“Generally, the greater the stigma or revulsion; the better the bargain.” Seth Klarman
The Nedgroup Investments Managed Fund has delivered net returns of 13.3% per annum or 7.3% per annum (p.a.) above inflation since RECM started managing it in June 2004. In most market environments for a restricted mandate this may not have been a terrible result. However, within the context of a bull market which has consistently delivered 10% above inflation for the last five years and relative to a peer group that has generously participated in these healthy returns, the result for investors in the fund is disappointing.
For more recent investors, the experience has been harrowing as the gap between the fund’s returns and its peer group has widened particularly over the past three years, delivering a negative return in the last year. This article will outline why this is so, explain why we believe we are positioned correctly, and highlight the extraordinary opportunity this presents for investors especially within the context of an expensive overall market.
Investing in cheap assets and staying away from expensive assets has not delivered…yet
The main reason for the poor relative returns can be found in the simple fact that for the past few years the South African market has been driven higher by expensive assets becoming even more expensive, whereas the attractively priced assets keep getting cheaper. This is typical of the late stages of a bull market, as we have had in South Africa for the past six years, but no less frustrating. While we know that over full market cycles a disciplined strategy of consistently avoiding over-priced assets and investing in those trading at far less than they are worth, will ultimately deliver good investment returns, the evidence of this has not yet come through in this cycle.
In South Africa, the effect has been most pronounced in the equity component of the portfolio, where the resources sector – to which we have significant exposure - has lagged, and the financial and industrial sectors have outperformed. The continued outperformance of industrials has resulted in the most extraordinary relative valuation to resources.
The chart below shows the price-to-book (PB) ratio of the resources sector relative to the industrial sector. When the line is at high levels, it shows the resources sector as being expensive relative to industrials, and when the line is at low levels, it indicates that the resources sector is cheap relative to industrials. We find this chart both fascinating and instructive. On the one hand, it shows how the market has continued to drive the relative rating of the resources sector lower from already very low levels for the past three years. On the other hand, it shows how, at the height of the commodity super-cycle bubble in early 2008, the resources sector was trading at about twice the historical average relative valuation level to the industrial sector. Today industrials are trading at about three times the historical average valuation level relative to the resources sector. Industrials are more expensive today in relative terms than the resources sector was when it was experiencing the greatest valuation bubble since the mid-1980s. We continue to fervently avoid highly over-priced industrials - irrespective of how good the underlying businesses may be; they make for poor prospective investments at these prices – and are investing in resources with the same discipline and vigour with which we avoided them in 2008.
Our conviction in our thesis regarding the resources we are invested in remains intact
The Nedgroup Investments Managed Fund has specific exposure to certain resources which are at cyclical lows, but has no exposure to others such as iron ore, which explains, for example, the conspicuous absence of BHP Billiton in our portfolio to date. Until recently, our estimate of a reasonable long-term iron ore price – a fairly important input in the valuation of an iron ore miner – was so far below spot iron ore prices as to appear almost ridiculous. But within a year, movements in the iron ore price have again placed us at risk of looking ridiculous – but this time on account of our estimate being higher than spot prices! We never cease to be amazed at how quickly prices can change and the status quo can be upended in financial markets.
Some resource stocks such as aluminium producers have already contributed to returns
The global aluminium price staged a strong recovery during 2014 on the back of supply cuts outside of China finally making their impact felt in the market. This boosted the share prices of the aluminium holdings in the global portion of the fund (Alumina and Hydro) dramatically – in stark contrast to the experience in much of the rest of the resources sector. The framework we employed in analysing the aluminium market and the shares of the aluminium producers is exactly the same as that we employ when evaluating any commodity market or resource company. The fact that the outcome was favourable so quickly in the case of aluminium, but is taking so much longer in for example platinum, is not due to our analysis of the investment opportunities being better in one market compared to the other. It is much more a case of investor sentiment swinging from negative to positive based on small changes in the underlying market. Forecasting or trying to time such swings in sentiment is futile. If our work shows that a commodity or the shares of a commodity producer offer value, we are happy to allocate capital to the opportunity in the knowledge that, despite the uncertain timing thereof, the value will emerge in time and deliver good investment returns as a result.
Despite elevated markets overall, we are finding new ideas locally and globally
Few would doubt that the South African market is expensive at the overall level. The aggregate global market is in a similar predicament. Despite this, we are uncovering opportunities in both local and global markets where bargains are on offer to the diligent and disciplined investor. In the Nedgroup Investments Managed Fund, we have initiated 21 new investment ideas over the past year – 10 local and 11 global. On the local side, only two of these are resource investments, with the rest being a diversified group of stocks trading cheaply for a variety of reasons.
Risk is in the price you pay rather than the stock itself
The fund today may feel ‘risky’ to investors, given exposure to businesses going through difficult times, and after the drop in unit value in the second half of 2014. However, it is the principle of investing in cheap companies going through temporary challenging times, which gives it its conservative return profile over time – excellent real returns in early bull markets but lagging increasingly towards the top of the market, and protection against capital destruction in down markets. The latter comes about precisely because we do not hold the much-loved stocks that take the market to its highs, as these are then vulnerable to correction.
A compelling proposition
The Nedgroup Investments Managed Fund maintains its 25% exposure to offshore assets, of which just under 20% is invested in a selection of cheap equites, and the rest is held mostly in US$ and JPY cash. The local equity portion of the fund has increased slightly to just over 52% in the last six months, while holding just over 20% in local cash and maintains a small exposure to fixed income assets.
The current composition translates into a discount to our estimate of fair value of 25% for the fund with the implied potential upside in price being 33%. This includes cash at fair value. Our value-based process of investing in a variety of assets remains the same as ever and is intact to deliver solid real returns with capital protection over time.
We thank our investors for their trust in allowing us to manage their capital, alongside our own, and are confident that their patience will ultimately be rewarded.