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. My guest today is Mark Dunley-Owen, he is a fund manager at Allan Gray. Mark, thank you so much for joining me. We’ve seen a dreadful first quarter, especially in equity markets. How did your funds hold up?
MARK DUNLEY-OWEN: Thanks, Ryk. Thanks for the opportunity. As you say, it has been a difficult quarter and in terms of Allan Gray, we haven’t been spared. So our two biggest funds, which are our balanced fund and our stable fund, both had had difficult quarters both down sort of high single-digit or low double-digit returns on a one-year basis. And that has been driven, though the hardest part about the quarter was that all South African asset prices fell. So often you would have, for example, equities doing poorly and bonds doing okay, but definitely in March, the way most people described is that correlations went to one, so everything fell at the same time, which meant if you had equity exposure, you got hurt. If you had bond exposure, you got hurt. And even if you had global exposure, you always got hurt because of global markets or so down. So it’s been a difficult time for multi-asset funds, but we hope the worst is behind us.
RYK VAN NIEKERK: I see that in the [Allan Gray] stable fund, performance between 20 January – 23 March 2020 was the biggest drawdown the fund has ever seen and that was close to 17%. How did that compare to other funds you guys manage?
MARK DUNLEY-OWEN: It comes down to how much equity exposure you had and your duration on your fixed interest. So stable as the name suggests has lower equity, then our balanced fund and the balance has lower equity than the equity fund. So the stable would have done better than those funds, but the performance on stable, was particularly disappointing because if you’re an equity fund client or balance fund client, you expect some volatility and the stable fund, you expect much less volatility and part of our objective is to not have a negative return over any two year period. And that has been true since the fan started, which started in July 2000 so that has been true since 2000 except for now.
So this is the first time that that stable fund has had a negative performance over two years. And that’s obviously very disappointing and it’s disappointing for us and it’s disappointing more importantly for our clients who want more stable returns. And if you’re in a stable fund, which has quite a lot of bond exposure and cash exposure, but also equity exposure when everything falls, it’s hard for the fund to do well.
RYK VAN NIEKERK: What is the international exposure of the fund?
MARK DUNLEY-OWEN: It’s about 30%, it crept up as the rand weakened, but we have brought some money back to keep it around 30% and that is invested in similar to South Africa, I suppose, it’s invested across global equities, global bonds and some global cash. But unfortunately for us not only did South African assets do poorly, but the foreign portion of the fund, which is managed by Orbis, which is our sister company also did poorly so both Orbis and Allan Gray had a difficult quarter and you put all these effects together and you get the performance that you’ve already talked about
RYK VAN NIEKERK: During a period like this, I must assume it causes fund managers a lot of stress. Did you change anything during the past quarter to try and preserve some capital?
MARK DUNLEY-OWEN: It is stressful, but at the same time it’s, it’s exciting that it gives us more opportunities going forward, in terms of how we’re positioned. So the hard thing was a few months ago, really for the last few years, how have things been that South African assets have done poorly? So in our minds South African assets have been cheap for a long time and that’s both South African shares and bonds, global assets were different. So global assets have done well and we were quite cautious on global equities in particular. But locally we saw the value. As it turned out, the prices of these assets have fallen even further. So we thought they were cheap two months ago but they cheaper now. So in terms of asset allocation, we haven’t changed a whole lot on the asset allocation size side and in terms of the value we still take most of the investments in the fund, the values we had before are similar to the values we have today. The biggest thing that has changed is the prices. So that is painful in the short term it’s, it leads to the performance numbers we are seeing, but it’s also positive in the longterm in that the gap between value and price today is extreme. So we think most of the fund’s holdings are undervalued and therefore if we are right, we think future returns are a lot more attractive today than they have been for much of the last 20 years. So we do think this is a, it’s a difficult time today, but for longer-term investors, we think it is a good opportunity for future returns.
RYK VAN NIEKERK: And of course, we’ve seen a significant spike since the last week of March until today and many people may have exited, not only this fund, but many other equity funds and that shows you that you don’t try and time the market. If you ride out volatility, you may be surprised even sometimes on the upside.
MARK DUNLEY-OWEN: I think that that’s very true. I mean, unfortunately, human nature is to reduce risk when uncertainty increases. And the problem is that markets tend to be one step ahead of you. So by the time that certainty is there, markets have already fallen. So we have seen recently we’ve seen some client flows from funds with equity exposure, whether it had to be the equity fund or the balanced fund or the stable fund we’ve seen flows out of those funds and to lower risk alternatives, which are a money market type fund or a fixed interest fund. And while we understand that, historically this has been the worst time to do that. So you don’t want to move down the risk spectrum after prices have fallen. Now that doesn’t mean prices may fall some more, in which case it will be the right decision. But historically these sort of periods where there’s a lot of uncertainty, there’s been a major correction and there’s a lot of fear in the market. These have been better times to stay invested in assets with high risk, then to move into the lower risk categories.
RYK VAN NIEKERK: You have significant exposure to bonds as well, around 35% of the portfolio. Of course, we are seeing a significant decline in interest rates. How do you view the money market side of the portfolio and the prospects of it?
MARK DUNLEY-OWEN: What’s interesting about South African fixed interest today is that it’s split into two categories. So you have the cash type instrument, which is called the money market side of the equation and that has, it’s been a very good place to be for the last few years. It’s given you about seven to 8% returns and you compare that to inflation of four, so really you’ve taken almost no risk and you’ve got a return which is three to 4% better than inflation, so it has been a good place to have your money. Unfortunately, the reserve bank has cut interest rates now about 200 basis points over the last month. So the returns you’re going to get from these cash type investments such as money market funds are going to drop. So if they were seven and a half percent at beginning of the year, we think they are now, you should expect five and a half percent and is a chance that the reserve bank drops rates more, in which case the money market returns will fall as well. So while it’s been a great place to be over the last few years, we see less value in staying in cash today, you compare that to bonds. So bonds are often put into the same bucket but they are still fixed interest, but they are longer maturity instruments and those have sold off aggressively so that the yield on the all bond index was the average yield was 9% at the beginning of the year, it fell to 11% which is a big move for bonds to fall 200 basis points in a few weeks as is a really big and quick move. It’s recovered a bit so now it is at 10% but if you think about that you can get 10% holding government bonds today with relatively low credit risk because the South African government can print rands so they relative to all the other credits in the country, they are low credit risk, which 10% is a good return. So I think we see some value in bonds more so than we have for a long time and we see limited value in holding cash.
RYK VAN NIEKERK: Let’s talk about equities again, I’m looking at the main holdings of the stable fund, Naspers is at the top. It represents 3.6% of the portfolio and I see it also includes the Prosus stake. Then second British American tobacco, 3.2% Glencore. That seems to be low percentages of your top holdings. How many shares are in this portfolio?
MARK DUNLEY-OWEN: Just remember that three and a half percent is our funds, in terms of asset allocation is only about 20% of the fund allocated to South African equities. So Naspers is a big proportion of that 20%, it’s 3.6 of the 20 so it is, it is quite a big portion of the shares. But because it is a low equity fund, if you look at the potential of the fund it will look like a low percentage. So although it is a small percentage of the fund, it has quite a high percentage of the share exposure. And in terms of the total number of shares, I’m not sure exactly, but it’s, it’s probably in the region of probably 40 to 50 but by far most exposure is in top 20
RYK VAN NIEKERK: You said earlier that they are a lot of value in the local market. Where do you see the value? Which sectors and maybe which counters are you looking at?
MARK DUNLEY-OWEN: The top three shares are Naspers, BST and Glencor as you said. So it’s interesting, those are not South African shares. Right? So Naspers is mainly Tencent, BAT is global and Glencor is global as well. But all of them we think offer value. So what’s nice about South Africa is there are both some shares that happened to be listed here like Naspers and like BAT, which we think are cheap and not only do we think that cheap, but our sister company Orbis, which has the whole world to choose from, they also think they’re cheap so they also buying Naspers and BAT. So it does suggest that within the global context some shares are global companies happen to be listed on the JSE and they do appear cheap. So we like those types of shares. But if you look at the pure SA companies, there’s value across the spectrum now. It just really depends on how much risk do you want to take. So the riskier companies which have some debt and which are purely exposed to South Africa for example, the industrial companies, those have sold off aggressively and they down 60, 70, 80% and if you believe things normalize, there’s a lot of upside to those. But they, they have the gearing and they are riskier so that downside as well. The shares we have been buying recently are the banks because the banks have also sold off aggressively and a company like Nedbank or Absa trades at less than five times PE and then Standard Bank is low single digits as well and FirstRand, but these are companies that have been around for a long time and they are on most [inaudible] South African banks are cheapest they’ve ever been and we know things are going to be tough and we know they’re going to be a lot of bad debts coming out of the lockdown and maybe beyond that. But we don’t think that the banks, we think the capital businesses are very strong so we don’t think there’s a solvency or liquidity risk to the banks. And if you have a longer time horizon, we think this is a unique opportunity to buy some well run large South African companies at historical lows.
RYK VAN NIEKERK: That is been the view of many asset managers, but it’s a strange situation where we are going to see significant economic pain in the short term, not only in South Africa but also around the world. The whole world will probably go into a recession. But investing in such a climate must be pretty difficult because value does not put money in your pocket. It’s an interesting dynamic, isn’t it?
MARK DUNLEY-OWEN: It is very different. So let’s, let’s be upfront about it. No one knows what’s going to happen and a lot of opinions out there, and I think what’s particularly difficult about today is that there are very few precedents of a pandemic? So most of us haven’t lived through a pandemic and that makes it very hard to have a rational view of the future. So there’s, there’s a lot of scenarios that could happen and they differ vastly and it’s very hard to know which of those scenarios are right. So as an investor that makes life difficult and what you try and do is you try to find investments that are either going to be fine in all scenarios. So I’ll put Naspers into that category. Naspers is Tencent, which is the main holding Tencent is a very well run company. It’s dominant in its space. It’s getting stronger as more people go online, got net cash on its balance sheet. So that sort of company we think is going to be fine in most scenarios and it’s reasonably priced today and you can get a cheaply via Naspers because Naspers trades at a big discount to Tencent. So that is the first type of investment and we think no matter what happens, you’re going to do okay to well while holding that sort of investment. Another investment is, let’s call it South African banks, which have fallen a lot and they appear to be very cheap, but there are scenarios where things get worse, right? There are scenarios where bad debts spike to multiple levels of, of the financial crisis, interest rates are dropped even further a lot of people can’t pay or won’t payday their debt back. And in that scenario, one could see more pressure on the banks. Our view is that you’ve got to look at the price you’re paying and the price you pay for South African banks today discounts almost all probable scenarios. So doesn’t discount every scenario. But in the vast majority of scenarios, it’s going to be very tough in the short term and bank price. The share price could go lower, but if you can, if you have a longer time horizon and most scenarios you should do well holding the banks from current levels. So if you can try to find a combination of safe companies and companies already pricing in many futures. I think you should do relatively well.
RYK VAN NIEKERK: Mark. I’m looking at the fee structure of the stable fund and it shows a negative performance fee. I’ve never seen a negative performance fee. Can you take us through that whole structure?
MARK DUNLEY-OWEN: Our view is that performance fees are very important because they align us being Allan Gray with the client when the fund is there for the client does well, we at Allan Gray do well. So the way the fee works for, for the stable fund is that we charge a 1% let’s call it a base fee and then we add or subtract from that depending on performance. So we share in 10% of our performance, but we also share in 10% of underperformance. And what’s happened over the last period is that because the fund has underperformed we have the performance fees being a negative number. So you take away the 40 odd basis points from the 1% base fee and you get to the net fee structure of the fund. So it’s just a way to get to align our performance with the client’s performance.
RYK VAN NIEKERK: But this is not an industry standard, is it?
MARK DUNLEY-OWEN: Most funds would have a just a plain fixed fee. So they would get say 1% or 70 basis points irrespective of performance, which, which has been a strong push to move towards fixed fees over the last few years. And we have resisted that. Our views have always been that we need to be aligned to the client. And I think it’s times like this shows that it is the right strategy, but as you say, most funds will have a more than [inaudible] type structure.
RYK VAN NIEKERK: Thank you, Mark. That was Mark Dunley-Owen, he’s a fund manager at Allan Gray.