Ten years ago, optimism in South Africa remained high. SA had just hosted the soccer World Cup in 2010, and we were just three years into the Jacob Zuma presidency.
The South African economy tended to track the median performance of other countries, but as the Zuma presidency became increasingly associated with state capture and corruption, that linkage broke down. SA’s economic growth slipped behind the median.
While economic growth slowed, the cost base grew. Key operating costs – such as electricity, rates, water and refuse removal – grew at rates higher than consumer inflation, and this translated into lacklustre equity returns on the JSE. There was a structural decay in the SA business sector, and only recently have equities started to awaken from this long winter of underperformance.
“Investing against this backdrop has had obvious challenges. One of the big lessons we learnt over the last 10 years is that when you are faced with two securities with the same levels of upside and return – always defer to the better business,” says Iain Power, fund manager of the Nedgroup Investments Balanced Fund. “Generally, we think businesses that are cheap are cheap for a reason and it’s difficult to discern what is a value trap or a value opportunity.”
The Nedgroup Investments Balanced Fund, which is managed by Truffle Asset Management, has maintained top performance in its peer category over a turbulent 10 years. It did this by remaining nimble, by honing a research team willing to challenge the consensus view, by making sound asset allocation decisions – and, perhaps most crucially, by avoiding the losers.
Over the 10 years to September 2021, the fund came out first in its category, beating the Asisa (Association for Savings and Investment South Africa) High Equity category by 3.4%.
Over three, five and seven years, the fund has consistently ranked in the top 10% of performers.
“Our secret sauce has remained fairly constant and that has made performance repeatable. We look for businesses that trade at a discount to intrinsic value,” says Power.
“Where we’ve had more success than others is differentiating between cheap shares that have temporary issues, and shares that look cheap but are value traps. We’ve been good at determining whether these equities have temporarily lost value, and therefore have a good chance of returning to the median, or whether there is a more fundamental destruction of value in the company.”
Future returns will not look like the past
Some of the critical challenges confronting all research teams are the likely impact of Covid, climate change and ESG (environmental, social and governance factors) on company performance.
Covid will have lasting impacts on supply chains, as the great globalisation sweep of the last few decades now looks like a potential liability.
Many companies are looking for alternative supplies that are locally manufactured. Critical freight backlogs have developed in key ports around the world, presenting local suppliers with the best opportunity in decades to regain market share from foreign competitors and price the cost of international freight into their products.
“Covid, climate change and other factors have changed the way that people behave,” says Power. “From a research point of view, this has made some of the unfolding trends more difficult to read. We say future returns may not look like the past, and that’s where some of our peers have struggled to understand the fundamental changes that are taking place.”
One of those changes is the shift in the interest rate cycle, as the era of very low interest rates comes to an end.
This will have a serious impact on over-leveraged companies. “Businesses fail because they cannot pay back the debt, not [because] they cannot generate cash flow,” says Power.
One of the key reasons behind the fund’s success is an ability to avoid many of the losers such as Aspen, MTN, Brait, Omnia, Tongaat, EOH and others.
“We had some exposure to Steinhoff, but not terribly significant, and for us it was a good lesson well learned. At a fundamental level we are business analysts trying to build portfolios that are robust, and trying to spread our capital across as many independent business ideas as possible.
“We look for mispriced opportunities. We spread our positions broadly and will inevitably get a few wrong, but will get far more of them right,” adds Power.
Interrogating the downside
The Truffle approach to research places heavy emphasis on interrogating the downside.
“We’re always asking if we are wrong, where and how will that impact us and will it permanently impair our capital? We look for businesses that are undervalued, so if something goes wrong, we can still get 100c back in the rand.”
The research process is rigorous, involving on-site visits to warehouses, stores, and competitors. This allows the team to gain a sense of whether management reality is reflected in the investment reality.
“We have spent a lot of time developing our team and talent and we think we have a very strong bench. The reality is that we want to test the ideas in the furnaces of a robust debate. If those ideas can emerge from the debate unscathed, we believe it increases the probability of achieving the returns and also highlighting some of the downside risks.”
Challenges for the next decade
One of the big challenges facing SA over the next decade is youth unemployment, which in turn creates pressure on politicians to pursue more populist causes, such as minimum wages, basic income grants and free basic services.
None of these can be paid for in the absence of robust economic growth and there is little evidence of that growth being generated under the current administration.
It remains to be seen how well the ruling ANC performs in the upcoming local elections and what percentage of the electorate will bother to turn out.
“The shift towards populist polices is not unique to SA,” says Power. “It’s a global phenomenon. China is already going down that path with some savage consequences for shareholders, but the risk is in the execution. Where you have well established legal and administrative systems, the risks are not so high.
“The ANC has to deliver on some form of reform and growth for SA to emerge from these challenges in any reasonable shape.”
Brought to you by Nedgroup Investments.
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