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Investors unwind rand hedge positions

What are the driving forces behind market decline?
Piet Viljoen of RECM. Picture: Moneyweb

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, this is my weekly podcast, where I speak to leading investment professionals. My guest today is Piet Viljoen of RECM, one of the most well-known deep value investors or so-called contrarian investors. Piet, welcome to the show, we’ve had some significant political changes over the past few months, which did seem to change local and international investor confidence, luckily for the better. But despite this our market is down just 2.5% since the beginning of the year, while the rand has firmed around 4% against the dollar. What do you make of this?

PIET VILJOEN: Basically, what’s happened since November/December is that there was massive negative perception around South Africa and many investors were buying rand hedge-type stocks, at any price, to hedge against negative political outcomes. With a positive resolution at the ANC conference, in other words that Cyril Ramaphosa becoming president, a lot of those investors have been unwinding their rand hedge positions as the rand has strengthened. So although the rand has only strengthened by 4%, the rand hedge shares before the ANC conference went up and since then have declined, much more than the exchange rate changes would have dictated and I think that’s one of the driving forces behind the decline in the market.

RYK VAN NIEKERK: But do you think the valuation of the JSE is busy to reset because it seems to have been, we saw a good rally last year but is this a correction?

PIET VILJOEN: I think one needs to be very careful when you say the JSE or the rating of the JSE or the correction is actually… the JSE is very much a three-tier market, the one tier, which is 25% of the market and that stock has almost nothing to do with South Africa. The second tier is the rand hedge-type stocks like BAT, AB InBev, Richemont and so on, which are popular holdings in many investors’ portfolios, and also have very little to do with South Africa. Then the third tier of the market are the local industrials and banks, insurance companies and telecommunications companies, which are much more closely linked to the ups and downs of the South African economy. If one examines those three tiers in the market, from our point of view the best value is to be found in the local industrial-type companies that reflect what’s going on in South Africa.

RECM Flexible Fund

RYK VAN NIEKERK: Looking at your Flexible Fund it seems like you are invested in that third tier that you mentioned, MTN, Standard Bank, Anglo American, FirstRand, Sasol, BHP Billiton. Do you see the value there currently?

PIET VILJOEN: The value is in that third tier, I think that’s the neglected part of the market where most investors don’t want to be, and when you introduced me you said that RECM is a contrarian investment house, we are not contrarian just because we want to do everything different to everybody else, it’s just that most bargains, and in investment terms, alpha, is to be found where nobody else is looking, and that’s where we position ourselves. We think that local banks on low PEs are cheap, we think MTN is cheap, we think the resource shares are still cheap. In other words you are being paid in excess of the risk you take on when you buy those shares because when you buy any share there is risk. At the moment investors seem to think there is no risk in owning something like Naspers or something like AB InBev or BAT or those sorts of companies but we think there is risk in every company, it’s just a matter of how much you pay to take on that risk and we think you are paying very little to take on the risk of that so-called third tier, the SA industrial and financial stocks.

RYK VAN NIEKERK: Just ask investors of Steinhoff whether there is risk in single stocks. So were you invested in Steinhoff at all, I assume not?

PIET VILJOEN: When it started dropping quite sharply in November, before the news really came out – the market is very smart that way – we started nibbling at it. But when the news came out that there was potential fraud involved we sold immediately. So I think we had less than 0.5% position into that weakness and then we sold out of it completely. At the moment we have no exposure to Steinhoff equity, we have recently bought Steinhoff preference shares, which were at that point trading at 40c in the rand and we think that is good money.

RYK VAN NIEKERK: Your biggest shareholding is in Hosken Consolidated Investments, which has performed really well since 2016, from around R100 to R141. It would be strange if many, well, I don’t expect many fund managers to have that as their top stock investment, why HCI?

PIET VILJOEN: Well, we think HCI is a fantastic combination of good businesses run by a good capital allocator and available at a deep discount to its intrinsic value. So that’s the sort of trifecta that one looks for, good companies run by good business people, available at cheap prices. Now, you can get one out of three sometimes, often you can get two out of three but it’s very seldom you’ll get three out of three and I think HCI ticks all three boxes, and that’s why that is our biggest position at this point.

Value investing out of favour

RYK VAN NIEKERK: But not many companies perform like this if they do tick those boxes. Over the last few years deep value investors or contrarian investors haven’t really topped the charts.

PIET VILJOEN: No, value investing has been out of favour for the better part of six, seven, eight years now and basically the way we see it is that with interest rates having to climb to generational or almost multi-generational low levels, when one values a company basically what you are doing is deciding what sort of cash flow that company will produce into the future and then you’re discounting those cash flows back to present value. So that’s very simply the intrinsic value of any business or any asset. So when interest rates are very low you can actually discount cash flows which lie far into the future, they still have quite a high present value, if you discount them with low interest rates. So long duration stocks, growth-type stocks, stocks that don’t earn very much right now but the market expects to earn a lot sometime in the future, they tend to get quite high valuations by the market when interest rates are quite low because of the discounting mechanism. That works against value investing, value investors generally buy stocks where there is limited visibility, where there are low expectations and where cash flow…people only see cash flow as far out, you only see the next year or two’s worth of cash flows, so the low interest rates don’t really help the valuation of value stocks. But we think that as the interest rate cycle turns and interest rates start moving up the long duration growth-type stocks, their valuations could get hurt by interest rates increasing, whereas value stocks will be indifferent to that.

RYK VAN NIEKERK: But all investors are looking at the US and we will see some interest rate hikes throughout the year, what do you think the impact of that will be on local equities?

PIET VILJOEN: Well, generally one has to examine why interest rates are moving up. We’ve had six or seven years of declining interest rates and interest rates go down because the economic environment is tough and central banks are trying to stimulate the economy, especially a market like ours that’s very closely aligned with global economic growth via the commodity cycle suffer when growth rates are low. So we have suffered over the past while and most emerging markets have suffered. I don’t know if you’ll recall back five or six years ago when Brics was all the range, since then the Brics have really suffered and they have suffered because of low growth and low growth has led to low interest rates. We think if interest rates start going up it’s a reflection of higher growth and that is good for emerging markets in general and good for South African stocks specifically, and very specifically it’s good for value stocks. So we think interest rates going up is actually good news for investors such as ourselves.

Value in international markets

RYK VAN NIEKERK: Several commentators have said that the international growth is the most correlated at the moment, we see the US performing well and then China performing well and the EU picking up its head…

PIET VILJOEN: Even Europe, which most people have said is a dead man walking.

RYK VAN NIEKERK: What do you think of international markets, there’s a lot of people taking money offshore and you then meet very expensive markets, are you very active internationally currently?

PIET VILJOEN: We are, our global fund is not fully invested, we’re running with about 25% cash, so that’s a reflection of the fact that we can’t find a lot of value out there globally. So we agree with the view that markets are fairly expensive internationally. We are seeing better value in emerging markets. We are seeing good value emerging in the UK, especially with the very weak pound, we think there’s good value. But there are not a lot of places like that in the world, so we agree, it’s hard to find value, there is value but you can’t fill your boots, it’s very hard to fill your boots.

RYK VAN NIEKERK: Where do you park your cash internationally?

PIET VILJOEN: Our cash over the past year has been mainly in euro and pounds and yen, and in dollar terms those currencies have done fantastically well. So although we’re running with 25%, even at one time we had 40% cash, in dollar terms that cash generated 10% plus returns, so we’re quite happy with that because those currencies have been very strong against the dollar.

RYK VAN NIEKERK: So you think emerging markets will still perform well despite the US interest rate increase?

PIET VILJOEN: We think most emerging markets are very closely linked to the global economic growth cycle, most of them are producers of primary products. So we think to the extent that growth maintains its current trajectory, emerging markets will be the beneficiaries of that and we don’t think that has been fully discounted, although a lot of it has been but it’s not been fully discounted in the prices of many stocks in the emerging market. Remember, we are a bottom-up investor, so it’s hard for us to take a top-down view. We can only talk about what we see from the bottom up and that’s what’s falling out now, there are pockets of value available in emerging markets and fewer pockets of value available in developed markets.

RYK VAN NIEKERK: Are you invested in other emerging markets?

PIET VILJOEN: Yes we are, our Global Fund holds stocks in Russia, it holds stocks in Brazil, it owns one or two stocks in South Africa and a couple of Asian stocks. And very importantly, it owns stocks that are listed in the UK or in the US, which have the majority of their operations in emerging markets. So one can’t always look at where a company is domiciled to say that’s what they’re exposed to, sometimes its domiciled in a developed market but their business operations are in emerging markets. So we have a fairly large exposure towards emerging markets, larger than normal at this point, yes.

RYK VAN NIEKERK: Thank you, Piet. That was Piet Viljoen of RECM.

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Very sensible and informative market outlook. If only this conviction can be converted into some positive and attractive investment return for the funds of RECM, of which most haven’t performed very well over the recent past. A follow up article six months and 12 months down the line will be very interesting.

The story that active management tells is always so compelling, pity the numbers don’t back up the great story.

…because half of the time active managers call it right?

Micky in Klerkstown – Yes, if active managers make the right call half of the time, it also means 50% of the time they make they get it wrong. If 50% is the right call(positive move) and 50% wrong (negative move), you are still treading water and going nowhere – fast. It’s like playing roulette and you bet 50% on red and 50% on black and then it hits the zero (green). You get the Micky.

End of comments.

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