Hit ratios, win-loss ratios, and shorting

‘Look for great companies to hold for the long term, but at the same time look for companies where something strange is going on …’: Jean Pierre Verster, Protea Capital Management.

RYK VAN NIEKERK: Welcome to this week’s edition of the Be A Better Investor podcast. It’s a podcast where I pick the brains of the top professional investors in the country, and we delve into their own personal investment approaches. We also talk about the research processes they follow to identify potential investments, their personal best and worst investments ever, and we also look at what is in their personal asset portfolios.

The idea is to find the golden nuggets from their perspectives and experiences to assist amateur retail investors to become better investors. My guest today is Jean Pierre Verster. He has been in the industry for more than 15 years – it actually seems much longer – and he has managed portfolios at Melville Douglas Investment Management, 36One Asset Management and Fairtree. He recently founded his own business, Protea Capital Management.

Jean Pierre, thanks so much for joining me. You’ve been doing the rounds a bit, but how is it now to run your own business?

JEAN PIERRE VERSTER: Yes, Ryk. I’ve worked at a number of other places, as you mentioned, which I think was a good experience to then bring me to the place in the middle of 2019 when I decided to set up my own business, Protea Capital Management. So I think all of that was a good grounding.

What is different at my core job is to sit and to read, and to think, and to invest people’s money. But when you start your own business there are other things that you need to give attention to. As well as [being] a CEO of a business you need to manage other people, and we have a team of six people. I need to make sure that the whole team is pulling in the same direction. You need to do some marketing. You need to get involved [in] operational matters, strategic matters.

So it is more complicated to run your own business versus working for someone else. But I must say I actually enjoy it. I have a natural tendency to want to be in control, and I like being in control of the strategy of the business. At the same time, thank goodness: because that has been running quite smoothly, it hasn’t taken up too much of my time so I can still spend the majority of my time on the core business of managing people’s money.

RYK VAN NIEKERK: That’s a big responsibility because it’s the life savings of many people. But what is your approach, especially regarding your own personal investment portfolio versus the life savings of other people. Do you approach them differently?

JEAN PIERRE VERSTER: I like to, and the saying has been said a few times before, I believe: ‘A good fund manager should eat [their] own cooking’. So they should invest their own money the same way they invest other people’s money. You can also flip [it] a bit around by saying that I’ve always managed my money in a certain way, and when I started an asset management business, I then effectively invited other people to invest with me and I would invest their money like I do my own.

I always, firstly, had an affinity for Warren Buffett, and I’ve read all the letters that he has written for Berkshire Hathaway for more than 50 years. Through that, I have a strong grounding in value investing. But in his letters he’s not a purist, I would call it. He’s got a very big influence from growth investing as well, which came [from] Philip Fisher, not just Benjamin Graham, who’s the father of value investing. Through more Philip Fisher-type influences, Buffett became a quality investor – but quality at a value price, and that resonated with me. That became my own philosophy as well, where I like to find great companies and not to overpay for them. And then when you buy them you hold them for the long term, and that does very well for you.

At the same time, I also have a keen eye for detail and a key eye for seeing when things aren’t right, when something is wrong.

And that sense of seeing when something is wrong where maybe others don’t, also means I’ve a natural affinity for short selling, which means one makes money not when share prices rise, but when share prices fall.

I personally enjoy both these parts of my own investment philosophy, [which] became Protea’s investment philosophy – that is: look for these great companies to hold them for the long term but, at the same time, look for companies where something strange is going on, something is wrong. Short those shares and try to make money through that as well.

Do both of those, and if one can do both well, the funds will do well over the long term.

RYK VAN NIEKERK: That is quite a common investment theme. You look for great companies and buy them at low prices, but it’s not always easy to do. Many professional investors get it wrong and they get it wrong more often than you would think. What is your hit rate and what do you aspire to achieve?

JEAN PIERRE VERSTER: We actually track both the hit rate and what you call the slugging ratio or the win-loss ratio in the performance of our funds. I can tell you we do that on a periodic basis, so the last time we did it was for 2021, and my long-term returns are slightly different. I’ll get to that.

So firstly, our hit ratio – which means when we make a decision, when do we make money versus when do we lose money – was around 60% for 2021. Over the long term, that’s the average as well for the business. So for me personally, roughly 60%; so six out of 10 times when I buy a share, it does go up, or six out of 10 times when I short a share, it does go down.

The other ratio, which is important, the slugging ratio or win-loss ratio, is: when you buy a share and you are right, how much do you make, relative to when you are wrong, how much you lose?

A good investor makes a lot more money on the winning positions versus on the losing positions. You can actually have a below-average hit ratio, but if your win-loss ratio is above average, you can be less right than wrong, but you make so much more when you are right that it compensates for not having a good hit ratio.

Now our win-loss ratio is around 1.1 for last year, which means we make R1.10 on a winning position versus losing R1 on a losing position. Let me say that again. We make R1.10 on a winning position versus losing R1 on a losing position. Over the long term that ratio is a bit higher, it’s closer to 1.4, which is what we want to see because you want your winners to be much more profitable than what you lose on your losers.

Therefore it’s important both to look at your hit ratio – you want to be right more often than being wrong, so you want it to be more than 50% – and [to look] at your win-loss ratio, which is what you want when you are right, to make a lot more in terms of profits versus what you lose when you are wrong.

RYK VAN NIEKERK: But it’s still a big portion of the portfolio, which does not contribute to the profitability. It is still significant if you pick four dogs in a portfolio of 10 shares. I’m saying this in the context of retail investors, people who try to invest their own money in the market. They do not always follow the most rigorous financial analysis process. They use other metrics to make buying decisions. Is the six-out-of-10 hit ratio an industry average? Do you know what the average is, and what are your perceptions of the hit ratios of amateur investors?

JEAN PIERRE VERSTER: I don’t know what a typical hit ratio would be in professional active asset management. I wouldn’t be surprised if it’s roughly six out of 10, so roughly the same.

But it’s also important to note that when you have a hedge fund, a fund that also shorts, that necessarily brings down your hit ratio because you can actually slightly lose money on your short book, as we call it; all your shorts together.

But that still is very good because it allows you to take that capital from selling shares short to buy more good-quality companies on the long side. So typically, if you have a hedge fund strategy, it decreases your hit ratio, but it can increase your win-loss ratio. That’s why we don’t look at just the hit ratio, so we have an average hit ratio. But it’s okay because of the shorting component.

Secondly, there’s a time in market cycles where this rate is higher or lower, and there’s a time in which your long positions make money, and there’s a time when your short positions come into their own and they make money. So over the long term, you don’t necessarily see that it was very valuable for, say, the short positions in the first quarter of 2020 when Covid hit to actually make money when the long positions were under pressure.

You also ask what I think retail investors’ ratio is. I would say in the retail market there’s also a differentiation between, I would call them, patient retail investors and impatient retail investors. I’ll do the second one first.

An impatient retail investor is an active retail investor. I would say that’s very dangerous.

If you are a retail investor, it assumes or presumes that you are not doing investing as a full-time job, and for you to not be doing it as a full-time job. But being very active, buying and selling quite often, is not a good idea because you’re probably going to make more mistakes.

The only way really for the retail investor to compete with and sometimes outperform professional investors is to be patient, to be more long-term orientated, to make fewer decisions. If you make fewer decisions and you only wait patiently for those, the ones that are really almost obvious as good investment opportunities, then you can have a very high hit ratio, even better than the professional investors’ hit ratios.

RYK VAN NIEKERK: Let’s look at your personal portfolio and investments. What was the very first share you bought? When did you buy it and why?

JEAN PIERRE VERSTER: The very first share I bought was when I was at university, and it was the initial public offering [IPO] of Telkom. I remember that it wasn’t a great time in the market so, from what I read in the newspapers, I wasn’t sophisticated enough to go through prospectuses and analyse financial statements in detail yet.

But what the newspaper told me was that Telkom was going to list at a relatively depressed valuation, which is good if you want to buy shares in that initial public offering. At the same time, they offered a discount to the IPO price, the initial public offering price, to retail investors. And therefore you firstly got a very reasonable price and secondly, you also got a discount on that price.

So my first purchase was R5 000 [worth] of Telkom shares when it first listed.

I held those shares for more than a decade, which means that I also got Vodacom shares out of Telkom when Telkom unbundled Vodacom – Telkom used to own Vodacom. That means that the shares did very well for me and therefore it was a very good start to my personal investment journey, I would say.

RYK VAN NIEKERK: Telkom definitely was an investment success, especially that decade after the listing. Was that your best investment ever?

JEAN PIERRE VERSTER: I would say that in percentage terms, that was one of them. The other one that comes to mind is in the property market. The SA property market did very well for a decade from roughly 2005 to 2015. I bought quite significant property exposure around 2012 and I held it until about 2015. In those three to four years, the property shares that I bought increased a few multiples. They were more related to Eastern Europe than South Africa. I’m thinking of shares like Nepi Rockcastle – it was just Nepi at the time before the merger with Rockcastle – and Fortress B shares. Those did particularly well for me. So that’s another one that I would highlight that I made a very good return from,

RYK VAN NIEKERK: You also made a name for yourself by shorting Steinhoff and African Bank. How do those companies or that shorting of the shares rank among your most successful investments?

JEAN PIERRE VERSTER: That’s the interesting thing about shorting. With a short you could only make 100% of your money, maximum. If it goes down by a 100%, you make 100%. Or, with a long position through the wonder of compounding, you can make a lot more than 100%. Over time, with the beauty of compounding, you can make 200%, 300%, 400%, 500%. You can have a 10-bagger, which is 1 000%. And therefore one generally over the long term, makes a lot more money with long positions than you do short positions. So, similarly with me, I’ve made a lot more money on the long side than the short side.

RYK VAN NIEKERK: Shares fall much more quickly than they rise, don’t they?

JEAN PIERRE VERSTER: Correct, correct. In a short space of time you can make a very nice return on a short position if you time it correctly and you short, and soon thereafter you call it [a] catastrophic event. That’s sort of what happened in the case of both African Bank and Steinhoff.

We had some other shorts as well. I made more than 90% on a Rebosis short; I made more than 90% on an Ascendis short.

So I can tell you that, even though over the long term the shorts don’t necessarily account for as much, one can do really well over the short term with a short position that then drops very sharply.

RYK VAN NIEKERK: And the biggest dog you’ve ever bought?

JEAN PIERRE VERSTER: That was early in my career, a share called Alliance Mining Supplies. I effectively lost all my money because the share was suspended, so it effectively went to zero. The interesting thing about Alliance Mining is that there was fraud that happened within the company.

There were a few red flags, but I was a bit naïve about those red flags.

One of the worst red flags was that the financial director of Alliance Mining was not a full-time financial director. It was a lady, and she was a financial director of another company called African Dawn Capital. You can’t be the financial director of two companies, Ryk. It is a full-time job. I had met the lady in a meeting and she obviously could explain away the fact that she had two full-time jobs and she could do both well; but unfortunately the job was not done well and there was a fraud, and she was later found guilty and fined quite harshly by the FSCA [Financial Sector Conduct Authority]. It’s on their website. That’s Connie van Nieuwkerk, who was involved at Alliance Mining Supplies.

RYK VAN NIEKERK: What is your experience with retail investors? Many of them are very boastful when they beat professional investors. But what is your impression of the average South African retail investor? How good are they?

JEAN PIERRE VERSTER: It’s difficult again to know what the average would be of the typical South African retail investor. What I can tell you is that I started off managing friends’ and family money. Maybe because I was a friend and a family member they were always patient with me, and they never put too much pressure on me. Therefore we were aligned in our long-term horizon.

I think more generally if someone isn’t your friend or your family member and there isn’t that trust, it’s easier for a retail investor to get impatient, to not trust the process, to get thrown off course by cycles. And even recently, just in [the] first quarter of 2020, we’ve seen quite a harsh cycle in high-quality companies in global markets that have been under significant pressure. I wouldn’t be surprised if a lot of retail investors again became impatient and did things like selling a lot of high-quality shares because they fell maybe 20% or 30%; that’s typically the trap that retail investors step into.

There have been some studies that do show that unfortunately the big thing that trips retail investors up is they get impatient, they sell at the wrong time after certain shares have fallen, and therefore they don’t partake in the recovery and the long-term wonder of compounding. So that is, I would think, still the major issue for most retail investors.

RYK VAN NIEKERK: That is also a common problem, impatience and emotion. How do you think retail investors should then approach it, because emotion and impatience are poor investment strategies, but they are still probably dominating many investment decisions.

JEAN PIERRE VERSTER: Absolutely. Once again, if you think about behavioural finance, which is a whole area of study regarding this problem, people speak about ‘greed and fear’ or even ‘hope and fear’. That is that, you know, when things go well, ‘hope’ people continue. They become greedy. And on the flip side, when things go badly, people get fearful and they think it’ll just get worse and worse and worse.

Those two emotions actually have a much bigger impact on people’s personal wealth, rather than technical points of not being able to identify a great company, or seeing when there are problems in the company. So that should be the focus of most retail investors.

That is why the antidote, almost, of falling into this behavioural finance trap is to not look at your portfolio every day, is to not fall into the problem of knee-jerk reactions.

It is to focus on the long term, stick to quality companies, don’t try and time cycles. For instance, we are in a cycle at the moment where, after four, or five years of oil and gas companies not doing well, we have the petrol price, the oil price jumping, and then people want to get into oil and gas now. It might be a good two or three years, but what’s going to happen then? So we have these cycles and I think retail investors who try to play cycles get into trouble. So rather stick to long-term quality, and that also defends against behavioural bias.

RYK VAN NIEKERK: Do you think retail investors understand risk properly?

JEAN PIERRE VERSTER: I think a lot of retail investors maybe have an intuitive sense of risk. That means that certain things can happen that permanently negatively impact your portfolio.

But some people don’t learn about risk from other people’s experience, they need to learn it themselves, and therefore that can be quite an expensive lesson.

So it’s once again almost the makeup of the individual – are you typically a person that learns from other people’s mistakes, and therefore you are cautious in your personal conduct, or do you typically need to make a mistake – some people need to make the same mistake more than once before the penny really drops. The same goes for your finances.

So by nature some people are more prudent. They are cautious. In markets that means, for instance, that they won’t take on leverage, which I also think for most retail investors should not be something they do, you should not borrow money to invest, while those that don’t learn lessons the first time around have probably learned some expensive lessons when it comes to leverage. So that’s something to watch out for.

RYK VAN NIEKERK: Just lastly, what are the shares on your radar at the moment?

JEAN PIERRE VERSTER: At the beginning of this discussion, Ryk, we spoke about my career going back roughly 17, 18 years. For the first eight to nine years of that I was focused on South Africa, and for the last eight or nine years my focus has shifted more towards the global equity markets.

After a very tough first quarter when it comes to quality companies, where the technology companies – other than the likes of Apple, Amazon and Alphabet – most other technology companies have been under significant pressure. The share prices have fallen by more than 50%.

I think there’s a great opportunity, with the strong levels of the rand against the dollar currently, to invest in US tech shares and some other European tech shares which have been under pressure and have fallen a lot, and I do believe that current prices offer a long-term opportunity. So shares like Netflix, like PayPal, like Etsy are some of those that are on my buy list at the moment.

RYK VAN NIEKERK: Thank you, Jean Pierre, for sharing your insights with us today. That was Jean Pierre Verster, the founder, CEO and chief investment officer of Protea Capital Management.

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Hitrate * win/loss ratio * gearing * trading frequency = Days to bankruptcy.

Novices go bankrupt because they take large losses. Professionals go bankrupt becuase they take small profits.

End of comments.

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