Ten years ago, the world was in the throes of major geopolitical upheaval. The Arab Spring burst onto the streets, resulting in regime change in Tunisia, Libya and Egypt. Kim Jong-un took over the reins of power in North Korea from his father, and Raul Castro took over from his brother Fidel in Cuba. Occupy Wall Street, a protest movement against income equality, was stirring in New York, with copycat protests in London and elsewhere.
2011 was also the year that the Nedgroup Investments Balanced Fund was launched under the management of Truffle Asset Management. Over the last decade, the fund has ranked second in its peer group, due in large part to making an accurate reading of market shifts and, where mistakes were made, correcting these quickly.
At the same time the Jacob Zuma presidency was in its second year, and it was marked by a dislocation of SA’s growth trajectory from the median group. As corruption and state capture became more entrenched, SA’s growth declined and that had an impact on JSE stocks.
“One of the big lessons learned over the last 10 years is that when faced with two securities with both having the same expected upside, always choose the better business with better return on capital and a stronger moat that can see it through difficult times, and don’t necessarily opt for what looks like the cheaper business. A lot of businesses that look cheap are cheap for a reason,” says Iain Power, chief investment officer at Truffle Asset Management.
The risks of over-paying for cyclical stocks
While cyclical stocks have delivered sometimes extraordinary gains in recent years, Power says it is important to understand what the normalised or sustainable returns for that business are to measure what is fair value.
An example of this is Kumba Iron Ore, which, two months ago, was earning north of the going price of $220 a tonne due to the quality of its product, while many producers had cash costs of around $20/t. It was only a question of time before additional supply came onto the market to disrupt these super returns.
“If you were buying into Kumba’s current earnings with the expectations that they would continue to grow off that level, you would be sorely disappointed,” says Power.
The fund got involved in the platinum group metals sector three to four years ago at the onset of the PGM bull cycle.
Another investment aphorism at the core of Truffle’s philosophy is being honest and willing to admit mistakes and change direction when the situation calls for it.
Says Power: “When your investment thesis looks like it’s wrong, you should reflect on that and have the intellectual honesty to admit that you’ve made a mistake and cut the position. We have a view that there are no holy cows, so we are prepared to redeploy capital into an idea where you have a higher probability of achieving that target return. That’s where many managers fail, in their inability to deal with their mistakes and to cut those positions from their portfolios.”
Several of the Truffle Asset Management team members have been in the market for close to four decades, which makes for robust debate and intellectual rigour when it comes to developing an investment thesis. Part of the Truffle process is spending a lot of time exploring downside potential to test investment ideas and assess whether they would stand the test of time.
The impact of climate on the investment narrative
Global warming has become a major theme for both shareholders and governments, and the pivot to sustainable energy will see a rapid shift to electric vehicles (EVs), says Power. This will be flanked by accommodation by governments in terms of regulations that will facilitate this trend, along with the buildout of infrastructure to usher in this new era of renewable energy and EVs.
Truffle sees massive investment into battery storage technologies, which will help accelerate the shift to renewable energies. The problem with wind and solar power is the limited availability of generating capacity.
SA has strong exposure to nickel, copper and other new age battery metals, so it stands to benefit directly from this global shift towards renewable energies. EVs will be a major trend in the coming decade which means there’s a demand for charging stations and other infrastructure needed to support this shift. Trillions of dollars will likely be spent on EV-related infrastructure and renewables over the next few decades.
ESG (environmental, social, and governance) targets are now being legislated by governments around the world. Regulators are going to set limits where companies must comply and make the adjustments or get hit with carbon penalties. Another side to this is regulators penalising companies outside their countries by way of penalty taxes for “dirty” producers not meeting emission standards.
Regulators will adopt a carrot-and-stick approach to enforcing emissions standards. Those producers that can get emissions under control will be rewarded in terms of lower import taxes and easier market access. Penalties will be applied to those companies that under-shoot ESG targets. These targets go beyond carbon emissions to working conditions and general quality of life.
‘’We’re increasingly worried about the potential risks to long-duration assets, and we think there is a shift in interest rate expectations. There’s a lot of capital chasing stocks with heavy exposure to long assets and we think there is the potential for permanent capital loss, so we’ve exited many positions (exposed to long-duration assets),” says Power.
Structural change in China
China is undergoing a structural change in terms of policy direction, in that the government is looking at more inclusive growth. More than 600 million Chinese live on less than $140 a month and the government is attempting to close that gap by cracking down on anti-competitive practices, improving access to quality education and lowering the price of property acquisition. If successful, this will create a much larger middle class, but this also brings risks.
There are efforts to close that income gap, particularly to assist those seeking access to property. The Chinese property market is among the most expensive in the world if you look at property prices relative to average incomes. Power says there will be some disruption to Chinese companies in the short term, suggesting a more cautious approach than was the case in the past.
Brought to you by Nedgroup Investments.
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