Bravata Worldwide Flexible comment - Mar 18
In the past we have written about the advantages that a worldwide mandate offers. From time to time the volatility of our local market gives local fund managers wonderful opportunities to take advantage of reduced asset prices and repatriate foreign funds to local markets. This is not restricted to equity markets, giving us access to all asset classes like bonds, property and local cash. It also allows us to take profits on offshore investments and redirect proceeds to local assets without reducing our equity exposure. Typically, these opportunities are driven by emotional news underpinned by political events.
Prior to the election of the new South African president, Cyril Ramaphosa, pessimism proliferated. Asset prices were depressed on all fronts, the exception being Western Cape property. This, however, did not last owing to the well publicised looming water shortages. One struggled to find anything positive being reported about the country's future. It was as if it was a perfect storm of negative news. This ranged from the continued downgrades on the country's sovereign debt, dismissal of senior ministers, to a continued stream of daily updates of corruption allegations. Contracts with companies were being declared illegal and their share prices reflected the news. The bond market started to reflect negative news and the currency followed.
Through all the pessimism it is very difficult to envisage what the future looks like: the windscreen looks cloudy and we struggle to set the compass to true North. Fortunately, at Aylett and Co. we have never tried to forecast the future, nor have we tried to call the economy, the currency nor the direction of interest rates. Our efforts have, as always, been aimed in the direction of staying out of trouble or in other words, not losing permanent capital. The asset must reflect sufficient margin of safety and at the same time be a rational investment. This strategy of waiting for opportunities on our terms has stood us in good stead and returns over the long-term have underpinned the fund's investment success.
At one stage our bond market reflected rates more than double the inflation rate, a situation we felt was acceptable despite all the negative headlines. Interestingly, we do not employ a strategist or an economist to assist us in investing in local bonds, it just made common sense to invest in South African bonds. Subsequently, South African bonds have rallied and we were able to exit the position profitably.
It is well-known how fund managers find it difficult to beat market indices. One of the reasons is that if you lose five percent of the fund it means the other ninety five percent of the fund has to work much harder just to keep up with the market. We have been consistently advocating increasing exposure to South Africa over the last two years. This, however, could have been a disastrous decision had we invested in some of the many shares that suffered significant losses.
The maths is simply not on your side if you lose fifty percent of the capital. It means, to recover it, you have to go back up one hundred percent just to break even. One of the many popular investments, not listed above, that seldom gets mentioned is the Naspers stub or rump product. The performance of the Naspers rump has been disastrous for those that bought it. For nearly two and a half years, the value of Naspers' interest in Tencent has been 'worth' more than the market capitalisation of Naspers. A curious mind must ask - How can this be? How is it possible that MultiChoice, Media 24 and the many ecommerce investments owned by Naspers are worth less than nothing?
As a proxy for worth, we use the number of shares owned by Naspers multiplied by the current market price. It is debatable whether Naspers would get this full value from its stake as it seems likely any sale of that magnitude would require some sort of discount. When Naspers recently decided to sell 2% of its 33% stake, it did so at a 7% discount. Additionally, we suggest that there will be fees and taxes due.
Without going into the many reasons why, the vast majority of holding companies (Naspers being one of them) trade at a discount to the sum of its parts. If a single investment becomes very large in that holding company's portfolio, even a small discount applied to the holding company can result in the rest of the portfolio trading at a 'negative' valuation. That negative value has nothing to do with the quality of the smaller assets - it is just the maths.
A simple example can illustrate this. Assume a holding company (Holdco) owns two assets, A Ltd and B Ltd, each worth R50. Assume for argument's sake that a holding company discount of 10% is justified. The sum of the parts for Holdco is R100 and it trades at R90 after applying the holding company discount. Assume now B Ltd goes up in value 100 times. A Ltd is still worth R50, B Ltd is now worth R5 000. The sum of the parts value is R5 050. Apply the 10% holding company discount and Holdco will trade at R4 545. Using the Naspers stub thinking, you could fool yourself into believing A Ltd is trading at negative R505. Emails from your broker will try to convince you that you're being paid to own it. Unfortunately, if A Ltd and B Ltd never get spun out and they keep their value, there is no reason why that stub must ever trade positive. It is that simple maths that has kept us from buying the Naspers rump product.
Most books written on investing explain how to make money, but not enough text is spent on preserving capital and staying out of trouble. Purchasing is quite easy, but avoiding the popular stocks and investments is a difficult decision because it's hard to go against the crowd. While the investment process at Aylett & Co. gets more robust every day, one of the most important characteristics that make up our investment DNA is one that we have had from day one - we don't participate in investments that make no sense to us and we have the modesty to admit that sometimes we just don't know. If we can't understand the model; if the CEO's message sounds incomprehensible or unclear; if management display a total disrespect for minority shareholders or poor capital allocation we should stay away. We have avoided all of the stocks in the table of losers above because of these simple warning signs.
THE PORTFOLIO TODAY
Not much has changed in the portfolio other than the exposure to equities has increased to just below 70%. This is mainly as a result of a continued increase in exposure to South African companies; some withdrawals from the fund as investors switched back to South African assets; and the strength of the local currency.
There were only three notable transactions. Hospitality Property Fund Ltd is the hotel property REIT controlled by Tsogo Sun (largest hotel group in South Africa). It is our view that hotels are currently trading at, or near, to the bottom of the cycle. Because of this cyclicality in earnings, hotel assets are being bought and sold at levels approaching a fifty percent discount to what it would cost to build these assets today - representing an attractive asset for the long-term investor. Subsequently, however, a large transaction has been announced (which requires shareholder approval) for the REIT to also acquire the casino properties of Tsogo Sun, something we do not believe makes sense.
The other two transactions were minor were additions to existing positions in Investec Plc and the Longleaf Asia Fund and not new investments. There were no major sales.
PERFORMANCE OF THE FUND
One of our significant detractors was exposure to the US dollar. In the past, exposure to the lender of last resort, the US government, has turned out well. In this quarter, that was not the case and we would have done well to be exposed to currencies such as the euro. At a stock level, L Brands and Berkshire Hathaway detracted on a quarterly basis but we believe that to be temporary. In the case of L Brands, it is still a new investment for us, and Berkshire Hathaway was just taking a breather. On a relative basis we have been underexposed to developed market assets and this has resulted in a muted performance from the fund.
The markets generally look fully priced, in particular if one feels that interest rates will rise. The US Federal Reserve is on track for at least two more rate hikes. This is not significant, but should it surprise to the upside we will have weak equity markets.
Our research shows that US companies are having to pay higher salaries to retain staff. We have seen this in two of the companies we have invested into in the US. Secondly the imposition of trade tariffs does not bode well for margins. Any retaliation from trading partners will not be useful. All of this may lead to inflation in the longer term. Politics around the globe is not conducive to good equity markets and we may see more unfortunate circumstances that will lead to further losses. In truth, we don't know. We will continue to monitor our investments to ensure that our errors are of omission and not commission.
The portfolio is suitable for investors looking for a balanced exposure to both domestic and international assets, with maximum capital appreciation as their primary goal. This portfolio will typically display lower volatility than a general equity portfolio.