Searching for the value in local equities

Skilled managers have demonstrated their worth in an extremely difficult environment. How?
Deep due diligence and valuation work are key risk management tools. Image: Moneyweb

Between the start of 2014 and the end of 2019, the FTSE/JSE All Share Index returned just 6% per annum. This is significantly below its long-term average of around 14%, and only barely higher than inflation.

The first few months of 2020 have only compounded the bad news for local investors. Given global fears around the coronavirus, the JSE has been extremely volatile, falling back to 2013 levels.

This has been an extremely difficult environment for local equity funds. But it has also been one in which skilled managers have demonstrated their worth.

“It’s been a lot like a low-scoring game of cricket,” says Rob Spanjaard, chief investment officer at Rezco Asset Management. “There have been a lot of balls that you have to leave, and you have just had to chip away at getting the singles where you can find them. Only occasionally there’s been a chance to hit a four or a six, and sometimes when you have thought that there’s a ball you can hit for a boundary, it gets you out. You’ve had to work darn hard.”

Different times

This is a long way from the environment of the mid-2000s, when the local economy was performing strongly, sentiment was positive, and the market was enjoying the ride.

“It’s a lovely environment when the economy is growing at 4%, and inflation is 6%, when it doesn’t take much for company earnings to be growing at 15%,” says Spanjaard. “Then you are just trying to find the best companies. But in this environment, where there’s not really earnings growth, we have found that you really have to work hard.

“We have had shorter holding periods than normal, and we’ve had to be able to adapt quickly,” he notes.

“For example, we had Sasol going from a good investment proposition to a horrible one, and you have to be prepared and able to leave that party.”

For Gavin Wood, chief investment officer at Kagiso Asset Management, one of the key imperatives in the current conditions has been to avoid the big losses. There have been a number of JSE-listed shares that have experienced dramatic reversals in recent years, including Steinhoff, EOH, Resilient, Omnia and Brait.

Steering away from danger

“In an environment where the South African economy has been so weak, it has been a real challenge to avoid stocks that have fragile balance sheets,” says Wood. “These are the companies that can really run into trouble as a result of poor operating results.

“By and large we have avoided most of those big downdrafts, and we have done that by deep due diligence and valuation work, which are key risk management tools,” he says.

Maintaining this level of discipline has been vital. As Spanjaard notes, one can’t apply just one view to everything.

“If mean reversion is your guiding light, for example, you are going to be disappointed,” he says. “This is not a normal economic cycle. It’s not just a recession that we bounce back from in two years’ time. It’s a grinding environment, where some companies will fall and then revert again, but others have suffered permanent damage to their business models.”

Keeping your head

There have also been instances where external influences can have outsized impacts.

“There was a period in 2015 and 2016 that was an example of that,” notes Wood. “There were very large foreign inflows into emerging markets and the stocks that were lucky enough to be in the MSCI emerging markets benchmarks just went up very strongly – we felt unduly so.”

It was an environment where Kagiso felt that expensive stocks were just getting more expensive, and the fund’s relative performance looked poor because these were counters that it didn’t own.

“For us that’s the most challenging time, when things are dragged way above fundamental value,” says Wood.

“That’s when you must stick to your guns and wait for night to follow day – and as it happened, it did. Many of those stocks crashed massively.”

Then, when sentiment has turned negative, it is often the time when the best opportunities present themselves. Aspen, for instance, fell more than 80% from its peak, which, for a contrarian manager, was an opportunity to buy a good quality company at an attractive valuation.

The door is never closed

“Often it is the case that investors overreact on the downside and that gives us a good entry price,” says Wood. “This seems counter-intuitive, but often the lowest risk time to be in an asset is when it has disappointed and the price has come down.”

This may mean that the JSE is now presenting more opportunities than it has for some time. For Spanjaard, it is vital to remain flexible enough to take advantage of them.

“One of my experiences of being in investing for as long as I have is there is always another opportunity that comes along,” he says.

“You have never missed the last opportunity. That is one of the great things about investing. What those opportunities are going to be over the next five years I don’t know, but active managers that are able to be non-benchmark-cognisant and have good research capabilities are going to be the ones that can identify them.”

The Kagiso Equity Alpha Fund was recognised as the best South African equity fund at this year’s Morningstar Awards. The Rezco Equity Fund was runner-up in the category.

 

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