In many ways 2016 was a remarkable year for investors. Although general market returns were muted, the resurgence of cyclical stocks meant that a number of value investors generated some excellent returns.
In South Africa, the Investec Value Fund delivered an exceptional return of 62.37% in a year when the JSE was only up 2.60%. The RECM Equity Fund gained 43.04% and the PSG Equity Fund 25.12%.
“I’ve tried to contextualise what I think we can learn from what happened in 2016, and what I’ve settled on is that human beings, investment markets, and the world operate in black and white terms,” says the manager of the PSG Equity Fund, Shaun le Roux. “We are prone to think in either black or white. But the truth is that nothing is as clear-cut as we think it is.”
He says that perhaps the best recent example of this is the US election. If you were a white, working class American in the mid-west, chances are that you viewed Donald Trump as the first straight-talking politician you had seen for a while, and someone who would bring change to Washington. If you were more liberal, its likely that you would see him as a bigot who was completely unsuited for the office of president.
“So which is he?” Le Roux asks. “The reality is, he’s a bit of both.”
There is a similar tendency in investment markets, where stocks and sectors can be heavily in favour or heavily out of favour. However, often where the market is displaying fear is where you find the best opportunities.
“A market that is prone to thinking in black and white terms will go through stages where there is a very widely-held consensus,” Le Roux explains. “A year ago there was extreme conviction that interest rates were going to stay low for long period of time, growth was going to stay low for a long period of time, and we weren’t going to see inflation any time soon. If you had to invest in equities in that environment, you had to invest in quality equities or some of the popular growth stocks.”
There was good reason for thinking this way too. Investments in these types of companies had yielded outstanding returns between 2010 and 2015. Those who had invested in emerging markets, however, had done very poorly, and anyone who held commodity stocks could have lost as much as 80% of their capital.
“And what investment markets are always prone to do is extrapolate past experience,” says Le Roux. “So you had a deeply held view that the global economy was going to operate in this low and slow type environment into the foreseeable future, and because returns had been good in the quality counters, we ended up with extremely consensual positioning within markets.”
What transpired, however, was that last year saw a reversion, where the cheap part of the market outperformed the expensive part of the market. This was a classic example of value investing paying off.
“We think you can get very good long-term returns when there is a widely held negative consensual view on a stock or sector,” says Le Roux. “People like to herd. So it might feel very uncomfortable to invest in a mining share when commodity prices have gone down for four years, but if you can find inherently good companies at low prices, you are getting the odds in your favour.”
At the moment he believes there is a similar situation in local companies exposed to the South African economy.
“Nobody wants to buy SA inc. and the price-to-earnings (PE) ratios on some of these stocks are incredibly low,” he notes. “We think we can identify good opportunities to buy mispriced quality in that space.”
An example is industrial group Hudaco.
“Its had tough times from an earnings perspective because the South African economy has been going through tough times, but we think here is an opportunity to buy an inherently high quality business at less than 10x earnings,” Le Roux says. “We think that’s low for a business that has showed return on equity of 21 times for many years.”
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