HILTON TARRANT: Welcome to this Market Commentator weekly podcast, our series of interviews with chief investment officers, fund as well as portfolio managers. We’ll be interviewing them or the institutions they represent once every two months or once a quarter. Our guest this week is Greg Hopkins, chief investment officer of PSG Asset Management. Greg, we spoke with your colleague, Shaun Le Roux, back in November and a little earlier last year. You penned a piece in the PSG Asset Management quarterly newsletter, Angles and Perspectives, it was entitled ‘Simplicity is Often Underrated’ this in the third quarter of last year. Take us through your thinking in that piece, it’s a simple intro, one pager, ahead of some of the commentary that your guys penned in that newsletter.
GREG HOPKINS: Ja, hi, thanks Hilton. I think some of our thinking has been shaped by what we see out there in the markets and the example I used is the Apple iPhone, it’s a very, very simple user interface, it’s actually been reduced to incredible simplicity but behind the interface is a very, very complex product and it’s taken, I guess, years of thinking and manpower and an incredible will to get that down into that simple form. My sense is that asset management is not dissimilar to that, you have…and this is just referring to PSG Asset Management, what we’ve tried to do is distill our process down to the very bare basics, behind the scenes there’s obviously 140 years of cumulative experience but we condensed that thinking down to a very, very simple process with few moving parts and we think that serves our investors well.
HILTON TARRANT: What’s on your mind at the moment, Greg, when you look at the world and you look at markets, and you look at all the different asset classes, your view on the different asset classes is relatively well known in the market, you guys have been on a roadshow around the country, what’s occupying your mind at the moment?
GREG HOPKINS: Sure, just continuing the theme on simplicity, if you look at the core DNA of PSG Asset Management is typically putting risk first and what we strive to do is to place a very, very high bar for investments to clear before they’ll make it into our funds. We’re looking for asymmetry, very little downside and lots of upside. We’re taking a long-term view and if we bear that in mind in terms of the backdrop of what we’re looking for out there it’s a much simpler at reaching conclusions. We’re generally quite cautious on bonds, on interest rates in general, we don’t specifically forecast the path of interest rates but we just think that there’s quite a large negative asymmetry in interest rates, ie bond yields could go quite a lot higher and which would mean all things being equal bond prices would come down. Taking a longer-term view on bonds, if you go back to the early 1970s over 40 years average bond yields, particularly if we just look at the US, have been over 6.5%, they’re currently around 2.5%, 3%. It doesn’t take a lot for those yields to rise towards more of an average level and for that normalisation to take place. We’re not saying that that’s going to be the path of interest rates but we’re just saying that there are potentially risks in terms of higher bond yields. So if you start with that as a starting point it will feed through, I guess, into some of our thinking in the fixed income market. We don’t own any government bonds in our funds, we actually don’t own any property as well, South African listed property. We just feel that valuations in that space for us seem to feel very stretched and we’re a little bit concerned about potential oversupply in certain parts of the market. Often what we do find in the markets is people often extrapolate the last few years and think that that’s kind of a new normal. If you take a bigger picture, again in property, you look at dividend yields back in the early 2000s were around 15%, they’re currently on 5%, 6%. So you are getting yield pickup, at 5% to 6% looks attractive but if you look at it relative to where they’ve been in the past you’ve seen quite a large rerating in property, which we think has largely run its course. So we’d be quite cautious on property, property equities, we don’t own any in our funds. In terms of the equity market – and all of these views that I give you are pretty much just a distillation of our bottom-up views, which is I guess is how our process works – we are finding good opportunities still in the equity markets, particularly abroad but in South Africa as well. There are pockets of overvaluation and I think 2014, if you look out over the year, could well be more about what you avoid, rather than what you buy and what you’re avoiding is going to be important. So putting risk first, looking for that asymmetry, avoid certain areas of the market but there are still good opportunities out there.
HILTON TARRANT: It’s been a relatively easily market to buy stocks in over the past five years and that ease has perhaps narrowed as time has progressed since the bottom in 2008, 2009.
GREG HOPKINS: Absolutely, if you look at our asset allocation funds going back to 2008 we had lots of cash in our funds, through 2009 we deployed a lot of cash, there were just so many opportunities to invest in, it was a much easier call. Over the last three, four years we’ve been slowly building our cash levels again as we find fewer opportunities, it is much more difficult than it was three or four years ago to find high quality opportunities. That being said, we’ve seen quite a large selloff in certain parts of the market over the last couple of months and areas that we thought were very overvalued are becoming less overvalued and over the course of the next six months could actually start becoming more attractive.
HILTON TARRANT: Greg, is there a danger in what you’ve just told me about bonds and property, cash and your view on equities? I hear this very often, particularly the more value-orientated managers, is there a danger that this becomes or that this is the prevailing or consensus view, you’re hearing the same thing over and over and over, is that a problem or is that a good thing?
GREG HOPKINS: It’s actually interesting in terms of trying to work out what is the actual underlying market sentiment in terms of the underlying reality. I think there is still quite a large ownership of, in our view, some overpriced equities, which a certain segment of the market…have been on record as saying that they are a higher quality and a higher price and potentially, therefore, are defensive. So I think that there are still those pockets of overvaluation of parts of the market that they have focused on. I think your point is a good point in terms of looking at value and value traps, you’ve got to be careful about avoiding value traps, companies that look optically cheap often are not cheap when you look at the underlying quality of those companies. So we think there will be a rotation towards cheaper shares in the market but you’ve got to be careful which shares you own.
HILTON TARRANT: Greg, in your roadshow presentation you asked the question whether or not property is heading for the perfect storm, I want to go back to that, you hinted at the potential oversupply in the South African market, give us your thinking around where you see listed property at the moment. Obviously many of these listed property funds are trading at a premium to net asset value, we’re seeing shopping centres and malls, office developments going up literally on every street corner in the big centres in South Africa, do you see this potentially hitting a wall in the next 12, 24, 36 months?
GREG HOPKINS: For us it’s more about valuation than the underlying fundamentals. If you look at – and your point there is a very good point – in terms of that the share prices are trading at premiums to the underlying net asset values and those net asset values are actually struck in many cases at the underlying market prices of those assets. So the share price is actually trading at a premium to the underlying market values of the underlying assets. For us that is something that we just want to be cautious about. You look at some of the larger listed companies are trading at significant premiums to those assets, whereas in 2009 they were trading at discounts. So you have seen that situation shift in terms of how you’re pricing those underlying assets. As bond yields also rise the cost of borrowing will rise over the medium term, which will also impact on the earnings power of those companies. Then just generally in terms of oversupply it just seems to us that in terms of retail shopping centre space if you look at some comparisons between South Africa, we’re more like a developed market in terms of the overall shopping square meterage per capita but if you compare the GDP per capita we’re more like a developing market. So it does seem as though there’s some sort of anomaly there in terms of that we’ve got a large amount of shopping floor space per unit of GDP.
HILTON TARRANT: You spoke about those selective equity opportunities on our local market, if you had a blank page and had to fill that blank page with a number of opportunities that perhaps looked interesting, would that page be far emptier today that it was six or 12 months ago?
GREG HOPKINS: No, I wouldn’t think so. I think we’ve got our top ten holdings, I think they’re high conviction calls, they’re good quality companies. In fact, if you look at the philosophy of PSG Asset Management we typically are buying above average quality companies at discount prices or at below average valuations. We still think we can find high quality companies that are trading at large discounts to intrinsic value. I think if you look at it you need to take also once again a bigger picture view, at PSG Asset Management our process is a global process, so we do invest in offshore equities in our domestic equity funds, we just feel that gives us more opportunity to invest in high quality companies at those below average valuations. We’ve also got a smaller asset base than our peer group, than many of our larger peers, which means that we can also invest in companies outside the Top 40. So if you’re constructing ten high quality companies, looking offshore, looking in the mid-cap space and looking at certain pockets of the larger companies in South Africa that are undervalued I still think you can construct a very high conviction top ten portfolio.
HILTON TARRANT: And you do make the point that you tend to find value in sectors or portions of the market where there is a lot of fear around, you cite Capitec, there’s obviously a lot of fear and uncertainty around the unsecured lending market. You cite Adcorp as another example, lots of fear around labour legislation but I guess to go back to your earlier point, this is about picking those opportunities correctly and making sure that those are very good quality companies and not just buying the sector because there’s fear.
GREG HOPKINS: Ja, I think there’s always a tradeoff between price and value. We couldn’t execute on what we call our three M’s – moats, management, margin of safety – we’re looking for good business models, a good management team and a large margin of safety. Two of those are quality overlay factors and so we spend a lot of time looking at quality. If you close your eyes and buy cheapie stocks you will by and large potentially be buying value traps. If you look at a company like Capitec we think that’s a high quality company, it’s got a great track record, we think it’s got a big competitive advantage against its peers and more importantly for us we think it’s a very well capitalised bank, it’s actually the only Basel III compliant bank in the country. Its capital adequacy ratios, which is a measure of capital strength, are significantly higher than its other peers. So we think there’s going to be potential distress in the unsecured lending market but we think Capitec is well capitalised to be able to deal with those stresses.
HILTON TARRANT: You spoke about offshore and the opportunities offshore a little earlier on, the consensus is that there are good opportunities abroad, are those good opportunities perhaps less attractive with the rand at R11 to the dollar?
GREG HOPKINS: Ja, I think one has to be very open, very mindful of the fact that over the last two to three years a lot of the performance in terms of investing offshore has been driven by a weaker rand. That being said, over time we would typically spend less time focusing on the rand and more on the underlying opportunities. Our long-term view is the rand is a depreciating currency, given our large current account deficit and the inflation differentials that we have, versus our trading partners. So typically you’d think that the rand would be a currency that would weaken but over the near term that could either strengthen or weaken further. So we don’t take a specific view on the rand, we look at the underlying opportunities and we still think there are good opportunities in the underlying market, particularly I guess in developed markets, the US and Europe, where there are high quality companies that are trading at good valuations.
HILTON TARRANT: You offer a fascinating example in that roadshow presentation, you contrast SABMiller and IBM, and these two companies on a numbers basis are so incredibly similar, as you point out, in terms of growth, in terms of earnings, in terms of dividend, except the rating and that’s the crucial thing. One’s a darling, one’s a dog and you own one and not the other, not surprisingly.
GREG HOPKINS: Yes that would come back to that quality anomaly; both of them are quality companies, one’s trading at a big discount. If you look at their track records both SA Breweries and IBM have compounded their earnings at a very high rate at over 16% a year but, as you mentioned, one company is on 23 times earnings and the other one 12 times earnings. In fact, if you look out over the next two years the market is forecasting that they’re going to grow at a similar rate, yet one is at half the valuation of the other. A lot of that, in our opinion, is just pure perception, we think IBM is a high quality company that has got some issues that it’s dealing with and sorting out and that’s what’s driven the share price down and that’s what’s given us the opportunity to exploit that anomaly.
HILTON TARRANT: Greg Hopkins is chief investment officer at PSG Asset Management.