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When volatility happens, find certainty

‘Some companies have persisted and persevered… Find those, invest in those and hold those,’ Hlelo Giyose – First Avenue Investment.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast, our guest this week is Hlelo Giyose, he’s the chief investment officer of First Avenue Investment. Hlelo, welcome to the show.

We have certainly seen a very interesting January. We spoke a year ago and then you highlighted that volatility in local and international markets is the new normal but have you ever contemplated the volatility that we’ve seen over the past two months?

HLELO GIYOSE: I think that with experience you’ve seen similar volatility before, you just never get used to it and every time it shows up it feels like the first time. Yes, it has been quite turbulent.

RYK VAN NIEKERK: But surely in this modern age you do a lot more research than you did a few decades ago and you should anticipate surprises in the market? Why are we still seeing so much volatility?

HLELO GIYOSE: I think because investors have different approaches towards the market. Some investors, for instance, love to own companies that are cyclical because they give them outstanding returns over short periods of time but the challenge there is you have to know when and how to sell, which always catches people off guard and, hence, the volatility.

Another approach is the one we take, which is we never ever want to buy companies that are cyclical, at least we buy companies that are less cyclical than the market, so when volatility does happen we don’t have a desire to sell, we don’t have a desire to rush out, we actually have a desire to stay a little longer, if not a lot longer, in those companies.

RYK VAN NIEKERK: We saw an interesting trend last year: we saw a lot of pressure on the market, although the overall performance was flat, some of the big conservative stocks did really well, mostly because people were selling other, more risky stocks and putting their money in these safe havens. How did that impact the dynamics of the market?

HLELO GIYOSE: Sure, this is the point that I’m referring to – that if you have been anticipating economic growth and you think that there are companies that are leveraged to economic growth and you hold those because you think you’re going to get outsized returns. Well, if economic growth turns down before you get your returns or before you sell, then you’ll be in a rush to get out the door – but that’s a really, really dangerous point to make.

The most important thing is when volatility does return – because of people changing their minds, because they’re reading their economic situation differently for the first time or because the economic situation is surprising them, when it does happen, guess what – investors, like every human being who’s drowning, want nothing more than to breathe. They want oxygen and oxygen is certainty in the markets and you get certainty from certain quality companies, the defensive-type companies that we spoke about, and they’re defensive not because they have anything to do with beer, for instance, or cigarettes, but … because of the structural advantages or the way their operations run themselves so that their earnings are buffered from economic conditions or macroeconomic factors like interest rates, like inflation and so on and so forth.

RYK VAN NIEKERK: How will this pan out? What will happen this year to those companies? We are seeing a selldown across the world; we’re seeing a selldown in South Africa as well and some of those big companies have come back. Can you leave your money there for the short term?

HLELO GIYOSE: Oh yeah and you should. Equities reflect the best opportunity or the best vehicle to create wealth and I refer to real wealth – wealth above inflation by miles – and why do they do that? Because they reflect and represent ownership in companies that drive the economy.

Now you want companies that drive the economy – not the ones that are cyclical with the economy – and if you drive the economy and you give the economy not its ambience but its structure over long periods of time, you really want to own those companies. Because those are the companies that will take all inflationary pressures, price them in and … pass them onto the customer and take the prices from the customer and share them with you by way of, number one, entrenching their own competitive advantages, but number two, dividends. So you want to hold those. If you don’t hold those, what are you going to hold? What else is there? How else can you create wealth? There is no other way.

RYK VAN NIEKERK: I immediately think of British American Tobacco, AB InBev, Richemont, Naspers. What other companies fall with that category?

HLELO GIYOSE: Well, just look at the recent results, in the midst of turmoil, by some of the retailers. The one we hold, and we think very highly of, is Woolworths. The definition of pricing power is if you can get price increases along with volume increases and Woolworths got that: they got volume increases, they got pricing increases. In economics those two never go together, when you have pricing increases you have volume declines but Woolworths put that up and they’ve been putting these kinds of statistics up. And with their positioning now in the Southern Hemisphere, offering Southern Hemisphere-type fashion across the world, that’s going to be fantastic; they’re going to keep doing this. So it’s not necessarily cigarettes or beer but it’s also human ingenuity by some companies that may look cyclical but don’t act cyclical.

RYK VAN NIEKERK: I will come back to the actual shares that you own in the fund. We also saw late last year big political turmoil in South Africa, which sent the rand from around 14.40 to the current 16.50 against the US dollar. How does that change the dynamics?

HLELO GIYOSE: It changes the dynamics if you are a company that is beholden to the economic cycle, to macroeconomic factors, because you have to figure it out now and if you don’t have enough cash you have to look at your shareholders, as Lonmin did, raise capital, as most resource companies will, most construction companies will. The longer we drive through this desert the more they’ll go through their four sets of wheels and spare tyres, and need more.

But other than that, if you stay away from those kinds of companies you don’t have to worry about those dynamics. Why? Because you continue to give the global economy a structure. The human being is not going to die: we’ll be here, we’ll be demanding goods and services, and some companies will earn our custom. Those are the companies you want to own, you want to hold because they’ll share the proceeds of that custom with you by way of continued entrenchment in the economy, as well as dividends.

We did a study going back to 1960 and we took every cataclysmic event you can think of and we took about ten events per 20-year frame, so 1960 to 1980, and we had devaluations of the rand, we had political riots, we had stock market declines, we had all sorts of things, recessions in a row from 1960 to today and the stock market today has performed admirably relative to 1960. It’s created so much wealth for so many people. But within that it’s not every company that has done very well: some companies have gone the way of the flesh, have died, other companies have persisted and persevered. You’ve got to find those companies and that’s where the research comes in and that’s what you get paid to do. Find those, invest in those and hold those.

RYK VAN NIEKERK: That brings the debate back to active versus passive. Obviously in a market like this it is a stock picker’s market but passive investments could be more risky in this environment than in a bull market. What is your strategy in this market? What are your active decisions?

HLELO GIYOSE: You are completely right, passive is wonderful when everything is going up and things tend to go up in five to seven-year clips, and in that time you could be lulled into a false sense of security, where in passive strategies the markets seem to do as well as every active fund, if not better than most active funds. In fact, it would be so much better because you’re paying less. At that point the sales pitch by passive folks rises like an elevator and you’re told that you’re creating wealth by paying nothing, until the market turns and when the market turns you get to appreciate at that point who you really are. Do you value your losses more than your gains or your gains more than your losses? As you discover that for yourself, as an individual, you go back to doing the difficult work, which is I think I want active investments because active investments give me the opportunity not to fall like the market. Then you go about picking which ones you want, which fund managers you want, which funds you want or which stocks you want.

RYK VAN NIEKERK: If we look at your retail fund, you actually made a lot of changes over the last 18 months or so, and the biggest one was to largely get out of commodities and to move into Naspers and Woolworths. Why did you take the decision, first of all, to get out commodities? You sold down BHP Billiton and Sasol quite aggressively.

HLELO GIYOSE: There was a time early on last year…, I think it was about March or April, where the market did something really intriguing: it sold Mediclinic down, it sold RMI down, it sold FirstRand down, it sold Clicks down. It sold a few of the companies that we consider to be really stabilised companies, it sold them down. In that two-week period we took the decision to ‘high grade’ our portfolio, meaning that you’re increasing the quality of your portfolio by paying less, without the commensurate volatility that would come with a Billiton or a Sasol. So we switched, we took close to 18% of the portfolio out of those two companies, it wasn’t a whole slew of resources,18% out of Billiton and Sasol….

RYK VAN NIEKERK: When was that?

HLELO GIYOSE: Around April or March last year. We took 18% out of those two and we put it across Clicks, across Mediclinic, across FirstRand and a few other names that I may not recall now, and, indeed, increased our holding in Naspers. That has been wonderful. Discovery, by the way, is one of them and that has been wonderful because … what has happened is this: we have not only gotten growth in dividends in excess of the earnings reported by those companies, we have gotten less volatility from those companies and we’ve gotten far longer staying power in those companies than you’ll ever get in resource companies.

RYK VAN NIEKERK: And you avoided the big selldown in the commodity sector.

HLELO GIYOSE: Yes, of course. Active investing is always – at least this is how we think of it – if we can get the best and the highest quality possible at lower prices, we will – we will do that without hesitation, we’ll do that in a heartbeat. [That entails a bit of homework for you though]: wait for the opportunity…wait for it because it’s worth it and when that opportunity shows up to high grade, do it and after you do it do not look back.

RYK VAN NIEKERK: The commodity sector has been sold down; are you looking to get back in there?

HLELO GIYOSE: We liked only two companies in that sector, as you know, Sasol and Billiton, which, by the way, Sasol has performed admirably relative to Billiton but Billiton is a highly, highly stabilised company, we still own a small percentage of Billiton. If there’s any one of those companies that we’d like to go into it is BHP Billiton. We may not go in to the same extent now because obviously that money has been put to work in companies that, as I say, have much longer staying power but the capital allocation culture in BHP Billiton is exemplary, it is second to none. So at some point we’ll look to get into it, maybe not, maybe we will. But we’re not in a rush, there’s nothing that we hold that we think currently is overvalued and requires us to sell out of it to get into Billiton or Sasol, no.

RYK VAN NIEKERK: The top counters in your portfolio are all companies that earn a lot of money offshore. We’ve seen the sharp devaluation of the currency but not all of these shares have really shown their hedge attributes. So are you worried about a changing trend that some companies are not regarded as the big rand hedges anymore?

HLELO GIYOSE: I think the word ‘rand hedge’ is the least insightful phrase in the country, in the market, and it’s completely unimportant. The phrase ‘rand hedge’ is completely unimportant. Never ever do things for rand hedge because if you did you might buy companies that might kill you, that are exposed to the commodities cycle like Grindrod but then that never happens. The most important thing is this, the companies that you see that are ‘rand hedge’ are also highly intelligent companies: intelligence is one asset that we know is responsible for the success of companies but it’s not on the balance sheet. That’s the intelligence paradox. Human ingenuity is never on the balance sheet, we look at the balance sheet of any smart company, in fact the net asset value goes down. It’s very tiny, it’s very small relative to the market value. So you capture human ingenuity on the stock market, you don’t capture it on balance sheet, even though it resides within the company.

So the companies you mentioned are companies that have monopolised an inordinate, a disproportionate amount of human ingenuity in South Africa. They’ve exported that particular quality globally and happen to earn dollars or euros or pounds as a consequence but they didn’t go out and say we need to invest in dollar, pound or euro environments in order to hedge against the rand. No, they’ve exported their competitive advantage. So for us we’re purchasing the type of human ingenuity that is rare, that is actually highly competitive globally, that may not find that much expression in South Africa anymore because the economy isn’t shifting as much as it should.

RYK VAN NIEKERK: How do you measure that ingenuity? Is it just in rands and cents or do you have another metric to try and foresee it? I think you referred to what happened in Naspers…

HLELO GIYOSE: Excellent, that’s excellent…

RYK VAN NIEKERK: How do you measure that?

HLELO GIYOSE: Yes, so this is not what we get paid to do at First Avenue. Our mousetrap or our valuation methodology really captures what we first identify qualitatively as a competitive advantage or a structural advantage or an economic moat. An economic moat is really capital allocation into something that buffers your earnings and your free cash flow. Not only that but also market position against competition and against regulation. So it buffers you against that, so that you monopolise a …pool in your industry for a long period of time to come. Now it sound easy to say this but when AB InBev looks at SAB and says I want that, they’re hedging, what are they doing, rand hedge or dollar hedge? Do you think they really want rands because rands are fantastic? No, they want human intelligence. So the rand hedge actually works the other wa. If AB InBev can recognise human ingenuity in South Africa that’s based in rands and in Nigeria and Kenya and all the other places where SAB has operations in local currencies, they don’t care about the currencies, they care about the competitive advantage, human ingenuity, the intelligence that you don’t see on the balance sheet but that allows South African Breweries to monopolise …industry.

RYK VAN NIEKERK: But investors see rands, obviously the return in rands is the currency in South Africa, how should investors then look at it?

HLELO GIYOSE: Don’t spend time thinking about that. For the last 111 years, whether you splice this over the full 111 years, 50 years, 75 years, 20 years, South Africa is the third-best performing stock market in the world in dollar terms. So what does that say about that rand thesis? It says more actually by the intelligence, the moat accretive capital allocation that you see in management of South African companies, it says more about that than it says about the country. The biggest asset we have in this country, the greatest asset we have is our capital markets. If China had what we had, if the Chinese stock market worked like this China would be like America. If we had the human ingenuity that we see China displaying we would be like America. But the beautiful thing is we have this and this stock market is fantastic because it contains human ingenuity at a level that is admirable or, shall I say this quantitatively, that is the third best in the world over 111 years.

RYK VAN NIEKERK: Thank you, that was really an inspiring interview. That was Hlelo Giyose, he’s the chief investment officer of First Avenue Investments.

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