Quarterly Strategy Note September 2013

Transcription

1 Quarterly Strategy Note September 213 Neil Brown & Richard Hasson Boutique Co-Heads Total Returns to end of August month 3-month 6-month 1-year 3-year p.a. 5-year p.a. JSE SWIX (J43) 2.% 1.2% 7.4% 2.1% 19.5% 13.3% JSE All Share (J23) 2.6% 1.% 8.1% 22.8% 19.2% 12.% JSE Resources (J258) 7.5% 1.4%.8% 1.4% 5.6% -.6% JSE Financial (J58) 1.4% 1.8% 15.1% 33.6% 29.4% 22.1% JSE Industrial (J257) -.9% -1.9% 2.% 15.5% 18.8% 14.9% USA S&P (ZAR).4% 2.5% 24.4% 44.2% 32.1% 13.5% Economic Indicators 31-Aug May Feb Aug Aug-1 31-Aug-8 R/$ Prime Interest Rate 8.5% 8.5% 8.5% 8.5% 1.% 15.5% Sources: Deutsche Bank and Morningstar The JSE Mid & Small cap sectors, being the listed shares ranked 41 to 16 by market capitalisation, are key sectors in the South African (SA) equity market. Research has shown that investing successfully in these sectors is a critical factor for delivering excellent absolute and relative returns against the broader SA equity market. At ELECTUS, we know that we are extremely well positioned to deliver excellent returns for our clients across all our SA-based products due to our competitive advantages in the Mid & Small cap sectors. The key competitive advantages within ELECTUS in the Mid & Small cap sectors are as follows: ELECTUS assets under management are around R3 billion which, from a size and capacity perspective, enables us to invest widely across the Mid & Small cap sectors when opportunities arise. When teams manage more than R6 billion of SA equity, market liquidity severely constrains their ability to buy meaningful portfolio weightings in their preferred Mid & Small cap shares. ELECTUS has an investment team of 12 analysts and fund managers, which is large enough to enable us to both use our excellent corporate access and opportunistically target our equity research towards any of the 16 JSE shares. ELECTUS is structured so that whenever we choose to target selected Mid & Small cap shares for our proprietary research, we have excellent skills to do our research and to invest in our best ideas. ELECTUS is unique in the SA asset management industry in that it has three members of the team, namely Warren Jervis, Richard Hasson and Neil Brown, who each have more than seven years of dedicated and focused Mid & Small cap equity research and fund management experience, with superb excess return generating track records. This combined Mid & Small cap sector experience of 24 years is a huge competitive advantage in a very under-researched component of the SA equity market. Proprietary equity research is critical in the Mid & Small cap sectors, as the stockbroking analysts hardly provide any research on these sectors, due to the fact that most foreign fund managers and many SA fund manager teams are far too big to be able to access the necessary market liquidity. ELECTUS has an integrated investment team, enabling clients to invest into our Multi-Cap or Mid & Small cap portfolios, or any preferred combination of the two product offerings. Since we became an integrated investment team in ELECTUS in early 212, this has already proven with clients to be a key strength and industry differentiator. In this Strategy Note, Warren Jervis explains why it is so important to hold Mid & Small cap stocks in an equity portfolio. Many investors shy away from this area of the market, but the excess growth potential in these stocks cannot be ignored and can be successfully unlocked by fund managers with the right experience. Warren manages over R3 billion in Mid & Small cap portfolios, including a top performing unit trust. Old Mutual Small Companies Fund ranks in the top quartile of the South African - Equity - Mid- & Small cap category for the year to end of June 213. Going big on mid & small caps Insights by Warren Jervis Chart 1: Mid cap, Small cap and Top 4 indices since 1996 Since 1996 Mid & Small companies have generated between 1.21% 2.4% of alpha over the large cap stocks (FTSE/JSE Top 4 Index), and the power of compounding this alpha over 17 years is astounding. This makes this area of the market hugely important for the investment of long-term assets. In fact, many well-respected investors have established their reputations in this area of the market. 9 Mid Caps (J21) Small Caps (J22) FTSE/JSE Top 4 (J2) Not only is this alpha generation true in South Africa, but it also applies to international markets. I have seen studies in the UK and the US where the alpha generation out of the Mid & Small cap areas over the last 1 years has been in the region of 1.5% to 2.5% of excess returns over large caps per annum

2 Stock picking All funds, in my opinion, should have constant exposure to this area of the market to reap the benefits of this compounding effect of excess alpha over time. However, this is a stock picker s area of the market and your portfolio manager must be well experienced in understanding diverse business models and diverse business drivers. Imagine the potential returns of calling some of these shares correctly and going along for the ride. Capitec and Mr Price have both been hugely rewarding for shareholders over long periods of time. Chart 2: Capitec and Mr Price share prices Mr Price Group Limited Capitec Bank Alpha generation The average performances for the three sectors are the Top 4 at 17.4%, the mid-caps at 19.45% and the small caps at 18.25%. Mid-caps have outperformed the Top 4 by an average of 2.4% per annum and the small caps have outperformed the Top 4 by an average of 1.21% per annum. Chart 3: The 17-year returns for the Top 4, Mid-caps and Small caps Top 4 Mid Cap Small Cap % 15.78% 9.27% % -6.32% -.9% % 1.%.79% % 47.53% 18.58% % -27.4% % % 21.39% 14.38% % 21.98% 9.81% % 33.57% 49.61% % 35.55% 55.72% % 4.12% 47.88% % 43.9% 44.12% % 17.63% 33.99% % -18.7% -31.2% % 35.72% 28.28% % 3.27% 24.65% % 4.7% 1.1% % 25.7% 23.6% Total % 33.6% 31.23% Average 17.4% 19.45% 18.25% < Top 4 n/a 2.4% 1.21% 5-year average 1.1% 15.54% 9.29% Std Deviation 25% 21% 24% Maximum 79.17% 47.53% 55.72% Minimum % -27.4% -31.2% Median 17.22% 21.98% 18.58% Return/Risk Unit 67.2% 91.% 75.5% Return per unit of risk The level of return per unit of risk (as measured by the standard deviation) has also been superior. Looking at the average return divided by the standard deviation gives return per unit of risk figures of 67.2% for the Top 4, 91.% for the mid-caps and 75.5% for the small caps (i.e. a higher return in Mid & Small caps per unit of risk). This is not a definitive risk answer, but does help in understanding whether mid- and small cap shares are too risky for investors... or not. One of the key definitions of risk management, for me as a portfolio manager, is about protecting the client s capital. There are many types of risks out there and, at all times, a portfolio manager needs to consider an appropriate risk/return trade-off when making investment decisions. It never ceases to amaze me when I look at some of the money that is wiped off mining companies balance sheets at the stroke of a pen. Recently, we saw Lonmin write off US$62 million (R5.8 billion) on the Akanani exploration asset and Amplats wrote off R4.9 billion in impairments and restructuring costs. Both these amounts are way in excess of some of the market caps of the stocks I am invested in. The Lonmin and Amplats write-offs are 2.8 times and 2.3 times, respectively, the market cap of Bell equipment, as an example. Resource stocks can clearly write-off large amounts, but Mid & Small caps can also either go bust or require further capital injections from shareholders. Avoiding these calamities is a key aspect of Mid & Small cap investing and the decline in the African Bank share price recently, post a poor trading update, proves how quickly share prices can decline. The compounding of returns When looking at the compounding of superior returns over a longer time period we did the following simple exercise. Simplistically, investing R1 million into each of the three segments over 17 years would yield a 51.7% better result in the mid-caps and an 18.9% better result in the small caps sectors over the Top 4 sector. This is a significant difference generated by better annual results compounding over a 17-year period. Chart 4: The power of compounding Top 4 Mid Cap Small Cap R R1 157 R R R R R R R R R R R R R R R R R R R R R R R R R R R4 77 R R R R R R R R R R R R R R R R R R R R R R Difference R R Difference 51.7% 18.9% 2

3 Why are Mid & Small caps such alpha generators over time? There are a host of reasons, but simplistically many of these companies are in the natural growth phase of their business cycle. It is perfectly understandable that they will grow earnings faster than the overall market in this growth phase, and this extra earnings growth should drive share prices. According to Neil Churchill and Virginia Lewis of the Harvard Business Review, there are five stages of small business growth: Stage 1: Existence. In this stage it is all about product capability and selling to customers, and developing an effective business plan. Stage 2: Survival. In the survival stage the business is a workable business entity that now needs to generate enough cash to enable it to break even. Stage 3: Success. Now the business is doing well and it is then the right time to expand and grow. Stage 4: Take-off. In this stage of take-off the decisions revolve around growth and how the business funds that growth. Stage 5: Resource maturity. Here the company needs to consolidate and control the financial gains brought about by growth. Businesses in this stage now have the advantages of size, management, systems and financial resources to be a continuing success. Smaller businesses also acquire other smaller players relatively cheaply, which can be earnings accretive. Many businesses have used this acquisitive strategy successfully in the past to drive earnings. These businesses could also buy out assets from larger businesses that have been neglecting those assets, and then turn them around. Afrimat s acquisition of the Glen Douglas metallurgical dolomite mine from Exxaro Resources, a large mining house, in May 21 is a good example. The asset was too small in Exxaro s life to warrant any serious management attention and Afrimat secured the business at a price of R35 million. The mine reserves were for 3-4 years and the equipment on the mine was very good. Post some cost cutting and restructuring of the operations, the 213 return on the initial capital is approximately 8% and it is contributing handsomely to Afrimat s earnings. Chart 6: Afrimat share price The key to Mid & Small cap investing is to invest in these businesses early, before the rapid earnings growth and before the market has rerated the business as a result of these superior earnings numbers. Acquisitions Mid & Small cap businesses can also grow more easily through meaningful acquisitions, provided that they are well capitalised or have access to capital in the markets. Certain listed small cap stocks have the size and flexibility to change tack rapidly and change the overall structure of the company through these acquisitions. Consolidated Infrastructure Limited (CIL) is just such a company. CIL (previously Buildworks) bought 1% of Consolidated Power Projects (Conco), a power substation developer, in February 29 for an amount of R497.5 million. The acquisition was an absolute game changer for their business. What used to be a building supplies business suddenly transformed into one of the market-leading substation builders on the African continent. The need for power infrastructure in South Africa, and also in Africa, has been the macro economic backdrop that this business really needed to show some very strong growth. Almost overnight the acquisition of Conco enabled the CIL business to derive 86% of their revenue and 74% of the group profits from the establishment of electrical infrastructure. Chart 5: Consolidated Infrastructure Group (CIL) share price Bidvest is a well-respected South African industrial company that has been exceptionally well run and made some very smart acquisitions in the past. But now the business has revenues of over R153 billion and a market capitalisation of over R8 billion. Now that it is a much larger company, it needs larger and larger acquisitions to move the needle. This business drove solid revenue growth in through organic growth and acquisitions, but as chart 7 shows, the top line growth of +2% is not sustainable unless larger and larger businesses are acquired. These businesses are not that easy to find and generally they are well-known and very well priced. Chart 7: Bidvest s revenue growth percentage and trading margins 3% 25% 2% Turnover Growth Trading Margin % 1% 5% % % Sources: Company Financials, ELECTUS Management teams Executive management is very important in smaller businesses and, in general, they are very well run companies. Excellent key management can make a massive difference to the performance of a Mid & Small 3

4 cap share and most of these executives are well incentivised and have a decent equity stake in the business. They are aligned with shareholders and strive to generate better returns on capital with an appropriate level of risk. They can make or break the business and it is an area we spend a lot of time trying to understand: How do they allocate capital, do they have a stake in the business, how are they incentivised, what has their track record been like, and what is their current strategy for the business? Good management is very important in all companies, but particularly in Mid & Small caps where two or three individuals can be critical to the business success. It is vital that these individuals are retained in the business. Experience counts Specialist Mid & Small cap fund managers with good long-term track records have become reasonably rare. There are many good investors out there, but most Mid & Small cap fund managers naturally tend to move to the general equity category, and end up investing in the more liquid large cap companies. Many of these managers understand the value of investing in smaller companies and will always have a few key positions in Mid & Small caps stocks. Those fund managers that do not originally come from the Mid & Small cap area can have a fair degree of mistrust for these companies. Their inexperience in this area leads to poor decision-making and responses such as they are too risky, they are too illiquid, I don t know them well enough, it s too small in the portfolio etc. Large stakes in excellent businesses have been sold out way too early, and way too cheaply, in the past by fund managers that have not been experienced enough to understand the value in the business. In the Mid & Small cap portfolio management space it is absolutely vital that your fund manager has a wealth of experience across many different areas of the market. The business models in the Mid & Small cap sector are very diverse and there are numerous diverse key business drivers to keep a good handle on. Excellent understanding of the business models, the stage of the business cycle, management s strategy, management s incentives, the balance sheet strength, cash flows and access to funding, are all vital aspects to consider when investing in this area. Chart 8: Old Mutual Small Companies Fund (Net) vs Peer Average September 29 - June % 3% 25% 2% 15% 1% 5% % -5% 3% 25% 2% 15% 1% 5% % -5% Old Mutual Small Companies Fund Peer Average 22.55% 22.51% 18.1% 18.6% 28.76% 19.38% 3.17% -.26% September 29* 3 Years 1 Year 3 Months * Since managed by Warren Jervis Chart 9: Institutional Mid & Small Cap Portfolio (Gross) November 26 - June 213 Institutional Mid & Small Cap Portfolio Benchmark: JSE SWIX All Share (excluding top 7) 12.9% 9.94% 22.24% 16.15% 27.16% 14.9% 3.88% Inception: Nov 26 3 Years 1 Year 3 Months -1.85% As explained above, in ELECTUS we have a wealth of experience in this Mid & Small cap area of the market with my colleagues Neil Brown and Richard Hasson also having analysed and managed superb alpha generating Mid & Small portfolios before, including the winning of unit trust sector performance awards. It is a key and permanent differentiator and competitive advantage for the ELECTUS boutique, enabling our clients to target and incorporate their desired Mid & Small cap exposure. All about the scoreboard Generating alpha for our clients is what we strive for, and doing this over a longer time period of time demonstrates a sustainable competitive advantage. We have achieved the following performance numbers in this vital area of the market, and will continue to strive for superior returns for our clients. 4

5 Portfolio Positioning Within the resources sector, we continue to have a bias towards the large diversified and high-quality mining companies, as they are typically low-cost producers with diversified income streams across various commodities and geographies. Anglo American is our preferred holding in our clients funds, while we have a smaller holding in the leading globally diversified mining company BHP Billiton. We also hold selected single-commodity shares, such as Lonmin and Sasol, which we believe have a competitive position in their respective industries. In the South African industrial sector, we have reduced exposure to a few of the domestic industrials, especially if they are not of a high quality. With the proceeds, we further increased exposure to selected high-quality and better-value rand-hedge industrial shares, such as British American Tobacco and Steinhoff, as well as increasing exposure to South African fixed-investment and construction-related companies. We have also purchased some great quality Mid & Small cap local industrial businesses that are trading at attractive valuations. Within financials, based on our company valuations, we retain our preference for selected banks and have taken profits in Old Mutual, following its excellent performance and it reaching our fair value. The Funds all have weighted price:earnings (P:E) ratios below their benchmarks, with good metrics for future earnings and dividends. We believe that the JSE is currently trading marginally below its fair value, with many defensive industrials being expensive and several resources and more-cyclical shares offering excellent value. Based on our proprietary equity research, the ELECTUS Funds have around 26% upside relative to their JSE benchmarks, leaving the widest margin of safety that we have seen for over three years. This 26% gap relative to the broader JSE market makes us very excited for the potential of future excess returns for our ELECTUS clients. 5

6 R1 initial investment Old Mutual Top Companies Fund vs Sector Average 31 July August 213* R23 65 R22 R21 Old Mutual Top Companies Fund South African - Equity - General 6 55 R2 5 R19 45 R18 4 R17 35 R16 3 R15 25 R14 2 R13 15 R12 1 R11 5 R1 R * Since managed by Neil Brown and Richard Hasson R1 initial investment R7 R65 R R55 R R45 R R35 R3 R25 R2 R15 R1 Old Mutual Growth Fund vs Sector Average 31 March August 213* Old Mutual Growth Fund South African - Equity - General R * Since managed by Richard Hasson Nedgroup Investments Growth Fund vs Sector Average 31 March August 213* Old Mutual High Yield Opportunity Fund vs Sector Average 3 September August 213* R9 R Nedgroup Investments Growth Fund South African - Equity - General # R2 R18 Old Mutual High Yield Opp A South African - Equity - General 25 2 R7 24 R1 initial investment R R R R R1 initial investment R16 R14 R12 R R2 4 R1 R8-5 R R * Since managed by Neil Brown # Due to ASISA sector reclassifications, general equity sector average is used from 1 January 213; prior to that it s the growth fund sector average. * Since managed by Feroz Basa Old Mutual Small Companies Fund vs Sector Average (SA - Equity - Mid-/Small Cap) 3 September August 213* Old Mutual Global Emerging Market Fund vs Fund Benchmark 31 August August 213* R22 R21 R2 Old Mutual Small Companies SA Equity Mid-/Small Cap R15 R14 Old Mutual Global Emerging Market Fund MSCI Emerging Markets NR Index (ZAR) 5 4 R19 9 R18 8 R13 3 R1 initial investment R17 R16 R15 R R1 initial investment R12 R R13 3 R1 R12 2 R11 1 R9-1 R1 R * Since managed by Warren Jervis R8-2 Aug-11 Nov-11 Feb-12 May-12 Aug-12 Nov-12 Feb-13 May-13 Aug-13 * Fund managed by Anwaar Wagner since its inception For more information on ELECTUS or to read previous editions of our Strategy Notes, visit Figures sourced from Morningstar, Old Mutual Investment Group and I-Net. Unit trusts are generally medium to long term investments. Past performance is no indication of future performance. Shorter term fluctuations can occur as your investment moves in line with the markets. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Unit trusts can engage in borrowing and scrip lending. The fund s TER reflects the percentage of the average Net Asset Value of the portfolio that was incurred as charges, levies and fees related to the management of the portfolio. A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The current TER cannot be regarded as an indication of future TERs. A schedule of fees, charges and maximum commissions is available from the Old Mutual Unit Trust Manager Ltd (OMUT). Specialist equity funds may hold a greater risk as exposure limits to a single security may be higher. A feeder fund is a portfolio that, apart from assets in liquid form, consists solely of participatory interests in a single portfolio of a collective investment scheme. A fund of funds unit trust invests only in other collective investment schemes, which may levy their own charges. Certain funds may be capped to be managed in accordance with their mandates. Different classes of units apply to these portfolios and are subject to different fees and charges. Old Mutual Ltd is a member of the Association for Savings & Investment SA. Old Mutual Investment Group (Pty) Limited is a licensed financial services provider, FSP 64, approved by the Registrar of Financial Services Providers ( to provide intermediary and advisory services in terms of the Financial Advisory and Intermediary Services Act 37 of 22. Old Mutual Investment Group is a wholly owned subsidiary of Old Mutual South Africa Limited. Reg No 1993/323/7. September 213 ELECTUS MUTUALPARK, JAN SMUTS DRIVE, PINELANDS 745 PO BOX 878, CAPE TOWN, SOUTH AFRICA TEL +27 () , FAX +27 ()