Learn from the past, pick good shares and focus on value
President Zuma’s 8 January speech and Value Investing
By most accounts president Zuma’s speech was disappointing (surely that’s not possible when everybody had low expectations?). The most disappointing aspect however was the message that in 2017 the ANC want to use the “full levers of state power to transform the economy”. Transformation above growth and job creation. Worst: no mention of using the private sector (even as partners) to generate growth and jobs.
The emotional reaction is: “Another year of dismal growth, corruption, in-fighting and no progress. Sell South African shares”. And global markets aren’t easier: A Trump presidency with lots of uncertainties, negotiations about Brexit to start, a number of potential landscape changing elections in Europe and a Chinese economy that’s bleeding foreign reserves fast. Sell global equities as well?
Learning from the past
I always use the first two weeks of January to look back at the previous year(s) with the objective of learning from mistakes made. In writing the 2016 review for the Nedgroup Investment Financial Fund, managed by Denker Capital, something struck me.
Look at the figure below and see if you can also spot it.
Figure 1: Nedgroup Investment Financial Fund vs ALSI
Source: Denker Capital, Morningstar®
2016 was as eventful as 2017 promises to be (Brexit, Trump, etc.) and in South Africa things just seemed to go from bad to worse. But on 1 January 2016 (after South Africa had 3 finance ministers in 4 days in December 2015) nobody would have said:
- The rand will appreciate 13% against the US dollar (and 26% against the pound)
- The JSE Fini will outperform the Alsi
- No, the consensus was: Global markets are expensive, the rand will fall, SA will get downgraded to junk status, the consumer will be under pressure and bad debts will jump.
Yet, the Nedgroup Investments Financial Fund generated a return of 13% outperforming the Alsi by 10%. How? By focusing on valuations. Shares like Coronation, JSE, Standard Bank, Firstrand, Absa and Nedgroup generated a returns of over 20% (including dividends received). Why? Figure 2 gives the answer.
Figure 2: Value investing: despite a tough, uncertain and deteriorating environment, SA banks re-rated in 2016
Source: Denker Capital, company financials
The SA banks (Firstrand being the exception) were undervalued on 31 December 2015! And this is the mistake investors continuously make: Paying too much attention to the headlines and not enough to valuations. During the vacation I read Brandes on Value written by veteran value investor and founder of Brandes Investment Partners: Charles Brandes. Figure 2 could come straight from his book: Investing in good companies when they trade below historic valuations over time generates good results.
The lesson is not: Ignore the macro and simply invest in the cheapest shares.
The lesson is:
- bad news headlines are often already priced in by the time the average investor reads them,
- good companies can and do overcome bad environments (obviously they’ll do even better in good environments!), and
- don’t let your emotions play a role when good companies are trading at discounts to historical valuations.
Michel Pireu’s articles on 10 January 2017 were brilliant:
Business Day: “Top market lessons from 2016” & “Street Dogs”
- “..most investors are attracted to the strategy that takes advantage of seemingly certain themes and narratives, whilst the most beneficial strategies are likely to be those that prepare people for what they don’t already know (Cullen Roche of Pragmatic Capitalism)
- i.e. emotionally it feels safe to go with what everyone knows but the value lies in negative expectations – don’t pay for what others expect to happen.
- “the day to day events that dominate investment news are like waves crashing onto the beach; unique, absorbing and ultimately inconsequential”
- i.e. use the pricing inefficiencies created from investors’ over-emphasis of the short-term.
Don’t ignore current events but focus on the tide, not the waves…
Per Brandes value investing however is more than simply buying mispriced assets and being a “revert-to-mean” contrarian. Good value managers have a process that searches systematically and unemotionally for mispriced gems. To uncover quality companies overlooked and mispriced due to sentiment.
The Nedgroup Investments Financial Fund’s performance was based on such gems that were mispriced in January 2016: Coronation, JSE and the banks had been sold down due to negativity and misunderstanding about their earnings power.
In the Sanlam Global Financial Fund and SIM Global Emerging Markets Fund (both managed by Denker Capital) we had a few gems like that as well, the most noteworthy was Tinkoff Credit Systems.
Figure 3: Tinkoff Credit Systems (TCS)
Source: Denker Capital, company financials
The market sold TCS down aggressively in 2015 due to headline macro fears about the effect the combination of lower oil prices and sanctions could have on the Russian economy and bad debts in the consumer sector. When the oil price went below $40 investors panicked and ignored the fact that the valuation already reflected the low oil price and poor earnings expectations. In January 2016 TCS was screaming: “Buy”, not “Sell”. Result: The share price gained 247% in 2016.
Our process highlighted and allowed us to benefit from a few other such mispriced gems: TBC (Georgia), Yes Bank (India), Credicorp (Peru), Sparebanken Nord in Norway, etc.
Exactly as Brandes says, it’s when the dumb money exits and puts pressure on the share prices that the intelligent investor can invest with a high degree of certainty. 2015 and 2016 witnessed significant outflows from value funds globally and in South Africa. The Sanlam Investment Management Value Fund (managed by Denker Capital) beat the Alsi by 6% in 2016 after it had large outflows during the year. This always happens at the bottom of a cycle. The largest outflows from the Sanlam Global Financial Fund were in February 2009 and February 2016! Yet from February 2016 to December 2016 the fund generated a return of 47% in US$.
2017: Value investing, stock picking, circle of competence
Two spring tides will affect markets in 2017 (and for a few years thereafter)
The reflation tide:
The reflation tide has just started. This tide will bring stronger growth and higher interest rates globally. This tide started before Trump got elected, but as with the “reverse excessive regulation tide”, his presidency will act like a full moon, giving the tides more power. Financials globally will be major beneficiaries of this tide (we’ve written quite a bit about this – check our website).
The value tide:
RMB Morgan Stanley’s sales commentary on 10 Jan 2017 says: “The average value rally over last 40 years has lasted 24 months with 27% outperformance. The current ‘value’ rally is just 6 months old and has to date only outperformed 8%.”
2017 will be tumultuous. But we’ve been hard at work identifying companies with excellent track records that are currently mispriced. Operationally they’ll do well in any case, but the reflation tide will be a boost and the low valuations mean that the probability is high that they’ll surprise positively in 2017.
A few extra notes:
- Benjamin Graham: “To achieve satisfactory investment results is easier than most people realise. To achieve superior results is harder than it looks.”
- Both the Sanlam Global Financial and SIM Global Emerging Markets Funds are first in the world since inception and respectively 2nd and 5th in 2016 generating a returns of 20% and 31% (in US$) respectively.
- The SIM Value fund (managed by Denker Capital) is 5th since inception with a compound return of 19%
- RMB Morgan Stanley’s graph below highlights how emotional short-sighted investors have sold down value. (Source: RMB Morgan Stanley, 3D look at the market, 10 Jan 2017, Ian Doyle, MSCI)
Figure 4: MSCI Global Value vs MSCI Global Growth
Source: RMB Morgan Stanley