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How investible are so-called SA Inc stocks?

AB InBev and Discovery are two top holdings in the PSG Balanced Fund, co-managed by Justin Floor.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast. It’s my weekly podcast, where I speak to leading investment professionals. My name is Ryk van Niekerk, and my guest today is Justin Floor from PSG. He co-manages the PSG Balanced Fund with that Dirk Jooste. He is also an actuary and a CFA, and has been has been in the investment business for nearly a decade. Justin, thank you so much for joining me. You are an actuary, which is an interesting qualification in itself, but is that an advantage or a disadvantage when you look at companies and need to make predictions of their future performance?

JUSTIN FLOOR: I get asked this question frequently. I don’t have a good answer for you. There are a few of us kind of in the investment industry, and I’ve managed to escape from the clutches of pension and insurance companies.

I would say a couple of things. One is, with the actuarial training typically you are focused on long-term data as a very quantitative and typically quite a long-term approach. That’s with a very big emphasis on risk. That’s usually used by insurance companies to price insurance products or pension funds to manage their asset-liability matching. For some of us it’s actually quite a nice springboard into the investment world, as well.

RYK VAN NIEKERK: I’m sure there’s an interesting debate within the industry between CAs and actuaries – maybe an MBA or two as well. But anyway, let’s talk about markets.

I saw a very interesting presentation you did last year, and it related to how investible the so-called SA Inc stocks were at that stage. You were actually quite positive towards SA Inc stocks, which was in contradiction with the views of several other fund managers. Do you still believe that’s the case, even after the onset of Covid-19?

JUSTIN FLOOR: I think definitely so, but I would qualify that with a couple of very important points. Just to kind of dial back a bit and remind you why we thought they were actually good long-term investment opportunities, despite the pretty visible and visceral risks out there. Now that they were largely neglected, many of the companies we looked at had very little following, almost no … coverage and are perhaps in some cases perceived as more risky than they really are. And, in our assessment we were buying good companies – typically above-average companies, in our view – but with substantially below-average prices. And we think that they were set up for decent [performance] for a subsequent two years. Now, Covid was unexpected, and it just so happened it was a human virus and not a computer virus – as Reed Hastings of Netflix has pointed out.

So it has benefits at a certain very narrow part of the market, which was, in our opinion, quite expensive already. And the part of the market that we’re invested in, which actually is more sensitive to the human dynamic, came under pressure. But nevertheless, we think these are still exceedingly good investments on an appropriate time horizon.

And I think I’d also make the point that this is not simple macro-play on South Africa. We are just as concerned as everybody else on some of the fiscal and structural risks that our country faces.

But what we think people miss is that there’s a lot more nuance, there’s a lot more differentiation within the South African stock market than people think.

A good example is a company like the JSE. It’s classified as an SA Inc stock. It’s obviously the leading African stock exchange. It’s valued like one; it’s on call it an 11, 12 PE. It pays out most of its earnings in cash. And yet its earnings are going up substantially this year. It’s not really coupled with the South Africa economy. I think there are a lot of companies like that in our portfolio where, from a top-down view, people are selling them off or have sold them off because they are perceived as risky as SA Inc stocks. But actually there’s something intrinsic to them, which we think is under-appreciated.

RYK VAN NIEKERK: The JSE is an interesting company. Year to date virtually flat. Actually over the past five years it’s virtually flat. But I think it may be a good example as an SA Inc stock, which offers value. Many fund managers have invested in shares and stocks that offer value, but they haven’t performed at all. And it’s not only in the short term – they haven’t performed in five years. The stocks that did perform are the expensive Naspers and Prosus and the mining stocks. And of course many people don’t see value still at Naspers and Prosus, where they are currently.

Does that toy at the back of your mind, that the things we are buying are not going up, although they offer really good value? The stuff that’s expensive continues to run, but we don’t see it offering value.

JUSTIN FLOOR: Yes, it’s challenging, because it means that, especially over the short-term performance relative to our objectives, it can lag behind – as it’s doing now, and has done over the last year or so. But it is definitely challenging. I think what you’re alluding to is the importance of avoiding value traps and really identifying the true value. Sometimes it can take a long time to emerge. Ultimately, the cash flows need to emerge out of these investments over the appropriate time horizon. And, if they don’t, that’s going to be very difficult to achieve.

Yes, certainly I think we spending a lot of our time trying to think about sifting between what could be value traps and making sure that we are invested in ones that do have a good future and that are perhaps underappreciated now.

But it is important to also step back and actually just evaluate the importance of cycles. Our sense is that we are at the tail end of a very, very long cycle; and that there’s a number of components to it, emerging markets being one of them, and certainly the South African business cycle.

And, while there are structural components to this, we do think there are – and you can see it particularly now in a lot of our foreign flows on the equities and the bond side – they tend to move in cycles.

So what we like to do is buy good companies with good prospects at good valuations, and then if you bought them at the right points in the cycle, often it looks bad over the last five years, but you can get very, very good outcomes over the subsequent five.

RYK VAN NIEKERK: Covid-19 changed the world in many ways, and in many ways it also accelerated the performance trajectories of several companies. And it changed significantly especially so-called SA Inc stocks as well. Do you think Covid-19 has changed this environment?

JUSTIN FLOOR: I think there’ll be some aspects which will be permanent, some that would be quite short term in nature and would probably reverse over the next couple of years. And I think what’s challenging right now is to try and sift between those two things. On the one hand, you’ve got things like working from home – I think we all going to be doing a little bit more of that in the future. It’s not clear how much or to what extent, but there’s probably going to be a little bit of that at least, whereas, there’s some very short-term phenomena that also come in, which have been very good for a very narrow range of companies out there. And, as a result, their valuations have expanded to reflect that, which is partially appropriate.

But I think there’s also an implicit bet there that these shifts are going to be permanent and you’re not going to get a reversion at some point in the future. So I think it’s very hard to say, Ryk. We typically try to acknowledge that we are not very good predictors of big macro trends. What we prefer to do is really try to look at the bottom-up fundamentals of the individual companies that we’re looking at; and questions like this are relevant. But that’s typically the lens through which we try to do that.

AB InBev

RYK VAN NIEKERK: Let’s look at the fund fact sheet of the PSG Balanced Fund, the one you co-manage with Dirk Jooste. If you look at the top 10 equity holdings, right at the top are AB InBev and then Discovery.

Now AB InBev is an interesting company. I think many people see it as a conservative company, but it has been performing not too well over the past few years, year-to-date down 22%; over the past three years down 40%. And it’s got a PE ratio of 57, probably due to some provisions. But what are your views on a company like this? It’s the biggest holding you have in the fund, and it’s not performing too well.

JUSTIN FLOOR: Yes. It’s actually a fairly recent investment for us. And I think some of the reasons for where it’s at are very important. I think they completely overpaid for the SAB Miller acquisition. They bought excellent assets, but they got completely carried away, and I think they were perhaps a little bit surprised by how much the regulators forced them to dispose in order to get the anti-trust rulings through. So I think that probably destroyed quite a lot of value there. And then the emerging-market cycle has not been kind to them. They have largely dollar and hard currency debt, and a substantial portion of their revenues have been in emerging markets like the Brazilian real and the South African rand. And obviously the cycle has been very, very adverse for them over the last three years, in particular.

Now, that all sounds terrible but, when we look at it, we are actually very excited, because there’s a couple of things that we like about it now that we didn’t like about it before – and one is that the valuation has improved substantially. It’s fallen materially from the highs. It used to be this classic glamour stock that everybody loved; it was in a lot of people’s portfolios. And now, after it’s underperformance, nobody wants it anymore. And that’s typically the time when we get interested. We tend to take a fairly contrarian view on these things. It’s the one thing.

The other one is that there’s a big market perception that their debt is very, very high. As a result they are risky, which we would partially agree with. But what we think the market misses, if you look at the detail of how they’ve structured that debt, it’s a real master class in how a CFO should manage the balance sheet. It’s really amazing. They’ve taken advantage of this low-rate environment and they’ve extended their finance out to 30, 40 years in some cases. And they’ve got a very, very clean window in terms of near-term obligations at very low rates, and fixed rates as well.

So, if you put this all together, at the end of the day you always come back to the fact that this is a brewing company. It’s probably one of the highest-quality business models out there with very, very substantial competitive advantages – both on the demand and the supply side. And we think the emerging-market cycle will turn eventually.

So if you put all of that into our pot, we really, really like this investment from here. This is an investment that we didn’t own at all at the beginning of the year; but we bought aggressively in March, April. So for the Balanced Fund this has been probably one of the key areas of activity over the last couple of months,

Discovery

RYK VAN NIEKERK: Over the past six months it’s up nearly 10%, so it did perform well.

The second-biggest holding in the fund is Discovery, which is a very, very interesting company. It is doing interesting things. Why are you bullish on Discovery?

JUSTIN FLOOR: That’s a very controversial one; it’s quite amazing. It’s very well known by South African investors, but there’s very little love for it. I think you’ll find it in very, very few institutional-fund fact sheets out there. And one of the reasons why we are attracted to it as well is we think we think it’s a little bit under-appreciated.

One thing that is true is it’s a very complex business, and there’s good reason to be wary of complexity. I think that is an appropriate statement to make. But we think if you’re willing to spend the time sifting through the complexity, as we have done, it’s actually highlighted a number of very, very attractive characteristics. Principal among them is the JSE is starved of companies that can actually grow organically, and this is one that has a demonstrated ability to do that.

Even through this, it’s been quite amazing how they’ve performed through this crisis – reasonably defensive, they’ve gained substantial market share. This is a company that forfeits near-term profits in a substantial way, investing heavily counter-cyclically. And they’ve got a remarkable track record of building businesses from scratch.

Now, in South Africa most South African management teams, when they want to grow, buy things. This is one of the few companies out there that actually builds things. They’re not always going to get it right; a lot of the detractors point to the US and Destiny Health as a valid reason for concern. But we would say in general their batting record is pretty good. And I think Adrian Gore and the guys have been brave. They’ve taken risks, but they’ve typically been rewarded. I think this is one for patient shareholders. We think this is one of the few companies on the JSE that could be substantially larger in five, 10 years’ time – and there’s a variety of areas that could come from.

RYK VAN NIEKERK: They have an exposure to some Chinese businesses, which also show a lot of promise and potential. But I see that the share price rose from R67 on March 20 to the current R122/hare. That’s a bounce of nearly 85%. When did you buy into Discovery?

JUSTIN FLOOR: It’s quite a good example of, I think, of how volatile things have been. This is a kind of a good reminder that there are opportunities for active managers out there to take advantage of dislocations between value and price, because people over-estimate the risks, and there’s some technical reasons for selling in certain cases. But just the one thing to say is we were quite surprised at how volatile it was, but we are not surprised at where it’s at, at the moment. We think it’s worth a lot more than the current share price, as well. As far as it goes, we’ve been investors in Discovery for a while. It’s been in our fund for a number of years, probably at least the last three or four. But we took the opportunity in March to buy quite a bit more. So we increased the weight in the fund a little bit in March/April as well.

RYK VAN NIEKERK: We’ll have to leave it there. Thank you, Justin. That was Justin Floor. He is a fund manager at PSG, and co-manages the PSG Balanced Fund.

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How invest-able is the country South Africa itself ?

As an economic force SA is finished. It can probably bumble along but too much damage has been done.

Cash flows will disappoint in a failed state, no matter how good the management team. Obviously a ZA focused fund manager will not say that.

The amazingly life-like Gore must be thrilled by this write-up.

Not much to invest in here. Taken my money elsewhere

Think these guys may be well rewarded for going “against” market

As a global investor, it’s important to bear in mind that emerging markets stocks should account for no more that 5-7% of a growth portfolio, of which South African stocks should make up no more than 5%. Within this 0.35% of the portfolio, stock selection won’t even move the dial in terms of annual performance.

“Spending time to sift through the complexity” as the only remaining investors in Discovery has done (foreign institutions, index trackers, PIC and PSG) and as PSG no doubt did the past three years given their stock picking track record in SA

End of comments.

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