Binary decision exposes post-Brexit investment bargains: This too shall pass

Investec’s Asset Management’s Sumesh Chetty has been piling into a few stocks that were hit hard by the Brexit fallout – one of them losing a staggering 50% because of its exposure to the London property market. Portfolio manager at Investec’s Opportunity Fund, Chetty takes a 10 year view and concludes that an approach of analysing the companies themselves (“bottom up investing”) pays huge dividends in turbulent times. Because this too shall pass. – Alec Hogg

We’ve tracked Investec Asset Management portfolio manager Sumesh Chetty to Mauritius – nice place to be…

Well, Alec it’s the well-deserved break. It’s been quite a tumultuous time in the markets and September was the last time I managed to get away from the office, so it’s four days of a little bit of sun, a little bit of surf and hopefully some great new ideas when we get back into the office.

We all need to sharpen the saw…

I think it’s less about the pressure and more about seeing wood from the trees. Data, information, news comes first so quickly today it’s nice to just step back, not see the daily noise. You’re familiar with my responsibilities at Investec’s Opportunity Fund, the Cautious Managed Fund, our Global Franchise Fund where we take a very long-term perspective. We typically think about our holdings over ten years and with that longer-term thinking it really helps when you’re not faced with constant noise coming across your Bloomberg terminal.

Let’s talk about ten years for Brexit – June the 23rd  was Independence Day for some; the day Britain shot itself in the foot for others. When we look back on this what do you think we’ll see?

Sumesh Chetty Investec Asset Management
Sumesh Chetty, portfolio manager, Investec Asset Management

Not very apparent to make that call, I think potentially over the very long-term it could turn out to be better than people expect. If you look at the collapse in home builder shares in the UK right now, 30 to 50 percent down, I think that’s somewhat of an overreaction especially given that most homebuyers right now think house prices could go down maybe 15 percent. Seeing some of these businesses, if you take a business like Capco that we can access on the JSE in South Africa, just a few months ago was trading at about R100 and now you’re buying the business in the R50s.

That’s a 50 percent collapse because it is in Central London property. I think over a ten year period that movement is just somewhat too extreme and when you look at some of the financial services businesses including a business model could change quiet dramatically if you look at the way some of the investment banks have established themselves in London while they still have a lot of business dealings on the continent if you look at some of the asset managers this could have a material impact on the way those businesses are set up but once again these businesses will ultimately survive or find away and do think while there might be a splitting of the financial services hub there might be a migration of some of the importance of financial services to areas like Germany and Paris.

Ultimately there’s not an all fall down scenario for Britain. What does concern me though is it’s one of the first binary risks that has actually come to the fore. If you think about what South African investors are worrying about today having narrowly missed the downgrade of our sovereign rating in June. Of course we’ll take another go at it in December and it seems to be very likely we’ll get downgraded then; and if it doesn’t happen then there’s another go around in June next year.

We’ve also been concerned about Donald Trump being elected US President, we’ve been concerned about central banks whether they have the ability to raise interest rates at all. And of course Brexit was very much on the horizon and for whatever reason the market put a lot of faith in the polling numbers that we were seeing in the odds that a lot of bookies were making and the fact that Brexit wouldn’t occur and the rationality of individuals in London instead of looking at the vast majority of people who just appear to be unhappy and frankly disfranchised.

What this really points out is that the volatility we’ve been worried about is here to stay for a long time. Especially if you consider that an event like Brexit where we have the referendum, but Article 50 hasn’t been triggered and until it does, we have an additional two years of uncertainty and that’s a concern for us. We’re excited by the volatility because these really are the markets where the Opportunity Fund and the Cautious Managed fund excel, but ultimately this uncertainty isn’t good for the average investor.

There has been a movement to get the Brexit referendum rerun – are the markets suggesting that is a possibility?

At current levels I would have to argue they are. Because other than the banks and the home builders we’ve actually seen the FTSE 100 trading at levels it was at prior to Brexit. Now I appreciate you should be looking at FTSE 250 which hasn’t recovered to the same degree, but I’m still astounded by the extent to which markets have rebounded globally.  I suspect investors are holding off on the back of uncertainty about Brexit and expect interest rates to be cut in the UK in the near term. But you also have investors guessing that there’s going to be a recession at the backend of 2016 or the frontend of 2107.

So it still seems unlikely that prices should be rising in the short-term. You’re a lot closer to this than I am, given that you’re based in London. I would have assumed had Boris Johnson assumed power, he would probably try and negotiate favourable terms in some way or push for a second referendum or push for a general election. But all the rhetoric from Theresa May appears to be support for what the public has voted for and it doesn’t seem like there’s much desire for officials who are members of the European Union to allow for any kind of special privilege to Britain or to the UK.

If the markets are assuming something which is not going to happen, i.e. a rerun of the referendum, does this bring particular opportunities then for investors?

Very much so, there are definitely opportunities that have come to the fore and let’s think about the most basic of opportunities. On the Friday morning when the markets opened after the Brexit announcement, British American Tobacco our top holding in the Opportunity Fund and combined with Reinet our top holding in the Cautious Managed Fund was down five percent. We took that opportunity to top up because this business only has five percent in the UK in terms of sales. And what are the chances people are going to smoke less because of Brexit? It is effectively an emerging market business with 95 percent of its profits coming from elsewhere.

If you look at stocks that are more UK focused but you can still not have to use your foreign allowance on the likes of Intu, the likes of Capco, they’ve been absolutely punished. We’ve bought a little more Capco in our funds. We were slightly early because it fell, I think it’s down another five percent since then but as I say on a ten year basis is it likely that properties that are down, let’s say 15 percent of the sales basis now are still going to be looking as poor over ten years especially given the lack of housing in UK right now?

Interesting you mentioned Intu. I saw David Fischel on Friday – he also didn’t understand why the share price in Rand terms would be down 17 percent but the other twin from Liberty International, Capco, did even worse….

Correct, the original Liberty International, Capco, and Intu. Yes, with Capco at least you can understand the sentiment because the market’s effectively saying Earl’s Court redevelopment would have enjoyed demand coming from Hong Kong, the Middle East and the market expects that to dry up. Rightly so because in the short-term bankers in the UK don’t know if they’re going to be working in London or Paris, or in Germany. So property transactions are effectively going to go on hold in the short-term while there is uncertainty. There are hundreds of thousands of Europeans working in the UK and there’s an uncertain future in terms of what Brexit means.

The UK I’m sure is not going to want to lose productive employees. It will find a way through this, but there’s still going to be a penalty to pay in the short-term on the economy. Capco was down 20 percent in South Africa just ahead of the post-Brexit UK market opening, so it’s a case of either UK sellers dumping it in South Africa because of the shares that are fully fungible or South Africans taking a very dim view on what was going to be happening in the UK. Investors would rather stay completely clear of any uncertainty and then figure out later when the dust settles. We’re not going to have that clarity until we see the new UK prime minister and have an understanding of whether Article 50 is going to be triggered or not.

Sumesh, I like the point you made right at the outset that this was the first of the binary decisions. What happens if you take it one step further to the United States, if Donald Trump is elected as president – a similar fallout?

I think so. I think investment markets would be very concerned about the implication for free  trade as they are with the UK situation right now and for global relations because if effectively what you could say about Brexit, is this is the start or potentially the start of deglobalisation in the world today and this is a massive concern because clearly you want countries to be productive in terms of their most cost-efficient areas and deglobalisation ultimately means that you are entrenching protectionism and you are entrenching inefficiencies. Capital markets don’t like and Donald Trump himself is a little bit of a wild card, you know building a wall to keep the Mexicans out.  I heard a fantastic joke recently that says “The wall works because if you look at China, they built a wall and it kept the Mexicans out”.

Oh my goodness, but in this case though then it really does put a premium on stock selection, on being a bottom up investor rather than trying to play the big trends.

Very, very much because the easiest thing to sell is the trend, the easiest thing to sell is the exchange as a whole and other than very specific stocks you could get badly hurt playing the trend, playing the index right now, so what we find is that there’s been a lot of conversation around consumer staples, the high multiples because investors love looking at them on a valuation sort of basis looking at the 20, 22, 25 hands earnings that these businesses are trading on instead of looking at the free cash load  that they might be generating, the dividends they’re generating or even the stability of earnings growth that these businesses are generating and what events like Brexit, a potential Trump election, a potential derating of our sovereign credit rating South Africa does, is it shows investors the security of growth that exists within these businesses.

Read also: John Kane-Berman: Bravo to Britain – Brexit finally fixes big Euro mistake.

That’s what I meant about British American Tobacco, where it was hurt on the Friday but ultimately investors have become slightly more rational, that initial selling out of fear in British American Tobacco is still going to grow its top line by two or three percent irrespective of whether Brexit happens or not and so we are focused on those stocktaking opportunities.

Do you have a checklist that you would go through when you talk about stock picking, particularly in this kind of environment? We know that Warren Buffett has his checklist of moats. Do you have one that companies have got to qualify through before they make it into your portfolio?

The two characteristics we tend to spend most of our time understanding, are free cash flow yield and the return of invested capital, but more importantly not just the metrics that are being printed today or what the last time the company reported but the sustainability of what those metrics and the ability of companies to grow their free cash flow yield off the back of their current operations. Remember it’s not good enough for a company just to report a high return on invested capital because often there are assets that are depreciated for example, I mean you think about non-profiting companies, they actually depreciate the land they’re based on, they depreciate the buildings they’re based on, and actually have a poor company that suddenly starts generating a very strong return on invested capital.

In those cases we also look at the incremental return on invested capital, what return a company is generating for each additional Rand or Dollar of capital that they spend and that tends to be where we focus most of our attention. We are looking for sustainability as far as possible; we’re looking for a lack of technicality. It’s easier, should I say. There are more opportunities to implement this in the global market and so the 25 percent foreign component of Cautious Managed and Opportunity, we can remain as pure as possible in terms of their thinking, but if you look at the local market of course, there’s a significant number of stocks that are either resource companies, insurance companies, or banks and we have to be a little more careful in thinking about constructing an appropriate portfolio given that you can’t completely avoid those stocks at all points in the cycle.

Low beta stocks, those that aren’t exposed to the cyclicality of economic performance. It was also interesting to see that you are completely away from banks even though banks have fallen far over the past few years. When might you change your mind towards them?

The banks are looking more interesting given the dividend deals and the PE ratios that they’re currently trading on, but a concern that we have about banks is that their business models have been structurally impaired because of the increased focus from regulators plus the 2008 global financial crisis and the fact that the capital requirements for these businesses have gone up significantly and gearing has come down, so businesses that were previously 30, 40, 50 times geared might now be ten to twenty times geared and as a result of that and the lower return on assets that they’re actually generating, you have a structurally lower return on equity going forward.

Therefore, if you were previously generating 25 to 30 percent return on equity you’re currently in South Africa depending on the bank you’re looking at, receiving anywhere between 12 percent and 25 percent at the top end with First Rand. The opportunity becomes more apparent as our economy continues to deteriorate, so the forecast for our economy for this year is GDP growth of 0.7 percent but we haven’t really seen a pullback from the consumer yet, so a weaker consumer, a weaker retail environment, ultimately a weaker banking environment and lower prices potentially gives you that opportunity to get in but you need a much larger margin of safety given the inability of banks to generate those significantly higher returns that we’ve seen in the past, so we’re looking.

What about gold, and I say this because it’s something that most people who watch the investment markets have been ignoring indeed; I picked it up this morning that the gold price in US Dollar terms is up 25 percent this year. It’s still a long way off its top, it’s $13.50 at the moment, the top’s at over $1800 an ounce.

Correct.

Is it something that’s starting to attract your interest?

Actually gold has attracted our interest a long time ago and we hold a decent slug of it in both our portfolios. It’s about four percent in the Opportunity Fund and about two odd percent in the Cautious Managed Fund but to be clear we hold the new gold ETF, so the physical gold in our portfolio as opposed to gold companies. We can go into gold companies. That’s another can of worms but gold itself has always interested us because it acts as a shock absorber in our portfolios.

I don’t mean to be flippant but ultimately gold is fantastic in falling equity markets environment, it’s great when inflation is rising and it’s also great when you are sitting with a deflationary environment, so we like the shock absorber characteristics of gold. It’s really not going to do anything when you see an upward market. If you look at the first half of 2014 and 2013 as well you don’t really see a lot of movement in gold. The problem we have with gold though, is if you think about the four percent holding and the two odd percent holding I was talking about is that it isn’t a holding in itself that’s large enough to contribute significantly if the equity market were to pull back but the problem with gold ultimately is there’s no cash flow that arises from gold, so you can’t actually attach any kind of fair value to the yellow metal, it becomes… What’s the word I’m looking for?

Well, it’s an insurance isn’t it?

It’s an emotional response from investors, it’s sentiment, it’s driven by negative sentiment and as a result of that in those areas of shocks and surprises something like a Brexit or inflation, deflation, markets collapsing, gold really comes to the fore but it would be irresponsible of us to have a holding of 20 percent in the portfolio because in most environments if you think that the market on average is trending up over ten, 20, 30 years it could sometimes be a relatively dead to volatile position.

Now as I said, gold on its own isn’t going to get you the offset in return in the portfolio when things are going wrong but it’s also why we have a significant focus on bonds especially in the Cautious Managed Fund where we’re holding about 30 or 31 percent and as you’ve seen over the last couple of days South African bonds have done exceptionally well with a ten year bond trickling all the way down at about $8.60 right now.

That was Sumesh Chetty, Portfolio Manager at Investec Asset Management.

Visited 51 times, 2 visit(s) today