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Obscured quality - the market is pitching classic 3M opportunities

30 July 2020

Obscured quality - the market is pitching classic 3M opportunities

Investment markets move in cycles. Sometimes, opportunities abound to acquire the businesses we love to own: higher quality companies that are out of favour and hence cheap. Now is such a time.

Our process is orientated to finding cheap, unloved quality
Our 3M process is inherently designed to capture contrarian investment ideas. This investment philosophy seeks out mispriced quality assets in uncrowded areas and allows us to buy above-average quality companies at below-average valuations over time. One common characteristic of our holdings when compared to many of the popular stocks in global markets today, is that they have strong inherent qualities that are obscured by temporary issues. This requires the investor to scratch below the surface to form an informed opinion.

We are of the view that the odds are firmly placed in our clients’ favour by allocating capital to companies with ‘hidden qualities’, as they come with vastly different price tags relative to those where quality and growth attributes are visible to all. Additionally, once these hidden attributes become more visible to everyone, the potential to unlock value can be immense.

We think current market conditions favour building a classic PSG portfolio
A classic PSG portfolio has a high conviction in a number of great businesses where the market is currently under-appreciating the strength of their franchises. We have continued to highlight the crowded nature of popular investments and the opportunity set within out-of-favour sectors and geographies (read our article Why it is a bad time to give up on contrarian investing). We believe that the massive COVID-19 disruption has amplified this state of affairs. We have even spoken about COVID-19 as an ‘opportunity’ to long-term contrarian investors. If you are prepared to expand your investment universe and invest in what is not popular, you can buy companies that are trading at big discounts to what we think they are worth because expectations are very low. By contrast, visible quality and secular growth stocks are attracting a very high rating that carries a lower likelihood of meeting expectations, and hence long-term returns are likely to disappoint.

Our highest-conviction holdings over time have been dominated by businesses where there is clear evidence that they are of above-average quality. Typically, they have generated long-run returns on capital that exceed the market. An analysis of our 15 largest equity investments across all our funds in graph 1 below is insightful. These businesses have, on average, generated returns on equity well in excess of the market and investors have enjoyed superior long-term returns as a result. Yet, for the reasons described above, we can buy such companies at a material discount to the average stock.

We have always favoured large shareholdings in companies that have a strong alignment with the management team. This is because we take comfort that they are more likely to think and act like owners, taking a long-term view on value creation. It is noteworthy that our top 15 holdings have median inside ownership of R5.9 billion and in aggregate own R2 trillion of stock in the underlying companies. In particular, we reference the very large inside ownership in companies like Berkshire Hathaway, Simon Property Group, Glencore, Discovery and Liberty Global. Excluding Berkshire’s arguably outsized R1.5 trillion inside ownership, the median and aggregate shareholdings are R3.6 billion and R500 billion respectively. A partnership with a competent and an aligned management team is especially important in navigating a crisis.

Opportunity exists where fear abounds
As discussed in the article Why it is a bad time to give up on contrarian investing, the performance of global stock indices have been flattered by expensive large caps. A large proportion of global stocks are in deep bear markets – we calculate that 84% of SA stocks are in a bear market. Emerging markets and cyclical companies are more vulnerable to the deep global recession and hence find themselves deeply out of favour. The market in 2020 has treated cyclical companies with operating leverage harshly, and has been particularly brutal for businesses with financial leverage. We have observed many examples where limited recognition was given to out-of-favour companies that have strong business models and which should recover swiftly. In many cases, stocks that have the capacity to carry higher levels of debt were unduly punished. This opened the opportunity to buy more resilient companies that are temporarily impacted by the recession. Local examples include Discovery and the JSE. Offshore we have been buyers of AB InBev, Liberty Global, Prudential and Berkshire Hathaway. We also favour cyclical companies that can be acquired on very low valuations such as AECI, Imperial and Exxaro (domestically) and Glencore, Mosaic and Simon Property (globally).

The current opportunity to acquire classic 3M stocks is best illustrated by a few case studies.

We harness the opportunities we identify for our clients
Investment markets will always move in cycles. There will always be reasons for companies falling into and out of favour. The current circumstances have given rise to a number of exceptional companies falling from grace.

Our long-term investment track records have always been built on harnessing such opportunities for our clients, and we will continue to do so.

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Click here to read more articles from this edition of PSG Angles and Perspectives Q2 2020.

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Philipp Wörz

Fund Manager

At PSG Asset Management
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