27 J a n u a r y V o l u m e b y G l a c i e r R e s e a r c h

Transcription

1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 27 J a n u a r y V o l u m e Priced for perfection By Delphine Govender, Chief Investment Officer and Portfolio Manager and Mahomed Ibrahim, Equity Analyst, both of Perpetua Investment Managers Investment risk comes primarily from too-high prices, and too-high prices often come from excessive optimism and inadequate scepticism and risk aversion. Howard Marks, The Most Important Thing Analysing the performance of three large, well-known shares on the JSE over the past three years teaches us useful investment lessons. Over this time, these shares have journeyed from being well in favour as their prices and valuation multiples raced to record highs to being out of favour with their share prices falling sharply. This is shown in table 1 below: Table 1: PE at peak Return since peak Mediclinic % Aspen % Woolworths % Source: Bloomberg 1 These calculations adjust for Mediclinic s re-listing following its reverse takeover of Al-Noor Page 1

2 Declines of this magnitude in a short space of time are usually associated with cyclical companies which have wild earnings swings and are typically uncharacteristic of these relatively defensive companies, which the three companies above are considered to be. These price moves therefore raise questions. Why were these shares in favour? The share prices of these three shares all peaked around the middle of Looking at the investment environment at this time provides an important context in understanding their subsequent collapse. At this time, global economic growth was weak in spite of unprecedented financial stimulus by central banks which had depressed interest rates and bond yields to all-time record lows. We have seen that, of foremost concern in investors minds, are the realities of ageing populations and disruptive technologies. Adding these factors together created both an uncertain and subdued investment outlook. Locally in South Africa, economic fundamentals have been generally poor and political risk was high. Within this narrative and context, the ideal investment for South African investors was said to be in a defensive company with competitive advantages; an offshore revenue stream; stable earnings and dividends; a solid and rated management team and favoured by structural tailwinds or an earnings catalyst. The single word to describe these types of companies: QUALITY. As shown in the table below, all three of the above shares fitted this criterion. Table 2: Defensive revenue? Offshore revenue stream? Mediclinic 1 Yes Yes Aspen Yes Yes Woolworths Yes Yes Structural tailwind Ageing population in Europe Lifestyle diseases in Middle East Ageing population in Europe Growing middle class in Eastern Europe Growing middle class in South Africa Earnings catalyst Acquisition of hospital group in UAE Listing in London Turnaround of acquired European businesses Turnaround of acquired Australian business Source: Perpetua research and company reports Page 2

3 As the economic outlook grew gloomier by the day, investors were drawn into a this time is different narrative. Bond yields appeared to have lost a lower limit and there were no catalysts in sight for an economic recovery. In the consensus viewpoint, there was clear justification for higher valuation multiples for defensive, high quality businesses as well as businesses promising high earnings growth. Rising share prices seemed to confirm the consensus prevailing investment thesis; essentially it was useless trying to fight the Fed. The market began to fall even deeper in love with these companies, giving them the full benefit of their tailwinds, earnings momentum and earnings catalysts. They, along with many counterparts both domestically and globally, all displaying similar attributes, became priced for perfection through Graph 1 below depicts as a proxy for this outcome showing an index of Defensives + Growth Sectors vs Cyclicals. Graph 1: What caused the price declines in 2016? However, this consensus investment thesis began to unravel on a case-by-case basis during Many of the companies missed earnings expectations, at times only marginally. Some of these reasons were out of the control of company management and could be attributed to unfavourable exchange rate movements or regulatory intervention. Page 3

4 At the same time, the global economy began to show signs of a possible recovery. Cyclical companies which had been priced for extinction in some cases, began to rally and the investment theme of the day became a rotation into cyclicals. (Graph 1 again depicts this). From what appeared to be a fundamentally oversold level, the rand rallied versus most currencies and the price-earnings multiples of defensive, high quality rand-hedge companies fell. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The pendulum had begun its swing. Jason Zweig Some lessons from these examples 1. Be wary of herd thinking One of the most well-known concepts of investing is to invest when others are fearful and stay away when others are greedy. While this sounds simple in theory, practice has shown that this is also one of the hardest rules to follow. As news, themes and market movements confirm the prevailing thesis, it is very difficult to have conviction to act in the opposite direction. Furthermore, investing in quality companies might always seem the most common sense (and low career risk ) thing to do. However, when the herd changes its mind in a seemingly collective manner, prices can fall sharply and quickly. 2. Focus on the price you pay As we see illustrated once again in these examples, the rule ultimately in investing is to always focus on the price you pay. As society, we apply this fundamental principle to almost every other purchase we make in our lives (property, cars, appliances, clothes etc.), but ironically in investing, with our investor hats on, often society can evidently behave quite differently. As investors we have no control over the direction of interest rates; the cost of debt; the level of political risk or the outlook for economic growth. What we can control, however, is the investments we buy and sell; the price we pay for them and why (i.e. the assumptions made). An investor s future rate of return is determined by the price paid for the investment. High quality assets can be risky, and low quality assets can be safe. It s just a matter of the price paid for them. Howard Marks, The Most Important Thing Page 4

5 3. Invest with a margin of safety Another well-espoused investment rule is to allow for a margin of safety or room for error in expectations and assumptions. This has strong links to the above lesson. When the prevailing view is positive for a given investment, it is difficult to be objective in projecting earnings and one way of mitigating against this, apart from doing one s own work in determining intrinsic value for a company, is to reverse this question and analyse what expectations are implied by the share price. This makes it easier to assess the reasonability of the market s assumptions and whether there is a sufficient margin of safety priced in, especially if assumptions seem stretched on a normalised view. When others are fearful When fundamentally good quality businesses go through sharp price corrections as we have seen in these examples, they should ironically become more interesting to investors and not the opposite. Yet, disillusioned by these short-term results and also swayed by the prevailing investment theme of the day, the market now appears to be pricing in much lower future expectations for these businesses and in so doing, erring in a way to the other extreme of their behaviour just 18 months ago. This is evident from their respective PE multiples outlined in table 3 below (versus those in table 1). Table 3: PE ratio 1 Mediclinic 15.0 Aspen 19.0 Woolworths 15.4 Source: Bloomberg 1 Based on normalised historical earnings These multiples have now become more reasonable for these businesses whose core fundamentals have not changed materially. In addition, investors are now not being asked to pay for many of the earnings catalysts historically linked to them and these have become optionality factors. When investors in general are too risk-tolerant, security prices can embody more risk than they do return. When investors are too risk-adverse, prices can offer more return than risk. Howard Marks, The Most Important Thing Page 5

6 Glacier Research would like to thank Delphine Govender and Mahomed Ibrahim for their contribution to this week s Funds on Friday. Delphine Govender, CA (SA), CFA Delphine has over 21 years financial services experience of which the past 18 years have been spent directly in investment management. Delphine co-founded Perpetua in 2012 after having spent almost 11 years at Allan Gray Limited, where she held positions of Portfolio Manager and Executive Director. She is a qualified CA (SA) and a CFA Charterholder. Delphine is Perpetua s Chief Investment Officer and accordingly has portfolio management responsibilities over all asset classes. Mahomed Ibrahim, BBusSci, Hons (Finance & Actuarial Science), CFA Mahomed has over seven years financial services experience. He gained over five years investment consulting experience at NMG Employee Benefits where he was an actuarial consultant. Thereafter he joined Perpetua as an analyst in July Mahomed has a B Bus Science from UCT with an honours degree in Finance & Actuarial Science. He is also a CFA Charterholder. At Perpetua, Mahomed responsible for equity analysis, as well as input into equity portfolio decisions. Page 6