In tough, volatile economic times, why do equity markets offer an attractive option for investors? For the past five years the global macroeconomic environment has been characterised by low economic growth, low inflation and low interest rates. Analysts put emphasis on the current information and extrapolate this into the future, and the result is large discrepancies in valuations of shares. So how do investors seek out mispriced quality? The PSG Asset Management team consistently applies a process that sees them identify that mispriced quality, buy with a margin of safety and take a long term view on the markets. As the market pitches opportunities to buy mispriced value, the PSG team is ready to exploit the situation, identifying a diversified spread of high quality names that offer yields at a healthy premium to anticipated long term levels of inflation. David O’Sullivan spoke to Greg Hopkins, the Chief Investment Officer at PSG Asset Management about the equity markets, the economic outlook for South Africa, and the successful methodology used by the PSG Asset Management team. – David O’Sullivan
Greg, well thanks very much for your time, Co-fund Manager of the PSG Equity Fund, let’s start by talking about equity markets?
The equity markets are effectively a list of exchanges, so this is where shares are bought and sold and they represent holdings in underlying businesses and these are companies that you will be familiar with and sometimes companies that you’re not, there is a broad range of companies listed on the South African Stock Exchange, over 300 and then many thousands on global stock exchanges.
When you’re buying a piece of paper which is a share certificate and it’s a share traded on an exchange, you’re actually buying an underlying piece of the business, so you become a business owner, which is very, very exciting about the equity markets, you can sit in your office or you can be in the gym or what have you, but you own a piece of the business and the company that you have a shareholding in, they’re effectively working for you. If you view it that way, the rest of the discussions that we have will become quite simple.
Why is the equity market a good place to be as opposed to any other market, why not go into the bond market, for example?
Well, there are actually good opportunities in all the markets that we invest in, so bond markets, particularly in South Africa at the moment and equity markets, but over the long-term, anecdotal evidence has shown that equities have outperformed. They are seen as more risky and there’s a view that if things are more risky you need to actually get a higher return, but over time equity markets do compound, which means that they do grow at a faster rate than the other markets. That creates an opportunity for long-term investors. If you pick the right companies, companies that will grow over the long-term, you will be able to create more wealth if you’re investing in the equity markets.
How do you pick these companies? I’m going to rely on you to do it for me by investing in your fund, but how do you do that, how do you exploit the equity market?
Well, there are a number of investors, or a number of people in the world who are looking at investing in the stock market, so the markets are generally regarded as quite efficient, which means that they normally, a lot of the information that is seen in the newspapers is generally priced in quite quickly, but we at PSG Asset Management have a very simple process that we follow to try and get the odds in our favour to be able to outperform the general markets so we can actually create more wealth for our investors than if you were just to buy the average index. Our process is a very simple one. We call it our “three Ms”, so we’re looking for businesses with a very strong moat. If you go back to medieval times, a moat was a wall of water around a castle to protect that castle.
What we’re looking for is businesses that have some sort of competitive advantage, some sort of barrier around them which actually protects them from competition. Then we’re looking for a big castle that is protected by that moat. And then we’re looking for a good management team. So we’re looking for a good King or a Prince in that castle who would be ethical, honest and transparent, and who has a proven track record. Then lastly and most importantly we want to be buying the companies, the shares with a bigger discount between what we think they’re worth and what we’re paying, which we call a margin of safety.
If you get all of those right you can pick long-term winners. But the process that we follow, you’ve got to take a long-term approach and I think that’s very important for any people who are investing in the stock market, you need to take a long-term approach because these types of processes don’t typically work over the short-term, but over the long-term they’ve actually been proven to generate very good long-term wealth for investors.
You’re acquiring a lot of solid information, a lot of data from the companies themselves? If they’re not being transparent, that is surely going to be a huge problem in your decision-making.
It does vary from market to market. In South Africa our corporate governance, the way that companies report and the collection and distillation, and the reporting of information is actually very good (it’s actually as good as anywhere else in the world). Many people globally would be surprised when they look at our reporting standards, our accounting standards, our accounting profession, they’d be surprised in terms of how good we actually are, and so it’s a big advantage investing in South African companies.
If you go across to the developed world, there are accounting standards which many companies follow, which unifies the way that they actually report and makes it a lot easier, but there are some markets where there is not a lot of transparency, markets such as China and some of the other emerging markets, which makes it much more challenging and as a prudent investor, we often are much more reluctant to invest in companies where we can’t discharge that transparency angle of what we’re trying to look for.
How important are the prevailing economic conditions in the country in which the company is operating?
It’s quite strange, that it’s actually almost the opposite of what people expect. We would be more excited when the outlook in the economy or for the political situation is negative. It’s when opportunities arise when people are fearful and uncertain. If you go back, so for instance, I’ll give you an example, last year in January and in the year before in December, so in December 2015 and January 2016 there was a lot of fear and uncertainty in South Africa.
The outlook of the economy was very uncertain and we had a lot of fear around the political situation when our finance minister was replaced, but that created a lot of opportunities for the long-term investor because the market sold off and often investors panic. The markets, as I said earlier are very efficient, so they often reflect all the known information, but they often overreact on the downside when people are fearful and uncertain. So when there’s uncertainty, when there’s fear about the economy, that’s often the best chance to be picking up mispriced securities and that was certainly the case last year in January when there were some significant opportunities to invest within South Africa.
Given that we’ve just had the State of the Nation Address, has that had any impact on the equity markets, or is it still early days?
It hasn’t actually had much impact on the equity markets and I think everyone’s watching with interest in terms of how the political situation in South Africa will evolve, but it’s not different from the rest of the world. There’s an unclear political situation in the UK, there’s an unclear political situation in Europe, there’s an unclear political situation in the US, so we’re not unique, but the way that we see it is that if our government and our politicians actually do very little, i.e. they don’t intervene in the economy over the course of the next six to 12 months, there is a chance that our economy might actually pick up, so it’s quite obtuse.
If you’re not hearing much from the State of the Nation or not reacting to the address could in a way be a good thing because it could mean that our politicians will actually just let the economy pick up on its own and that normally takes place if the global economy picks up, the South African economy normally follows and we’re starting to see the signs of it. The global economy is picking up, so there is a chance that the South African economy could be higher than it is now, or better than it is now all things being equal, but one of the big ifs is that we can’t have our presidency and our cabinet reshuffle, which will gain confidence.
There are so many rumours that a cabinet reshuffle is imminent, that Brian Molefe, having been sworn in as a parliamentarian, is being groomed to take over as the Finance Minister. These are still rumours, and President Jacob Zuma has batted away any suggestion that this might take place. Nevertheless, it surely is of some concern and it is something that you at PSG Asset Management will be keeping an eye on, won’t you?
Absolutely, it’s one of the risks when we look at our dashboard over the next year or two, it’s one of the risks that have been flagged, but we need to say that this is very much top of everyone’s mind and it’s a very well-published or well-known risk and the markets are often quite efficient at discounting these known risks. We won’t say that it’s in the price of securities, but there is a chance that some of the fear around the cabinet reshuffle has been priced into the markets.
If it does materialise it might not have as big an impact as some people in the market might expect because some of that might be already in the price, but it’s something that we obviously watch with interest and it’s something that we plan for in our portfolios. In the portfolios that we have; equities, bonds and cash, we have quite high cash levels at the moment and if the markets do sell off on the back of some sort of government intervention, we will assess those facts and if the opportunities arise, we will be deploying cash.
Greg, some of the leading indicators of global growth have started to recover, we’ve begun to witness a significant rotation in the market, explain that to me.
If you look back over the last five years, the global world has been characterised by some very simple conditions. Growth has been very low after the great financial crisis. As a result, inflation has been very low, so in an environment of high growth there’s often high inflation, so there’s been low growth and low inflation. As a result interest rates, central banking interest rates and interest rates in the world on the money that we borrow and the money that we pay, has been quite low and that has driven a certain type of thinking and the market has become very used to that.
Therefore, the market has demanded certain types of companies, they’re preferred in a world of scarce growth, the markets have tried to find companies that will grow faster than the market, where there’s some certainty of growth and in South Africa that has meant some of these blue chip bond-like quality companies, companies like SA Breweries, Naspers, British American Tobacco, and Aspen and the prices of these securities have been driven to very high levels. On the other side of the coin, companies, because they are more sensitive to the global growth environment and local growth environment, these are called ‘cyclical shares’, they’re more geared to economic growth and they’re being shunned.
The markets haven’t wanted to buy these because there has been a very strong prevailing view that the growth is never going to pick up. We’re starting to challenge that thinking and when that thinking gets challenged you see this rotation taking place on the more expensive shares, those are the bond, blue chip shares into the more cheaper shares. The rotation started in January last year and it’s continued in earnest. It just seems that the market is quite poorly positioned because when we look at our peer groups and portfolios and I think a lot of investors are positioned to be buying these blue chip, Rand hedge-like shares and we think of those shares as overvalued and at the moment there seems to be a rotation into the cheaper cyclical shares in the market.
How do you identify mispriced value, what are the factors you take into consideration?
We’ll go back into what we call our ‘three Ms’, moats, management and margin of safety, what we’re trying to find in any security, any company we look at, we’re trying to assess the quality of that company and if we use our moats and the management, we’re looking for good business models and good management teams, but what we’re trying to do is assess a quality and we’re really trying to define mispriced quality, when the market has missed some part of a business that we think should be valued higher than it is.
Then we use our valuation techniques to try and work that out and we buy it at a discount to what we think the intrinsic value is, the value for that security. When the markets are fearful and uncertain, you get the bigger chance of finding that mispriced quality, where quality actually goes on sale. If you can buy above average quality companies at below average prices, because they’re out of favour at the time, you set yourselves up for a very good long-term return from those types of companies.
You have to spot something that nobody else has spotted, you’re relying on some very sharp people, and I believe that your sharp people have been recognised for their abilities. You’ve won a number of awards Greg, tell me about that.
We have. Over the long-term we’ve generated very satisfactory returns for our clients. Our equity fund is actually in the top three in its category since inception of the equity fund back in 2002 and we recently won a few Raging Bull Awards. We celebrate less the Raging Bull Awards or all the awards because I guess they’re just more of an outcome of our process. What we’re really trying to do is focus more on our process and what we’re trying to do the whole time is get the odds in our favour. We have a team that’s been working together for many years, we have good opportunities in the markets. We’re actually investing in global markets, so we’ve been investing in global shares since 2006. We’ve been buying foreign shares and when you combine them all together, I think we have a good chance of getting into the right areas and getting the odds in our favour.
Greg, are there any risk factors that should be taken into consideration?
Yes, you did touch earlier, in terms of political risks, but I think there’s this jump, you know, the broad landscape characterised by, you know we’ve been almost eight years into our bull market, so in many parts of the market share prices (and globally share prices are at very high levels). There has to be caution about the overall levels of markets. There are opportunities within the markets, but there are certain parts of the market that we think are overvalued, so we are finding fewer opportunities now that new were maybe three or four years ago and that’s why we’ve had higher cash levels. Therefore, the outlook is still good for certain parts of the market, but there are certain parts of the market one should be avoiding where there are potentially overpriced equities and bonds when we’re talking about the global environment.