It’s not easy being a contrarian investor. When you act against the prevailing market wisdom, you knowingly run the risk of looking very silly.
Right now, PSG Asset Management is taking that risk. In an environment where resource stocks are the dogs of every stock market on the planet, PSG is becoming a cautious buyer.
In 2014, three quarters of the mining companies listed on the JSE were down, and half of those lost more than a third of their value. Sasol’s share price was also more than 30% lower over the year.
Although there has been some stabilisation in the first month of 2015, very few people are giving resource stocks a second look. In an environment where commodity prices have dropped almost across the board, the market is shunning everything from energy stocks to platinum miners.
However, it is at moments like this that contrarian investors start sharpening their pencils. It’s when nobody wants to touch a stock that they get interested, following the well-worn dictum of being fearful when others are greedy and greedy only when others are fearful.
Shaun le Roux, manager of the PSG Equity Fund, points out that there is now a huge disconnect in the market. On a net price-to-book basis, the industrial index on the JSE is as expensive as it has ever been, but the resource index is currently cheaper than it was at the global financial crisis.
This, Le Roux believes, has been brought on by investors flooding into areas that they perceive as safe.
“People within equity markets have chased into areas where they perceive the risk to be lowest,” Le Roux says. “As a result, those parts of the market are extraordinarily expensive today.”
On the JSE this has been characterised by the huge increase in share prices seen in the large multinational industrial stocks like Naspers, SABMiller and British American Tobacco. This is where investors have felt they can take refuge in an uncertain environment.
Meanwhile, resource stocks have been sold heavily. The market has seen commodity prices dropping and run away, fearing that the risk in this sector is just too great.
Is this a classic case of the market overshooting both ways? Have perceptions of risk become so distorted, that the reality is actually quite the opposite?
“The perception is that investing in large cap, high quality industrial stocks is a low risk strategy,” Le Roux says. “But we take the opposite view. Investing in companies that are perceived to be riskier, but where the margin of safety is currently wide, is probably the least risky approach.”
In PSG’s view, there is currently a large buffer between the current price of many resource stocks and what they believe to be their intrinsic value. This, they believe, is the next opportunity for long-term returns.
The PSG Equity Fund currently has three big resource counters amongst its top ten holdings and has been a recent buyer of all of them. Glencore currently enjoys the second highest weighting in the fund, while Anglo American and Sasol are numbers five and six.
Le Roux points out that all three have improved their capital allocation and are are well-positioned on the cost curve. They also all show a material discount to their intrinsic value based on what PSG believes to be their through-the-cycle cash generation.
“We look at where commodity prices are likely to settle in a normal environment,” he says. “And if you work out those cash flows compared to what you are paying today, the margin of safety is very wide.”
He believes that Anglo American is the cheapest it has been in 50 years on a price-to-book metric.
On top of this, all three companies currently look attractive on a dividend yield basis too.
“For the first time in my career I am looking at mining stocks on the basis of them being the highest dividend payers in the market,” Le Roux says. “And these three all have strong balance sheets supporting those dividends.”
Anglo American is currently offering a dividend yield of a little under 5%. Le Roux points out that, historically, if you had bought the share at a dividend yield above 4%, that has been a good entry point.
PSG isn’t, however, being indiscriminate about what it buys in the resource space. It is still being careful about the opportunities it picks.
“There is a tremendous amount of distress and turmoil in the resource sector, and that’s inevitably going to result in mis-pricings,” Le Roux says. “We are not rushing in guns blazing, buying anything that has a mine in the ground, but we do think that if we buy carefully in this sector that this is where returns are going to come from.”