address excessive correlations or unintended macro exposures to any specific variable. In combination, we believe that this allows for robust, multi-dimensional portfolios.

Both our local and foreign equity buy lists are attractive relative to history
A notable theme in our multi-asset portfolios is a sizeable weighting to neglected SA Inc. stocks, an opportunity we’ve highlighted for some time. Stocks exposed to the local economy remain out of favour against the backdrop of a low-growth environment and intensified political tension. However, we believe that those businesses with proven track records (in some instances spanning decades) and strong management teams have a good chance of weathering the storm – as they’ve done before. We’ve been able to acquire such businesses at low prices and on arguably low levels of earnings, which bodes well for future returns. Top 10 holdings we’ve previously referenced include Super Group and AECI, while the recent sell-off has allowed for new additions to our buy list, such as JSE Limited.

Globally, although valuations generally remain high, we continue to find select opportunities in less popular market segments, or those shunned by investors out of fear or uncertainty. These include investments in Japan and US real estate and, more recently, quality names such as Anheuser-Busch InBev, Asahi Holdings and Prudential plc.

South African fixed income continues to offer compelling value
We believe that long-term government bonds currently present one of the most attractive risk-adjusted opportunities in our portfolios. These instruments, which offer good liquidity and a government guarantee, are currently available at substantial real (above-inflation) yields. In fact, a recent study by Morgan Stanley shows that the real yields on South African government bonds are presently the highest among investment-grade peers.

Other opportunities our funds have taken advantage of include government-guaranteed Eskom bonds (however, as these instruments are not as liquid, positions are smaller) and inflation-linked bonds (ILBs). Both longer- and shorter-dated ILBs continue to offer notable real yields, along with an inherent buffer against upward inflationary shocks.

We are finding some good prospects in US real estate
Fears around the impact of Amazon and other online players on traditional retail outlets have presented an opportunity in US retail real estate. Some of the businesses in this sector have valuable property portfolios, which we think the market is underestimating. The shares are also currently offering high real dividend yields.

Despite a period of sustained price weakness in local listed property, the asset class does not yet present the margin of safety we require for investment. Our funds currently have no local property exposure, given the compelling alternatives available.

Credit exposures are limited
We have reduced corporate bond exposures in our multi-asset funds, as several existing investments have reached our estimates of intrinsic value. Given that these are illiquid instruments, their hurdle for inclusion in the portfolios is high. As such, we are finding few new opportunities that compare favourably enough to those in other asset classes.

Cash balances offer liquidity for counter-cyclical investing
Our process sees us defaulting to cash, which we will only allocate if we can identify opportunities that offer the potential for attractive risk-adjusted returns. We therefore view cash as valuable firepower that can be employed when we need it, which is usually in the inevitable moments of market panic when quality assets sell off. In fact, we think the value of cash is often under-appreciated.

The value we are finding across asset classes has allowed us to build diversified portfolios
The current asset allocation of the PSG Balanced Fund (as at 31 March 2019) is shown in Graph 1.

We don’t take an explicit rand view and aim to build portfolios that will deliver on their mandates regardless of how the rand moves. The segments separated out in Graph 1 indicate portions of the fund that are exposed to the South African economy: SA Inc. stocks and South African government bonds. These instruments are influenced by local macroeconomic events and could respond similarly to movements in the rand. Foreign equities, foreign real estate and local equities listed offshore (shares such as Quilter plc) act as a counterweight to balance the portfolio.

The fund’s allocation to ILBs provides an additional diversification benefit, as these instruments behave very differently to others in the portfolio. While we deem it unlikely that local inflation will rise significantly, ILBs will also offer some protection if it does.

Finally, local and foreign cash holdings are not exposed to capital market risk. In addition to the attractive yields currently available on longer-dated securities in this asset class, cash holdings give us the ability to capitalise on potential equity or bond market volatility in future.

We believe that the diversified nature of our portfolios makes them more robust
Our bottom-up process results in a selection of what we deem to be the most attractive opportunities currently available, with each security included on its own merit. By reviewing the overall portfolio, we also aim to ensure that all risk factors are balanced appropriately. In combination, we believe that this enables us to build robust, all-weather portfolios with good odds of achieving the returns our investors require.

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Dirk Jooste

Fund Manager

At PSG Asset Management
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