The impact of the COVID-19 outbreak on the global economy and financial markets has been severe. The scale of the sell-off, spike in volatility and subsequent rally illustrate just how challenging the environment is as investors grapple with a very wide range of potential outcomes. Our investment team has diligently been working its way through the risks and opportunities the COVID-19 outbreak presents (for more detail on the opportunities we see, read Head of Research Kevin Cousin’s and Fund Manager Lyle Sankar’s articles).
We acknowledge that analysing company fundamentals is a continuous and challenging process with many unknowns. Our process is, however, identifying a number of companies (both in South Africa and abroad) where the sell-off looks materially overdone. If the COVID-19-related knock to what these businesses are worth is relatively small, the opportunity for returns is staggering. It may well be a case of companies that were cheap becoming even cheaper. Good things lie ahead if we can accurately separate risk from opportunity in this environment and be brave where appropriate.
We think it best to communicate with our clients by answering the main questions that are being raised.
Q: What is your message to investors?
We acknowledge that this is a very difficult time to be making investment decisions, as there are a lot of unknowables and the implications of making the wrong decisions are amplified. If you sell stocks worth a rand for 20c to buy stocks that are also worth a rand but are trading at 120c, the long-term impact on your portfolio could be severe. Obviously, the challenge will be to identify which are the 20c stocks and which are the 120c stocks. This is why an investment process is so important – it removes the emotion and weighs the evidence, focusing on the process and not the outcome. If you are trying to predict outcomes and back-engineer a portfolio, the likelihood of error is high. In times like these we always encourage investors to try take emotion out of the picture, fall back on the process and manage the risks. However, investors should also be prepared to be brave where it is appropriate and make decisions that will reward them over the long run.
Q: PSG’s performance was poor in 2019 and continued to lag benchmarks over the past quarter. Please can you help us understand this?
We are acutely aware that it has been a very disappointing and challenging time for our clients. They had endured poor short-term performance by our funds and the additional pain of the March COVID-19 sell-off has naturally caused a lot of concern. Many of the cheap stocks our clients owned performed poorly in 2019 and, despite wide margins of safety, were hit hard in March. Under the circumstances, it is entirely appropriate to be questioning whether this is indicative of flaws in our investment process.
In order to understand our recent performance, is it important to delve into both the reasons for poor returns in 2019 and the March drawdown.
Our performance in context
PSG’s 3M process focuses on identifying cheaper securities, typically in uncrowded areas. We look for stocks that have an inherent quality that the market is missing. This style of investing has worked very well over long periods of time and is suitable for clients with a longer investment time horizon. Over the past few years, we have identified attractive domestic opportunities on the JSE as well as in less popular and cheap global stocks. The reasons for the pre-COVID underperformance by the stocks in our portfolio can broadly be attributed to two factors: the low levels of confidence in South Africa that depressed local stock performance, and the widening divergence in global valuations between cheap, out-of-favour stocks and their expensive widely owned counterparts. Clients will recall that the JSE’s performance at an index level in 2019 was driven by a handful of resources stocks and Naspers, with the vast majority of shares continuing their multi-year bear markets. It is very important to note that the COVID-19 pandemic has not changed the rationale for owning the businesses that our clients do. Instead, future returns have been delayed and potentially improved. If fear results in the opportunity to invest in good companies at very low prices, given low expectations about their future prospects, then COVID-19 has enhanced the opportunity to execute on our investment philosophy.
Market developments in March
Other than cash and developed market bonds, there were few places to hide in the March sell-off. Despite underperforming before the crisis, cheap stocks were hit particularly hard in March (both locally and overseas). While the selling was broad-based, stocks that were economically sensitive, leveraged or in emerging markets were hit hardest. This weighed very heavily on some of our global holdings as well as many companies on the JSE, hence the losses we incurred in our portfolios. However, for the reasons that Head of Research Kevin Cousins expands on in The opportunity in the COVID-19 storm, panic selling has the tendency to be irrational and prices can be expected to reverse quickly if they have overreacted. It can also create tremendous opportunities and we have pounced on a number of COVID-19 opportunities as discussed in that article.
Our recent analysis has been focused on determining the extent of the COVID-19 impairment to intrinsic value. We have concluded that while the prices of the securities in our portfolios have fallen sharply, their fundamental values are still intact. That is why we expect the vast majority of the loss in capital to be temporary. We also believe that the current environment of low confidence, temporarily weak economic conditions and abundant liquidity sows the seeds for the next bull market. Our research indicates very sizeable upside for a number of securities when conditions stabilise.
Q: One of the characteristics of your process is investing with a margin of safety – yet this has not prevented your shares from falling further. Why?
It is true that buying at a margin of safety is our main tool for protecting our clients against permanent capital loss. We should, however, remember that share prices can move in a very wide range around your assessment of intrinsic value, and during extreme environments prices can over- and undershoot by a large degree. We are currently witnessing such an environment and we believe that share prices have moved to very extreme levels relative to fundamental value. In many cases, SA stocks are much cheaper than they were during the Global Financial Crisis (GFC).
Fundamental value must be considered alongside share prices
We also think it is important to distinguish between permanent and temporary capital loss. We expect that the majority of the losses incurred recently will prove to be temporary in nature. An economic contraction as severe as the current one does, however, result in some impairment of shareholder value for many companies: they will make less profit or incur losses and/or take on more debt. In some cases, equity value will be wiped out. Viewed through this lens, some reduction in fundamental value has been incurred by most global equity investors, but this reduction in shareholder value cannot be looked at in isolation – it needs to be considered in conjunction with much lower share prices. The surest way to crystallise permanent capital loss is to sell at very depressed prices.
The margins of safety in our portfolios are substantial
Most businesses grow their intrinsic value over time and will not take long to restore any value lost. This is especially the case in industries where weaker competitors fall by the wayside, enabling survivors to grow market share and extract more pricing power. In this way, a deep recession can be very cathartic, enable the strong to get stronger and result in higher long-term returns on capital for market leaders. While it is still unclear what the ultimate impact of the COVID-19 outbreak will be and when a recovery is likely to take place, it is clear that our stocks and bonds were cheap going into the recent COVID-19 crisis, i.e. they had large margins of safety when viewed over a longer period. We estimate our local and global buy lists were on a price to intrinsic value of 0.55 (an 81% margin of safety) and 0.64 (a 56% margin of safety) respectively. This value is still apparent today in the midst of the crisis.
Q: What have you concluded on the COVID-19 impacts on your portfolios and what changes have you made?
Our portfolios underperformed in March, as outlined above. However, we consider these losses as temporary, for two reasons. Firstly, the reductions in intrinsic value have been relatively small at a portfolio level. Secondly, we have been able to harness the COVID-19 driven opportunity to acquire very good businesses at exceptional prices. We expand on the dislocation between prices and value in more detail in Navigating the storm in fixed income markets and The opportunity in the COVID-19 storm.
Broadly speaking, we have retained the shape of our portfolios. Our highest conviction is reflected in domestic sovereign bonds – from which we expect equity-like returns – and more resilient companies (domestic and global) trading at wide margins of safety. Our largest current stock holdings (AB Inbev, Liberty Global, Discovery and Japan Post Insurance) are representative of this opportunity to own higher-quality resilient and cheap businesses. Our clients also own a number of very cheap companies exposed to parts of the economy that are experiencing a drop in demand. These include local financials, mid-cap industrials and US retail REITs. Although the nearer-term earnings profile of these companies has been impacted by COVID-19, their low earnings at the start of the COVID-19 crisis bode well for their longer-term earnings growth potential. Our analysis of balance sheets and valuations indicates a very wide disconnect between the share price and a conservative value that factors in sustained suppression of economic activity as a result of the lockdown.
Q: What does COVID-19 mean for emerging markets like South Africa and your SA Inc. investments?
It is quite easy to paint a dire picture for most emerging markets, given the impact of the collapse in demand on their economies and their fragile fiscal status. There is no question that significant challenges lie ahead and the exiting of the COVID-19 lockdown is likely to be a stop-start affair. Emerging market economies also lack the firepower for stimulus to compensate for the collapse in demand. But, in the rush to reduce investment risk, global investors have fled emerging markets at an unprecedented rate, extracting US$100 billion in three months. This has had a very severe impact on currencies and asset prices in South Africa and other emerging markets, and it can be argued that the extreme price movements provide an opportunity to generate long-term returns that will handsomely exceed those available in developed markets like the US. Fund Manager Lyle Sankar unpacks the extremity of the pricing of SA sovereign bonds in Navigating the storm in fixed income markets and offers a number of reasons to substantiate our view that yields are likely unsustainably high (and prices unsustainably low).
The impact of a change in sentiment could be pronounced
Similarly, equity markets tend to recover well before the economic data and if the point of maximum global investor pessimism lies behind us (even if the economic woes lie ahead) it is possible for the wave of outflows to turn the other way. Historically, an environment of massive global monetary and fiscal stimulus creates liquidity that finds its way into the cheap growth assets and high-yielding securities that are abundant in emerging markets. Given the high yields and very low prices in emerging markets, the impact of a change in sentiment and direction of flows on domestic security prices could be very pronounced. Our clients still have material exposure to domestic companies and bonds that we think will produce exceptional long-term returns.
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Click here to read the next article: The opportunity in the COVID-19 storm by Kevin Cousins