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Diligent stock picking in a volatile market

‘55% of investible shares are down 18% during the past six months’ – Perspective’s Daniël Malan.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, my weekly podcast with leading investment professionals. My guest today is Daniel Malan of Perspective Investment Management. Daniel, welcome to the show. You started Perspective Investment Management in January last year, so you are approaching your 18-month-anniversary. How are you and the firm doing?

DANIEL MALAN: Thank you, Ryk. We are doing very well, thank you. It’s early days and it’s an exciting time to build a business in South Africa. We’ve thought long and hard about the design of the firm and its place in the market, and we’re very excited. With any startup in the early days, it’s friends and family while you build your track record and you tell your story, and then at some point you transition over to being able to tell your story and back it up with a bit of data. We’re in that phase now, where we can actually show a bit of a track record and can start showing people what we do, as opposed to just telling them, so it’s an exciting time for us.

RYK VAN NIEKERK: You were, of course, the chief investment officer at RECM for a long time, more than 10 years, I think. During the last few years you were there, the performance of the funds at RECM, under Piet Viljoen, weren’t all that stellar. When did you actually take your decision to try and go it alone and implement a new investment vision?

DANIEL MALAN: Well, if I think back over my career, I’ve been in the market since 1996, so this is my 23rd year in the markets. When I was at RECM as chief investment officer, I was one of three portfolio managers – and, as per the process we were following, we were investing, slowly but surely, more heavily into the cheaper parts of the market, which as you recall, included the commodities sector. And the old value-investor’s curse took hold. We tended to be a little bit early. But in hindsight, when I think back on it now – if you look at the performance of the commodity markets from the bottom of the market in 2016, 2017 and even now, into 2018 – those stocks have actually done really well in a generally benign and flat JSE market environment for the last three years. So when I look back on it, I am quite proud. I think the firm was busy doing the right things to transition client portfolios into the cheaper parts of the market. Ultimately, if you look at some of the other competitors in the market like John Biccard, Investec Value Fund, those funds recovered really well. So I feel confident that the process was working, and we had gone through that a number of times in past cycles in the market. Of course, while you are busy transitioning the portfolio into the unfavourable parts of the market, then clients question that because initially you underperform your competitors and it can cause a little bit of stress.

RECM versus Perspective Investment Management

RYK VAN NIEKERK: But you now run and own Perspective Investment Management. What is your philosophy now? How does it differ from, for example, the RECM model?

DANIEL MALAN: I haven’t changed the way I think about investing. From the very early part of my career as a stockbroker, I have been very sensitive to client needs and my clients. I believe the individual investors out there think like businesspeople because most of them are in business themselves. They tend to think long term, and they tend to think in absolute terms. So I have never ever met anybody who, like a normal person, not a professional investor … you’ll never hear anybody say that they’re trying to beat the index or trying to beat the competitors. Generally speaking, most people want just to make money and that’s all they really care about. I’ve learnt that by focusing on the index or focusing on competitors it’s usually not a sensible thing to spend your time on. When I left my former business I had been in the markets for about 20 years, and I thought it was a good time to take stock of my career, and I spent the best part of a year just taking a pause, case-studying all of my investment decisions that I had made since 1996; just trying to pull together the threads of the good things that I had done and the mistakes that I had made – and pulling all of that learning together, and just revisiting my convictions, and maybe having to challenge a few things that I wasn’t happy with in my own process. So that is a process of gathering perspective, of course, and that is where the name of the firm comes from. It’s not that I have a point of view and that I’m going to convince you or anybody else about it, it’s that I have an evidence point of view. But I’m curious as to what my clients and what my competitors and what anybody else thinks about it, because I think I always want to keep my mind open to new inputs and new facts, even from people who have diametrically opposite views to me. I think there’s value in listening to that at least.

RYK VAN NIEKERK: But let’s talk about money, and let’s talk about the current market. The JSE seems to be extremely volatile, and although we have seen the JSE All Share Index perform relatively poorly over the last few months or so, it’s not all what it seems. There’s a lot of volatility within the different companies on the JSE. What are your thoughts on that?

DANIEL MALAN: That’s a good question, and we are looking at the data quite carefully. At the JSE level in South Africa, the market capitalisation weighted index, say over the last six months, is down 6%. Now that doesn’t sound like a big deal. It’s the type of number where most people are like ‘Ja, okay, that’s fine.’ But the truth is in our investible universe we’ve got 209 companies and out of those, 115 of those, which is 55% of the market, the average share prices of those companies are down 18%, and that’s significant. That’s a serious number. Twenty of those companies that are down, the share prices are down over 50%. So there have been a lot of proper disasters and ways to lose serious money in this market. I think that’s something that a lot of investors in funds, and in the market, are definitely feeling – but it’s not that obvious when you look at the headline indices and the headline news flow in the market yet, which is quite interesting.

Diligent stock picking is essential

RYK VAN NIEKERK: That is, as you said, quite alarming. So what does that mean for a fund manager who is chasing an index? You need to actually be able to pick shares a lot more diligently now than previously?

DANIEL MALAN: Yes, most of the time you’ve got a trending market and the index is up and all the stocks are up, and it really doesn’t matter that much, but every once in a while, when you get this kind of market environment, your stock picking ability within a market, of course, becomes incredibly important. If you were unlucky enough to have owned a lot of those companies that have share prices that are down that much, your performance relative to your peers and to the market is going to be quite bad, equally if you were fortunate enough to have selected a couple of the winners. So what I’m saying is that the performance discrepancy at the moment, in the last six months at least and probably in the last year between the different fund managers, is going to be very much wider than usual. You can see it already when you look at the performance of the equity and balanced funds in South Africa. There’s an enormous discrepancy at the moment between those who got it right and those who didn’t.

RYK VAN NIEKERK: The balance of those shares that actually went up, so the 96 shares that went up over the last six months, by how much did they actually jump?

DANIEL MALAN: Their average share price increase was in the order of 25%. So you can imagine if you caught a couple of those in a market index – that’s down 6%. That’s very good for you. Equally if you caught a couple of those that are down 18% against the market’s -6%, equally that would have hurt you quite badly. But the interesting thing for me is that the concern that I have is, and it’s one of the reasons that our balanced fund is not fully invested, is that of the companies that we follow and that we like, and the process we follow, those stocks that are down the most in the market are the ones where our conviction is, that we still don’t want to buy them. So maybe just to put some colour around that, so we try to follow a long-term investment philosophy. There are a lot of people who will tell you that they are long-term investors and that’s not necessarily true. So people shouldn’t just listen to me, they should look at what we’re doing. In our portfolio, for the last nine months, our portfolio turnover level is less than 2% …

RYK VAN NIEKERK: What does that mean?

DANIEL MALAN: That is the percentage of the portfolio that’s actually being transacted as a sale, so it gives you an indication of how active we have been in buying and selling stuff in the fund.

RYK VAN NIEKERK: So that has been stable, but in many ways you have a very diverse market. The contrarian investors would look at the shares that went down, and the momentum investors would look at the shares that are going up. Where are you looking?

DANIEL MALAN: We follow what we think is quite a common sense approach, so we want to invest in companies that we think we can understand, that’s the first thing. The second thing is we want to invest in companies that are managed by people who we think we can trust. Those are critical things in our process. If we don’t understand a business, we will not spend any time working on it. If we don’t trust the people, we will never ever buy it at any price. Then it has to be cheap, based on our numbers, and it also has to be liquid enough to make sense in our portfolio. We don’t want to be stuck in situations where we cannot change our portfolio if we’ve changed our minds. So those are the four things that matter in our process. As I said, many of those companies that are down in the market still fail one or more of those four primary criteria of ours. We haven’t bought heavily into those. So our portfolio, we run a balanced fund and we’re still less than 50% in equities at this time.

RYK VAN NIEKERK: Why? That seems to be a conservative approach.

DANIEL MALAN: Yes, very much so. At the inception of the fund in September 2017, the portfolio was 33% in equities. Let’s face it, that’s a super conservative stance. But when we prepared the portfolio in terms of doing our research through the first nine months of 2017, we valued each and every asset – and we could not find in the market at that time enough investible ideas that met all four of our criteria to warrant having a more invested portfolio. So we back our own work, and even though we know that it’s a very different looking portfolio. But that’s our commitment to our investors: that we will only invest in situations that meet our criteria. And if that means having a conservative stance, we think that the market conditions warranted that. There’s no doubt. We’ve had an uninterrupted 10-year bull market in South African equities and in the world. Every measure that we look at implies that this is a time to be careful. So we’ve been careful and we’ve managed to grow the capital in our fund during a market environment that, let’s face it – it has been pretty brutal out there. Now we have lots of cash and we have the patience and the discipline to sit back and slowly but surely increase equity as and when companies that we like reach our buy levels.

Property shares, government bonds and cash

RYK VAN NIEKERK: Your benchmark is CPI plus 5%, but where do you park your cash – because that will influence that significantly, and you can come pretty close to CPI plus 5% currently in some bonds and other money market products.

DANIEL MALAN: That’s a good question. So most of it is invested in money market funds, and we have some offshore currency and sterling, which we think is cheap, which of course is low yield. We have an investment in Growthpoint in the property sector, which gives us some yield. We also have a small exposure in government bonds, which we bought – between 9% and 9.5% nominal yields on the 10-year bond. So just simplistically, if you buy a 10-year government bond at 9.5%, if inflation is going to be approximately 6% over your holding period, then you’re going to get a real return of about 3% to 3.5% from that bond. So that’s how we think about it. We don’t really see value in the bond market at the moment. The 10-year yield is at 8.5%, so you’re going to get 2.5% in real terms on that if you own that for the next 10 years. So it’s not exciting to us at this time. In our money market funds in cash, we can get in the order of 8%, which again is about a 2% real return. So it’s not exciting, but cash is an interesting one. It never looks exciting except when other stuff goes down, then suddenly cash looks incredibly exciting.

RYK VAN NIEKERK: And a good strategic decision.

DANIEL MALAN: Exactly. So making a 2% real return while the average stock that is down is down 18%, it suddenly looks quite exciting. Even at the market level now, the stock exchange in South Africa being down 6% over the last six months, suddenly the plus 8% starts looking quite exciting.

RYK VAN NIEKERK: But looking at your equity portfolio – I’m looking at two factsheets, one from October 2017 and the one until the end of April this year, and it’s very clear that you actually bought into Sasol. It doesn’t appear on the October fund factsheet for the top 10 equity holdings, but it’s right at the top in the April one. Sasol actually had a good run over this period.

DANIEL MALAN: Yes, fair enough. Sasol and Discovery are two of our largest positions and, to me, those are two companies in South Africa that have what we consider globally-recognised intellectual property. There are very few companies in South Africa that have truly partnered internationally with best-in-class global businesses, and both of these companies have done so. And I think there’s an important recognition in that. Sasol, we bought our first tranche below R400/share. If you look at the share price over the last while, it’s pulled down. The company is exciting in the sense that it’s got terrific management. This share price had gone nowhere for the last almost four years, the company is busy developing its Lake Charles chemical project in the United States, and it’s essentially transforming completely. As Lake Charles comes into full production, Sasol will no longer be an energy business. It’s essentially becoming a chemicals business. I don’t think the market has necessarily recognised that. That’s not our thesis. Our thesis is not that the market hasn’t recognised it – our thesis is that it’s a fantastic business, we think we can understand it, it’s got terrific people leading it, it’s invested heavily in a very significant growth asset; the company is transforming. But, again, our intention is to own it for the next five to 10 years. That’s how we think about things, so that’s why our portfolio turnover is so low because we don’t mess with the portfolio. So Sasol has now become our largest holding, more so than what you saw in the April factsheet.

RYK VAN NIEKERK: It’s been up year-to-date around 20%, which is significant, especially in the context of what we’ve discussed earlier. The other names on the top 10 equity holdings list include several financial services businesses, as you said – Discovery, Old Mutual, Investec, RMB. Do you see that as a sector that shows potential?

DANIEL MALAN: Yes, I do, primarily around Discovery, to be quite honest. We bought quite a few of those insurance firms at the end of 2017, and at the time they were cheap. Some of their share prices have run quite hard. Discovery probably got a little bit ahead of itself, for example. But just in terms of fitting into our mental model in terms of having a business we understand, we don’t really think of Discovery as a financial services company, we think of it as a database business, and that’s really its core strength – the value of its intellectual property that sits in the database that’s obviously structured around the Vitality model, and that’s what they have taken it global. You’ve got an extremely ambitious leadership. I like that the founder is still there. Adrian Gore seems as excited today about growing Discovery as he was 25 years ago. It’s still very much the same vision and plan. I think as a core long-term part of a portfolio it’s just a fantastic asset that you want to own.

RYK VAN NIEKERK: Especially if the Indian and Chinese ventures take off. That could be a significant asset. That was Daniel Malan of Perspective Investment Management.

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