PSG Flexible comment - Dec 16
-2016 experienced a strong market rotation on global equity markets from defensives to cyclicals which rewarded our portfolio positioning. -Even after underperforming in 2016, most of the popular large cap defensive equity names on the JSE remain expensive. -We can find better opportunities for our clients: primarily higher quality cyclical businesses in SA and abroad. -The stocks in our portfolios are still attractively priced, despite strong share price performance in 2016 in general. -The Fund retains relatively high levels of cash as a buffer against unforeseen future events, ready to be employed when we can buy quality businesses at a margin of safety. -Our portfolios comprise a diversified selection of higher quality businesses trading at attractive prices and at a substantial discount to the broader market. -We are confident that the holdings in the Fund will produce satisfactory long-term returns.
2016 in review By the end of 2015, defensive bond-proxies and popular growth stocks had become very expensive. Hence, our clients owned none of the large cap rand hedge stocks that dominate the JSE indices. At the same time, economically-sensitive businesses with cyclical earnings streams found themselves deeply out of favour. We could find fantastic opportunities for our clients, particularly amongst higher quality cyclical businesses in South Africa and the US.
In our December 2015 commentary we concluded that: 'sentiment is very poor in several areas of the market and it is possible to buy stocks at similar valuation levels to during the global financial crisis of 2008. These are circumstances in which we consider it appropriate to adopt a contrarian approach and invest in unloved cheap stocks on behalf of our clients. Investors should enjoy good long term returns from these stock price levels.' It is pleasing to report that many of these 'unloved cheap' stocks delivered handsome returns for our investors during 2016. The JSE (at an index level) was, however, weighed down by poor performance by expensive large cap rand hedges.
Portfolio positioning and outlook
The panic of 2015 and early 2016 provided the opportunity to buy good businesses at a wide discount to our assessment of intrinsic value. Cyclical companies were deeply out of favour with widest mispricings to be found in the Resource sector. Most commodity producers had very strong share price performance in 2016 and as a result, we reduced our exposure, selling out of Anglo American, BHP Billiton and Kumba during the year after share prices exceeded our estimate of fair value. The Fund retains exposure to Glencore, where we continue to perceive an attractive discount to our value for the business.
We are long term investors, not traders, but given very strong share price appreciation in some of our holdings, portfolio activity was higher than normal in 2016. We sold Capitec during the year (in favour of PSG), reduced Berkshire, Imperial and Barloworld and took profit in US financials (JP Morgan, Capital One, Wells Fargo and Markel).
The fears around the potential downgrade of SA soverign debt saw attractive opportunities arise within interest rate sensitive SA financials and we were buyers of strong franchises like Firstrand, Old Mutual, Barclays and Nedbank at what we thought were very attractive prices for long term investors. We have also added to Discovery throughout the year. We think the current share price materially understates the strength of the business model, addressable global market, sustainable growth rate and quality of the management team.
At the end of 2015 the Fund had 29.3% of its assets invested directly offshore. By the end of 2016 this had reduced to 22.5% as we could find better opportunities within the SA market in some of the stocks discussed above, especially given the extreme weakness of the rand against other currencies. Our offshore equity investments remain an important source of portfolio diversification and we have high conviction in the long term returns to be derived from our global equity positions, including Sainsbury, Brookfield, Cisco and Berkshire.
The Fund had 31.1% in cash at the end of 2016. This is slightly higher than the end of 2015 (30.6%), but it is worth noting that we employed cash to opportunities that arose during the sharp correction of January/February 2016 and subsequently found ourselves building cash in the latter parts of the year as the margin of safety in the individual holdings narrowed. Cash levels are above historic averages which reflects the limited availability of higher quality businesses at a margin of safety. Cash has always been an important building block in the PSG Flexible Fund. It acts as a buffer against the risk of equity holdings, which are inherently long duration assets and very sensitive to unpredictable changes in economic conditions, company fundamentals and market sentiment. The true value of cash is only apparent when liquidity tightens and panic sets in. What has been pleasing is that our cash positions have been able to lock-in attractive real yields without taking on duration or liquidity risk in recent times.
A feature of the bond bull market of recent years is that certain equities have competed for capital with developed market bonds and have become very expensive. These have included some of the popular higher quality rand hedges on the JSE like Naspers and British American Tobacco. As a result, investors are poorly compensated for the risk they are taking and are likely to experience poor long term returns. We constantly screen for opportunities to buy quality at a margin of safety but can currently find limited opportunities within the traditional JSE rand hedges and dual-listeds. We think we can find better long term investment ideas, some of which we have discussed above.
Our portfolios comprise a diversified selection of higher quality businesses trading at attractive prices and at a substantial discount to the broader market. We are confident that the holdings in the Fund will produce satisfactory long-term returns.
The PSG Flexible Fund is a managed flexible portfolio and will seek to follow an investment policy which will aim to achieve superior medium- to long-term capital growth through exposure to selected sectors of the equity market, and/or the gilt market and/or the money market. The asset allocation will be actively managed and will continually reflect the portfolio manager's view of the relative attractiveness of the equity, gilt and money markets, both locally and abroad. The selected sectors of the equity portion of the portfolio will change from time to time in accordance with changing market conditions and economic trends.