Form follows function
Form follows function is a principle associated with architecture and industrial design. The principle is that the shape (form) of a building or object should be based on its intended function.
The Nedgroup Investments Opportunity Fund has a dual function: firstly, to produce investment returns in excess of inflation + 5% per annum, measured over rolling 3-year periods (return function). Secondly, the fund aims to achieve this return without subjecting investors to any negative 24-month periods (risk function).
In this article we explore the topic of how form must follow function, and will attempt to illustrate, by way of a number of examples, how the fund’s design (form) is an outcome of its dual objectives (functions). We will do this by exploring the various tools we make use of in the fund to deliver on our stated objectives.
The asset allocation decision is a key driver of both returns and risk in the portfolio. Exposure to growth assets affords us the best chance of meeting our return objectives over the long term, but also increases the likelihood of a negative return experience over shorter investment horizons. We need to get this balance right. To achieve this, we seek to understand how much additional return we are able to generate for taking on additional levels of downside risk for different combinations of asset classes. We therefore attempt to structure the portfolio to explicitly meet our return objective without compromising our risk objective; the form must follow the function.
We apply a valuation-based process to derive the expected range of returns for the various asset classes that make up our investment universe. This process quantifies how the component drivers of asset class returns will contribute to that asset class’s overall expected return.
For example, our expected return for the domestic equity market is a function of earnings growth, dividends, and a fair exit rating. We use top-down expectations along with our proprietary bottom-up knowledge of the companies in the index to triangulate estimates for earnings growth and dividends. The ‘fair’ exit rating is built up from its fundamental drivers: we use a combination of the global risk-free rate, a suitable South African country risk premium and a fair equity risk premium.
We do not simply assume that the exit rating will revert to the long-term average. This is because the structure of the South African equity market has changed significantly over the past 20 years. Back then, the vast majority of revenues were generated locally, whereas today well over 70% of revenues are generated offshore by what are truly global, dual-listed businesses. These companies should be valued based on global, rather than domestic, interest rates and risk premiums. Simplistically, this implies a fair value rating that is higher than that afforded to pure domestic companies, which by definition should attract the full SA country risk premium. Simply assuming a ‘fair value’ of the market based on the past 20-year average will lead to inappropriate results.
It is important to note that forecasting asset class returns is by nature an imperfect science. One must be wary of placing undue emphasis on point forecasts where the forecast risk is high. We therefore see our asset allocation models as tools to help us find a suitable range for each of the asset classes, rather than an exact and prescriptive allocation. Furthermore, our bottom-up stock selection process cannot work in a vacuum – we require flexibility to take advantage of valuation opportunities at an asset class and individual share level. The fact that we operate within ranges assists us in integrating our top-down strategic asset class views with our bottom-up view of individual securities. As an example, assume Stock A drops 15% on market open (due to what we believe is a temporary setback, such as a short-term earnings miss), but the overall market is flat. Stock A is a business that we have wanted to own for some time, but its valuation has rendered it out of reach until now. Our process affords us the opportunity to purchase Stock A (without having to sell something else) even though the overall market has not moved lower (and by inference equity as an ‘asset class’ has not become more attractive).
We follow a bottom-up fundamental valuation-based stock selection process. We believe that earnings and dividend growth are the primary drivers of share price appreciation. Our thorough research enables us to identify companies – preferably with an enduring competitive advantage – that will show superior earnings and dividend growth which is not reflected in current valuations. In the fullness of time, the market prices of such businesses will converge with their steadily growing value.
A number of holdings have been in our portfolios for longer than a decade, although their weightings have been actively adjusted based on shorter-term prospects and relative performance. We call this ‘rotating at the margin’ – it helps augment returns and control risk effectively. This higher quality component makes up the ‘core’ of our portfolios. Businesses like Naspers, British American Tobacco, and FirstRand fit this description well.
We also endeavour to remain flexible and opportunistic. There are often attractive returns to be made in businesses that are good operators, albeit without the same competitive advantages as the businesses that make up our quality core. These businesses can often be very attractively priced relative to their prospects. Here, our holding period is unlikely to be as long as within the quality core component and our positions may not be as large, due to higher levels of uncertainty. Businesses like Old Mutual, Alexander Forbes and Sasol are good examples of this.
We have built a research capability that extends deep into the investment universe. You will often find a number of smaller (mostly) high quality businesses that are very attractively valued in our portfolios. Currently, counters like the JSE, EOH, Master Drilling, Italtile, and DRD Gold are good examples of fantastic businesses that are not widely followed or invested in by our peers.
Actively seek asymmetric pay-off profiles
An investment with a reasonable measure of upside, but where we have high confidence that the downside is limited, greatly assists us to structure the portfolio to meet its dual objectives. We explicitly seek out assets with asymmetrical pay-offs.
Convertible bonds, whereby we earn a regular coupon and either end up having our capital returned (no conversion) or additional upside if conversion eventuates, are a great example of an asymmetrical payoff. Unfortunately, there are few attractively valued convertibles in the market at present. We have a small allocation to Impala, which is a busted (interest only) convertible, yielding 14% p.a., and expiring in 18 months. We also have a small exposure to the Shoprite convertible, which is trading relatively close to the strike, implying that any upside in the Shoprite share price will translate into a performance kicker for the convertible holders.
We have successfully utilised our derivative skillset to create our own asymmetrical payoff profiles. Our research suggests that we have been able to create pay-off profiles with similar expected returns to holding the naked equity, but with a significantly reduced range of likely outcomes. For example, Steinhoff is a business that we are positively predisposed to. However, we found ourselves in a position where the share price had run relatively hard, increasing the risk of a sell-off. Rather than reduce our position, we simultaneously sold an out-of-the-money call option and an out-of-the-money put option. We used the proceeds from these two transactions to fund the purchase of an at-the- money put option (at zero total cost). The net effect of these three transactions was that a portion of our Steinhoff holding was protected from the first 10% capital loss, but we continued to participate in the next 10% capital gain should the strong momentum continue, at which point we would become capped out.
Over the course of 2016, we have overlaid structures on our holdings in FirstRand, Naspers, Steinhoff, Nedbank, Barclays, and Anglo American. In addition, we have opportunistically hedged some of our foreign currency exposure and swapped fixed for floating rate exposure as a cost effective way of reducing our fixed income duration.
The Nedgroup Investments Opportunity Fund recently celebrated its fifth anniversary. We are pleased that since inception, the fund has delivered a return of 14.2% p.a. (inflation +8.6%) and has not yet delivered a negative outcome over any rolling 12-month period.
The fund has grown substantially over the years and we would like to thank all investors for their support. We are aware that it has been a favourable time to be invested and that from these elevated market levels and increasing levels of volatility, it is going to be more challenging to meet our objectives in the future. We will work hard to keep delivering for you. We may need to be active and nimble; we will need to be ready to pounce on opportunities when they arrive. Fortunately, this suits our natural style, and we are grateful that we have a full toolset at our disposal.