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‘The country is in checkmate’

Hlelo Giyose, CIO First Avenue Investment Management, separates politics from markets in this market commentator report.

Will a US interest rate hike cause a market crash, are there still opportunities for offshore investing and why automation in mining is not an option for South Africa.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, my guest today is Hlelo Giyose, he is the chief investment officer of First Avenue Investment Management. Hlelo, welcome to the show, we saw some fireworks in Parliament on Thursday night. On Friday the JSE was up 1% and the rand was stronger, is it a case of the markets becoming more immune to local political events?

HLELO GIYOSE: The markets have always been, especially the South African equity markets, have always been [more immune]. I think I may have mentioned to you once that we did a study going back to 1960 and we took the ten most socio-economic and political events in 20-year clips, so from 1960 to 1980 we chose the ten worst, from 1980 to 2000 we chose the ten worst, from 2000 until today we chose the ten worst and you could have everything in there, you could have the Sharpeville shootings, you could have the Rubicon speech, you could have the devaluation of the rand relative to the pound by 20% in one day. Today the market is far higher than it was in 1960 and I don’t believe there is a country that’s had it quite as bad as South Africa. So the markets always shrug off what occurs politically and economically, on just one condition, that the country does not part ways with market-driven principles. If you do part ways with market-driven principles and you pursue a Venezuela-type style then the market doesn’t know what to price, then you may as well list the government so that the market can price the government, which will never happen.

RYK VAN NIEKERK: Do you think we are moving towards that? There are some populist policies being mooted.

HLELO GIYOSE: No, no, there is absolutely no ability to execute on them either. If we cannot give the government credit to execute on growing the economy, we cannot give the government credit on actually changing policy to move towards anything else. So, no, we are not moving anywhere, we’re stuck in neutral.

RYK VAN NIEKERK: Exactly, the market has done virtually nothing over the past two to three years, the economy is not going anywhere quickly, how do you foresee then the short and medium-term future of our market?

HLELO GIYOSE: I’ll tell you what I think we ought to do, let’s separate the conversation about future returns from the political environment; where the market is today actually rhymes with previous periods where the market had gone through a period of uncertainty because of local economic growth. If you look at the run-up to the 2008 crisis because our economy was doing extremely well from 2004 to 2006, in fact, because of the resource boom the market did phenomenally well but from 2007 to the crash of 2008 the market didn’t do well. But in that period when the market didn’t do well that happened because uncertainty was creeping into the economic system, not to the political system, to the economic system. When uncertainty creeps in and the cost of funds starts to go up before interest rates had to come off, what we like to call safe assets, safe assets, which investors are willing to pay a premium for in order to protect against bankruptcy or loss of capital, those assets did phenomenally well. Risk assets, which had done very well in the run-up to the 2008 crisis, resources, construction companies and furniture companies did phenomenally badly in that period. So now we are back to that period, where from 2009 to 2016 the investor was very concerned about what will happen to China, was it going to have a hard or soft landing. Investors were very concerned about the manner in which the US economy was healing itself and the rate at which it was doing so. So at the point the investors were willing to pay a premium and were willing to buy companies that would safeguard their capital, not only safeguard capital but grow. Those are high quality companies. We did very well in that period because we always guard against bankruptcy risk. By 2016 the investor became very comfortable with the fact that China, as a managed economy, landed softly, not hard, that the US is now back to trend GDP [5:09] fallen to pre-2008 levels, the housing market is strong, the auto market is strong, consumer consumption is very strong and consumer consumption, as you know, drives most of the US economy, 75% of it. In that period the investor does not need insurance against uncertainty, doesn’t need safety anymore, so he’s very willing to reach out a little further and grab for risk. They did that in spades, they bought commodity companies, which, by the way, accounted for most of the outperformers in the top ten performing stocks last year. But to do that, to fund purchasing risky assets because there is no risk to those assets, especially if the economy is doing well, the global economy is doing well and, of course, the US economy is 25% of world GDP, China’s economy is 15% of world GDP, so that’s 40% of world GDP doing well. To fund purchasing of risk assets, to extend their risk appetite, they had to sell something, after all investing is a zero-sum game, you have to sell something to buy something. So they sold safe assets that the investor had used as a protective layer as insurance against uncertainty, they sold Anheuser-Busch, they sold British American Tobacco, they sold Woolworths, they sold Truworths, they sold all the wonderful companies, they sold Clicks in order to buy, would you believe it, DRDGold. Companies that were actually deep within bankruptcy risk like Anglo American, where the bonds were trading at junk status but that is simply a function of risk in no different a fashion than the investor did from 2004 and especially 2005, 2006 and 2007. But it all ends, whenever risk leads a market up it eventually leads it down, it all ends in tears. This time it will be no different from 2008, it will be no different from 2001 when the tech bubble, which had absolutely no cash flow generating companies leading the market up, and at that time you may recall that Berkshire Hathaway, which is a collection of high quality companies, shrunk 42%, it declined 42% and not many people know that, Berkshire declined 42% in the run-up to the 2001 tech bubble. By the way, Berkshire declined 45% in the 2008 crisis, a lot of folks don’t appreciate that but what you have to do is never ever lose faith, lose confidence in high quality companies because, as you can imagine, from 2001 to today Berkshire has compounded at a huge rate above the market, without selling the companies he held, he held the same companies, they were just compounded off those lows.

RYK VAN NIEKERK: But a lot has changed in the last few months, we have a new US president, who has interesting economic policies and the markets seem to love him, do you think that may return some economic uncertainty in the market, which could drive people back to more conservative assets?

HLELO GIYOSE: I think it’s going to do two things, the first thing that it’s going to do is that it’s going to boost profitability. That’s the first thing it’s going to do. It’s going to boost profitability of companies, especially financial services companies that were highly regulated. As you know Trump ran on the campaign pledge of for every new regulation that comes on you have to take out two and he signed an executive order two weeks ago for exactly that purpose. But we also know that he thinks that the US tax code is very complicated and the US is not competitive on a tax basis, he wants to bring the tax rate down 15%. That will benefit everyone, that’s a tide that raises all boats.

RYK VAN NIEKERK: If you can do it because the US has massive debt.

HLELO GIYOSE: Well, what he’s going to do on the other hand, which is where a lot of the uncertainty is going to come from, to fund that guess what he’s going to do, he’s going to cut all, if not most social spending the US government has engaged in so far. So mandatory cover by ObamaCare, some programmes that go to children in school and so on, he will just go line by line cutting them in order to fund this because he will figure that if you cut the tax rate you will stimulate the economy to create jobs, so that people can fend for themselves rather than being funded by the government. It will be true in some instances and it will not be true in other instances but as the economy flexes to try and cope with this that’s what will cause uncertainty. But you don’t even have to crystal gaze, let’s forget about what I say about Trump because, after all, I shouldn’t really take economic views with other people’s money, their guess is about as good as mine, let’s simply look at valuations in the United States , the valuations are high. Go through all the sectors, tell me which sector is cheap? With high valuations, rising interest rates, rising inflation, what happens, the market comes off. No matter what Trump does the market comes off, it’s as simple as that. So if you stay focused on investment perspectives versus handicapping what politically Trump may do and how that may result in the economy because I’m not good enough to do that, maybe some people are. I can simply tell you that in the next 12 months, if not 18 months, we should have a market crash. There is no way that rates go up in the US and don’t go up in Europe sooner or later, and don’t go up in China sooner or later, and marginal [11:19] companies don’t take a hit. Then the market is back to seeking certainty.

RYK VAN NIEKERK: A very interesting perspective. Within that context do you think there are still opportunities for South Africans to take money offshore? It has been a theme of recent years, especially when the rand devalues, it has strengthened now slightly, is this an opportunity or rather be conservative and stay at home?

HLELO GIYOSE: The biggest value-add to investors over time, the biggest value-add is not whether or not you give your offshore money to a US manager or a local manager to manage global equities, the biggest value-add is when do you take your money out? That is the biggest value-add. If you can determine that, which is a very, very difficult thing, I would personally say the answer to when you do it is very simple, if you want to take your money out, never bring it back. If you put some of your money in dollars and you put some in Swiss francs and you put some in pounds and you leave some in rands, have that as a standing allocation but you only have that as a standing allocation because what you want to do is do two things, you may have consumption that you want to do later on overseas, you may have to pay for your kid’s university fees later on or you may just know that structurally the rand will depreciate relative to those currencies. So over time if you have to subsist or to exist on some money coming from the US when you convert it back to rands it will boost your quality of living, it will boost your income levels in South Africa. That’s the reason why you do it but what you do not do is say, well, it’s cheap to take it out today, it’s a good time to take it out today and then when it hits R15 or R16 you bring it back. Now you are playing the currency and you are not good enough to do that. You should take the money out on condition that it serves a purpose in your life and keep it in that allocation.

RYK VAN NIEKERK: Very interesting perspective. Hlelo, let’s look at your equity fund, it’s a very interesting fund and I’ve compared the January fact sheet with the December fact sheet, the latest one that is available, and it seems like the top shareholdings have remained very stable, have you kept those shares or have you done a lot of trading?

HLELO GIYOSE: We’ve kept the shares, the primary objective of our investment strategy is to compound shareholder value and compound wealth for investors. To compound the one thing you do require is time and time requires you to have the temperament to stay the course. So we haven’t changed the top holdings and we’ll only change, by the way, if we’ve made a mistake. In that regard we are intellectually honest, there is no need to compound a mistake because when you compound a mistake that’s decaying. So if you are going to be compounding, it’s very important to be honest. So we’ve kept the holdings the same, we haven’t changed one bit. In fact, last year, if I recall, we only did three trades, put three trades in the portfolio, when I say three trades, not so much reducing and increasing but actually exchanging one for the other.

RYK VAN NIEKERK: The top shareholding is Naspers, then you have British American Tobacco, Woolworths, Aspen, Discovery, FirstRand and Spar, good solid companies. Let’s start with Naspers, it’s also a bit up and down, it seems to be all over the place currently and there’s a big discount to the value of the Tencent share, what are your expectations of Naspers?

HLELO GIYOSE: A lot of folks would have given an investor credit if he had purchased Naspers really at the beginning of Tencent and, as you know, Tencent has really worked out very well. People would have said that was great stock calling. Well, that was speculation actually. Nobody would have known what the probability of Naspers succeeding really was, in as much as no one knew whether or not Amazon would be very successful business. If you go back to Jeff Bezos’s letters in 1997 when they listed, he also couldn’t tell you, they were just doing the right things. But today you can see that Naspers is following the law of networks, that of networks there will only be few, so count on your one hand today how many networks there are in the credit card industry, five. Count today how many networks there are in the social networking business, five. The barriers to entry are significant, not just financially, there is enough money to do anything, smart or stupid, money is never a problem. The problem is today if I want to build a network that connects consumers to sellers, that connects people who want to communicate with one another through WeChat, for instance, I have to go and convince all these folks to get off Facebook, to get off KaTalk in South Korea, to get off Tencent in China and to get onto mine. That, no matter how much money you give me, is an unthankful task, I will not do it. So today Naspers, like Facebook, like Amazon, is generating so much cash flow that they have an option, they can actually reduce their development spend and begin to more traditionally allocate capital towards things other than just growth. Now whether or not they will do that this year or next year I have no idea. But, like Microsoft, they’ll get to that point, where they will allocate capital towards things like share buybacks, things like special dividends, things like increasing the dividend payout ratio and those are the kinds of things, by the way, that distinguishes a high quality company from a growth company.

RYK VAN NIEKERK: Just lastly, there are no commodity stocks in your top ten, that was the big success story last year, did you buy commodity stocks and if not, why not?

HLELO GIYOSE: No, I think commodity stocks you really have to think about them very carefully, a lot of what’s written about them by folks who advise you to buy or sell them – by the way, a lot of what’s written about, even by management companies, isn’t really material to an investment case. So portfolio diversification, for instance, is completely useless, in fact, it’s a myth, portfolio diversification across geography doesn’t matter, portfolio diversification by commodity actually doesn’t matter. Size also, by the way, doesn’t matter. Do you know what matters the most, productivity. Do you know there is an inverse correlation between productivity, both capital productivity, how much you stretch your assets, and labour productivity, there’s an inverse correlation between productivity and commodity prices. But would you believe that productivity and mining around the world is 28% lower today than it was 20 years ago. Mining companies all over the world are struggling with productivity, for whatever percentage increase in volume they get, they have to spend both in capex, as well as labour cost, as well as head count, as well as consumables, a lot higher than whatever percentage growth they get in volume growth. So what actually bails out commodity companies, it’s commodity prices, commodity prices tend to mask the loss of productivity in companies. What do you need in order to raise output without incurring additional costs, what do you need? You need innovation, unmanned drills to drill the rock, automated trucks, automated trains, automated conveyer belts, automated ships, you need to automate as much as possible the value chain from digging stuff out of the ground until it gets out of the door. Here’s the problem, today there is an intellectual limit as to how much of that process you can automate, compare that to the auto industry, today 80% of a car is made by automated machines. Today only 5% to 10% of the process of mining is automated. That’s why productivity is so much higher in auto companies than it is in mining companies. By the way, think about this, Warren Buffett would have never owned a car company but he owns General Motors, why? Productivity, you can automate to increase output without incurring additional costs, not so much in mining.

RYK VAN NIEKERK: Well, in South Africa there are many social pressures, a lot of focus on mining, a lot of focus on employment, would that impact your view on the sector going forward?

HLELO GIYOSE: That’s why you kiss goodbye to automation in South Africa, kiss it goodbye. Look, take a simple petrol station today, it should be self-evident that you don’t really need to have petrol attendants but we do because of the social pressures that you talk about. By the way, I talked to a bunch of politicians the other day, I said to them the one thing that every developing economy that wants to become developed has to do is to introduce innovations that increase productivity, if you did that in mining it would be great, the problem is you can’t. Some economies completely get rid of mining, today the United States has very little mining. If you had to shut down mining today you would have a civil war, so you can’t shut it down but how do you convert a rock-drilling position into unmanned drills, it’s impossible, you would have another riot. So what can you do, absolutely nothing, the country is in checkmate.

RYK VAN NIEKERK: Hlelo Giyose is the chief investment officer of First Avenue Investment Management.

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I love intelligent people. Too bad there’s not many in the government!!

This CIO talks a lot of sense. Watch out for the market crash!

This what happens when two opposing camps of uncompromising zealots come head to head. Well done guys.

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If the world's best investment managers, who came together at a recent CFA conference, cannot figure whether a crash or correction is looming, ordinary investors can be forgiven for their hesitation. Thus the June issue of The Moneyweb Investor does its best to fill the gaps. With 17 stories and a podcast, you wouldn't want to miss it.

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