Generating long-term wealth by investing off-shore: the PSG solution

Are you an investor looking to generate long-term wealth? The PSG Global Flexible Sub-Fund is a unit trust fund based in Malta that might provide the solution. It’s denominated in US dollars and invests in equities, debt instruments and money market instruments on global markets. It aims to achieve equity-like returns at lower levels of risk. The fund invests in global companies which are identified using an award-winning, tried-and-tested methodology pioneered by PSG. David O’Sullivan spoke to Philipp Wörz, Fund Manager at PSG Asset Management about the Global Flexible Sub-Fund’s investment criteria, how mispriced quality in the market is identified and the benefits of investing off-shore.

This interview is brought to you by PSG. Philipp, what is the Global Flexible Sub-Fund?

Well, firstly if you take a step back, many people would be familiar with the PSG Flexible Fund, which is a South African-based unit trust. The PSG Global Flexible Sub-Fund is pretty much a mirror fund of that fund. It’s based in Malta, so it’s a global fund that invests into global investment opportunities. Ultimately, the mandates of the PSG Global Flexible Fund are flexible. This allows us to vary our equity exposure from anything from 0% in equities up to 100%. The real benefits of a global flexible fund is that when we find many high conviction investment opportunities that meet our investment criteria, we can ultimately be fully invested in the equities. When this isn’t the case, when we can’t find equities that satisfy our criteria, we’re able to patiently sit in cash and deploy those that cash when opportunities come up.

You talk about the three ‘M’ investment criteria, spell that out for me, Philipp.

The three ‘M’ investment criteria, just to remind people it’s the same globally as locally. Ultimately, we’re looking for companies that have a strong competitive advantage, which refers to a moat, so the first ‘M’. The second ‘M’ refers to investing in companies with strong, capable management teams and teams that are really aligned to shareholders, which in many cases are companies where the management team has a large exposure to the company and the last M, which refers to margin of safety, really speaks to wanting to find companies that are also trading at a cheap valuation.

You want to invest in what you call mispriced quality. Explain what you mean by that.

What we’re really looking for is buying above average quality at below average prices. The easiest way to explain this is by using an example. If you take a stock like Microsoft five years ago, which everyone hated back then, the fear was that new technologies and operating systems were going to kill the company. Five years ago when we bought Microsoft, it was trading at eight times earnings, which I think at that point the JSE, or the average South African Stock, would have been in the mid-teens and you had a company with, at that point, $25bn to $30bn of cash, margins of over 60% and a billion customers. The quality aspect has been there, but fears have allowed us to buy into the company at a mispriced valuation.

This refers to maybe, in today’s day, whether you’re looking at companies like Cisco, which we think is also a mispriced quality asset. Many people up to now continue to view the company as more of a hardware business. The quality angle really comes in, but firstly, because they are a leader in networking products, with the largest installed base and dominant market shares in their industry. Although, where the quality angle expands is that, they’ve been transitioning their business from hardware, more into services and software, but now 40% of their business comes from those types of revenue streams, with over 30% of the business recurring in the last quarter. Where the mispricing comes in, you can now buy this company (and we’ve held it for a number of years now), at a valuation of under 15 times earnings and a dividend yield of about 3.5%.

When do you spot that the market is missing something?

That’s always a good question and I think it’s important not to be arrogant, because firstly, there are many smart people globally. We’re not just talking down here in Cape Town, but also globally, looking at companies. Generally, we are of the view that the market is quite efficient in pricing in the latest available information, but if you could take a further step back and look who makes up the markets, ultimately, it’s people and those people, as you all know, from time to time act in irrational ways.

Firstly, I think that the best opportunity to look for opportunities is when there’s fear or uncertainty in the market. That’s one ‘requirement’ and that’s the biggest chance for mispricing. In terms of finding quality, we make use of obviously reading very widely and going to conferences, but also screening and looking at hard facts. We generally like to invest in companies that have had strong returns on equity over the long-term, but would have temporarily had a bad year or fallen out of favour for whatever reason and the ideal case would be if that reason is temporary.

This concept of fear and uncertainty in the markets, when does that happen?

I think last year would be an ideal case in point, events like Brexit. People obviously are uncertain what Brexit would mean to the UK economy or even a bit earlier last year, more South Africa related if you look at Nenegate, those kinds of events cause fear and uncertainty. We would actually embrace those kinds of opportunities because that allows us to acquire quality assets at cheaper entry points. Taking Brexit as an example, in the last six months myself and a colleague, we’ve each been to the UK once over the last six months to visit companies that are domestically focused as Brexit uncertainties have depressed valuations.

A further example would be, as I mentioned Microsoft earlier. There were fears around new technologies killing the business, or a couple of years ago our global bank holdings, which have been under pressure, or banks have been under pressure since the global financial crisis, low interest rates, many costs and legal expenses and that has led to valuations that have become depressed. Another example would be the resource market 12 months ago when everyone thought commodity companies were going out of business.

How would you characterise the mood in the markets right now? Is there a certain level of fear and uncertainty?

No if you had to generalise, if you look at markets they have been making all-time highs recently. So you really have to be quite circumspect where you look, so it really only refers to various pockets in the market. I talked about Brexit, about UK companies earlier, some emerging markets and even people are still sceptical on South African domestic companies due to political issues. Energy would be another area where there is quite a bit of fear in the market, but to characterise generally, people have become far more greedy recently and that’s reflected in valuations and in global markets.

It also speaks to our cash holdings in the PSG Global Flexible Fund, which has recently increased to 30%. If you look back 12 months ago when markets were extremely fearful in the early part of 2016, we had as little as 8% of the fund in cash, so the mood of the market has certainly improved, but that has led to valuations that have risen in many parts of the market.

Let’s talk about the way you collaborate with management teams. You said that you require them to be ethical, transparent, with proven track records of capital allocation. Take me through that process of acquiring the knowledge of the companies in the funds.

We really like management teams that have what we call ‘skin in the game’. That is, managers that have a large shareholding in the business because it makes it easier for us to trust them because we know that they’re going to act in their best interests, which also means they’re going to act in the best interest of other shareholders. One simple way that we look for that is to look at their personal shareholding in the company and how this has changed over time and secondly, many management teams, if you take a look at that, many companies obviously don’t have these kind of founder CEO’s who have a lot of money in the business. Therefore, if you’re looking at professional managers, many of these end up moving around in their career and they leave footprints at various companies.

Bruce Flatt

What we really do there is look at their capital allocation track records, we look at operational track records and then assess whether they are going to be capable of taking the company forward, things like remuneration plans and policies, we look at board members. It doesn’t really help as much if you have many high profile board members, but they’re just there to collect their cheques. The alignment part is the most important for us and when we find those companies that have a strong moat and are trading at cheap valuation, it enables us to have a lot more conviction when they actually tick the management box as well. The best example would be our biggest position in the fund, which is Brookfield Asset Management, where Bruce Flatt and his management team have around $7bn of exposure to the company; it just makes us feel more comfortable on those opportunities.

You’ve been investing offshore since 2006, what are the benefits of investing offshore as opposed to investing on the JSE?

You mentioned, since 2006, the first share that was bought as part of PSG Asset Management, was Berkshire Hathaway in 2006, so a long-standing holding. I don’t want to be too simple here, but firstly, South Africa is quite a small market in the global context and in South Africa we are constrained to a few hundred investable opportunities, but globally one has tens of thousands of opportunities. Secondly, in investing, people always talk about diversification.

It isn’t just from a risk perspective that one wants to diversify, but also globally we are able to access industries that aren’t available on the JSE, whether that’s in defence stocks or in certain technology companies, or Bio-Tech. Lastly, while South Africa has some amazing homegrown champions with the likes of Aspen or Naspers, Remgro, globally one has the extra benefit of having access to the world’s brightest managers that are working for our investors. An example would be, as I mentioned earlier, Brookfield Asset Management, or Berkshire Hathaway, which we’ve owned for a long time, or Microsoft, so it’s just more opportunities and in many cases, better opportunities.

PSG Asset Management has won a number of awards recently; does your offshore fund process follow that award-winning process?

Yes, firstly, we have one integrated global team. Awards are definitely a nice-to-have to be put on the wall, but the real focus is on generating strong risk-adjusted returns for our investors and as you say, we have the same global process as we do locally and as you alluded to earlier, we’ve been doing it for over ten years. So it’s the same as we did locally. There’s a lot of benefit to doing local and global, as it really allows you to compare and cross-compare with the industries and companies and pick the best ones.

We’ve been talking about the PSG Global Flexible Sub-Fund. Talk to me about the PSG Global Flexible Feeder Fund.

The PSG Global Flexible Feeder Fund, if you look at it simplistically, is actually a client of the PSG Global Flexible Sub-Fund. The Feeder Fund is a South African-based, Rand-denominated fund, where people can invest South African Rands locally into that fund and that fund then feeds into the PSG Global Flexible Fund. Therefore, people won’t have to take their offshore allowance out of the country and you can invest in South Africa directly, but underlying holdings are exactly the same as the PSG Global Flexible Fund.

What are the benefits of a unit trust versus share portfolios?

David, share portfolios do serve a useful purpose in people’s overall investment portfolio, in my view, but the key factor in favour of the unit trust is the tax advantage that the investor gets, which ultimately should be worth a lot of money for a long-term investor. If you look at how this works, it’s important to understand that when people invest in unit trusts, they do not pay capital gains tax when the unit trust sells shares or the company at a profit. Where people in their individual capacity have to pay income tax or capital gains tax on those profits, the unit trust allows them to compound those profits tax-free as long as they stay invested in the unit trust and they only pay the tax once they dispose of the underlying units. A few other advantages are lower transaction costs for institutional investors like us and access to a team of people whose full-time job it is to find good investments for the clients.

How would you characterise the opportunities offered currently by the global investment universe for long-term investors?

Opportunities for global investors are still good, so if you look at the PSG Global Flexible Fund, we have 70% of the fund in equities, but I need to say that is down from where it was six or 12 months ago. One needs to look at companies from a bottom up perspective as headline indices have been making all-time highs and are trading at valuations that are at historically rich levels. But as I said earlier, in certain areas of the market fear and uncertainty has caused share prices to be available at attractive prices. Therefore, if you look into our fund for example, our biggest holding, Brookfield Asset Management, which is a company that’s been around for 115 years, is trading at an attractive price, on our calculations still at least a 35% upside to our intrinsic value, which is calculated conservatively.

Companies like Sainsbury, which is based in the UK where, first of all, Brexit, but also many years of food deflation has led to profits which have stood still, trading at 11 times earnings and which I have to stress, is half the MSCI Global’s market PE. I talked about Cisco earlier, at 15 times earnings and if you strip out their $70bn of cash, which should benefit from lower US tax rates if they happen, is still a great opportunity.

We’re finding opportunities in Japan where we own Yahoo Japan or opportunities in Asia with the likes of AIA Group. I guess you get the message, it’s a case of looking specifically at opportunities, but we would certainly not go into the market with a closed eye. As I said, the mood in the market has improved a lot recently and valuations compared to history aren’t as attractive as they used to be, but in certain parts of the markets they’re still very attractive and we’re certainly looking very hard for those opportunities.

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