Leading money manager Sumesh Chetty shares some of his secrets in this interview about his Investec Cautious Managed fund – a portfolio which will have plenty of followers right now. Chetty offers some insight into his his favourite stocks; interprets the way major geo-political shocks will affect the major asset classes; and explains he is underweight in property investments. It’s a fascinating discourse focusing on a portfolio that is ideally tailored for the uncertainties which investors are having to live with in this uncertain, changing world. – Alec Hogg
This special podcast is brought to you by Investec Asset Management and Sumesh Chetty joins us now from Cape Town. Sumesh, youâre the Portfolio Manager of the Investec Cautious Managed fund. Now, in this globalised age, if you put that into Google, youâll see that thereâs not one but two (also, a similarly named fund â in fact, an identically named fund run out of London by Alastair Mundy. Do you guys talk much?
We speak a fair amount but ultimately, we are working in very different capabilities and when we think capability, we think about the philosophical slant that we bring to the investments that we run. Mr Mundy very much thinks along the lines of a deep value/contrarian view of the world. When we look at the world, weâre looking at it very much from a quality bias. When we talk about quality, weâre thinking about high quality businesses that are strongly capitalised, donât have a lot of leverage on their balance sheet, very strong cashflow generation. Ultimately, weâre looking for some sort of protection in those businesses â some sort of barrier to entry â preferably, intangible in nature. As you would have guessed, given the balance sheet requirements, we shy away from businesses that are highly capital intensive (typically). When investors think about âcautious managedâ run from South Africa with a global point of view (25% allocated offshore), they should think about it very much in terms of a relative consistency of returns because typically, the businesses that weâre looking for donât trade at massive discounts to their fair values or to the market through an economic cycle.
The name Cautious kind of tells it all. It is conservative I presume, and diversified. Can you give us some other words that would go with your style?
Conservative, diversified, [thereâs the obvious] quality, a bias towards income-generating opportunities given that only a maximum of 40% can be invested in equities and I would classify the fund as absolute return because even though there arenât any guarantees, we are ultimately targeting real returns for investors. Weâre looking to generate a return of inflation plus four on a rolling three to five-year basis and weâre also looking to protect investor capital on a rolling 18-month basis. Importantly, no guarantee but based on the opportunities that weâre looking forâŚwith the focus on quality and the conservatism applied in the fund weâre pretty confident that we can deliver (and we have, historically). If you look at the history of the fund and the fundâs inception in 2006, our worst rolling 18-month period was approximately -.5% and of course, that came at the height of the global financial crisis. Weâre talking about the rolling 18-months out to February 2009 where at that point, the market was down 50% from peak to trough.
The inflation plus 4%: have you managed to comfortably achieve and exceed that?
Twice weâve delivered inflation plus 4 for investors, and so the fund has returned approximately 10%. Itâs a little difficult to quote because clearly, there are different fee classes but since inception, delivering 10% to investors with inflation averaging at 6% over that 10-year period, hitting the plus 4 target for investors.
The breakdown of the portfolio: youâve mentioned 40% in equities. Thatâs a very conservative number (under half) which, however you want to look at it, is certainly below your U.K. counterpart where they have 60% in equities. Why that structure?
That structure is very much a function of the South African market. If you look at the unit trust sector, thereâs a 75% equity sector. Thereâs the unconstrained, which takes you up to 100. You have the very low equity sector, which is 10% or less and then you have this cautious sector, which is sitting at a maximum of 40%. From a real return objective, 40% sounds like you are heavily constrained but over and above the 40%, youâre still allowed to put another 20-odd percent into properties if the opportunity presents itself.
Right now, do you have the full 40% in equities and the full 20% in property?
No. Right now, we have 30% in equities. That would be 20% sitting in global equities where weâve seen the best investment opportunities and then we are holding 10% in local equities but local equities is a little bit of a misnomer because weâre buying high quality, relatively global businesses â either because thereâs a secondary listing in South Africa or because you had exceptional management teams that have actually globalised their businesses over time. That gives you 30% out of the total of 40% maximum equity exposure. On the property side, weâre only sitting with about 2% in property right now, so weâre very conservatively positioned on the property side. We are worried about the potential for rising distribution yields. Property has been somewhat on the expensive side, but weâve been saying that for the last 10 years and we have been wrong, so take that with a truckload of salt. Our view is coming to fruition however, if you look at the most recent performance out of the property market over the last two quarters or so. In fact, over the last 12 months, property has delivered an anaemic 2.2% – still better than the equity market at -3.5% of course, over 12 months, but the opportunity in property is coming soon.
The message that you would be sending then with the stakes that youâre holding there is on the one hand, clearly, not very optimistic about the continued strength of the Rand if youâve got your full 20% in your offshore equity component there. It also says to me that youâre still worried about property being overpriced and indeed, South African equities.
Your first point about the strength of the Rand: whatâs very important to state, is we donât take a top-down macro view on the portfolio in deciding on the asset allocation. The asset allocation is an outcome of a bottom-up process and as a result of that, we are very cognisant of the fact that forecasting the Rand in the short-term is a losing game. If you told me the Rand was going to be ten next year, Iâd say âOkayâ. Youâd immediately turn around and say, âThe Rand is going to be 18â. I would say, âOkayâ because that range isnât completely unreasonable, given the pressures and the risks that weâre seeing in the world today. When we think about the individual stocks in the portfolio, weâre looking at their cashflow generating characteristics and the ability for those business models to weather cyclical downdrafts/increasing volatility in the market.
Weâre looking for businesses with self-determined opportunities where, irrespective of the potential downturn, you could still generate a reasonable return out of those businesses. As a result, looking at those businesses in the portfolio, I wouldnât necessarily draw the conclusion that weâre saying that the Rand strength is over because we donât want that forecast. Having said that, over the very long term (even from current levels in the Rand) we donât see â over 10 years, for example â that the Rand is going to be stronger from its current level. In fact, if anything, youâre possibly going to be seeing depreciation in the Rand of between zero and 4%. While there might not be the material tailwind to global investments that weâve seen historically, the structure of the local economy, the declining growth in terms of GDP per capita, the anaemic overall GDP numbers, the fact that our inflation rates are higher than inflation globally, and our lack of competitiveness ultimately means that a weaker Rand over time is more likely than a stronger Rand.
The other thing to remember when we introduce investments into the portfolio, is that we arenât traders. We arenât tactical asset allocators. We donât believe our strength lies there so invariably, when we find an opportunity, we would ideally like to hold that opportunity for the medium to long term (letâs call it five to ten years) unless of course, thereâs a material change in view. Either things have worked out far more positively at a faster rate than expected and then we need to reduce or thereâs been a significant change in the business model, which means that we have to reduce. Given the way we look at constructing these portfolios, that longer-term view is really more important.
Interestingly, with the volatility of the Rand there, you wouldnât be surprised to see ten and you also wouldnât be surprised to see 18. I think that kind of puts it into perspective, doesnât it? A world that is volatile, which is different and when youâre a cautious investor, how are you seeing it? Take away from South Africa for a moment because South Africa is a small economy that is affected by what happens internationally⌠Weâve had Brexit. Weâve had Donald Trump being elected in the United States. We have concerns going on in Euro Land (Italy, France, and possibly the Netherlands following Britain out of Brexit). This is not a certain environment.
No, not by any means and if you think about the risks weâre facing right now and especially the fact (and I think Iâve used this term with you before) of unforecastable binary risks: no-one forecasted Brexit. In fact, you would have assumed that the entire world would have said, âWell, Brexit happened so the probably of Trump is extremely high.â Yet somehow, with the following three of four months, sentiments seemed to drift towards Hillary and we suddenly started thinking âwell, maybe the polls are actually rightâ and the markets were caught somewhat unawares. If you look at whatâs ahead for the South African investor: On the 30th of November, OPEC potentially says whether theyâre going to be able to cut production or not.
On the 2nd of December, we have the S&P assessment of South Africaâs credit rating. Then, on the 4th of December, we have the Italian Referendum and if it goes against Prime Minister Renzi, it might effectively be a catalyst for the breakup of the Euro. Then on the 14th of December we have the Fed Fundâs rate decision but arguably, you could say âwell, thatâs no longer uncertainâ because analysts are pricing in a 98% chance of a rate hike in the face of expected higher growth in the U.S. and expected rising inflation. It wouldnât surprise me if the Fed did decide that another 25 points was opportune. Listening to those, those are fixed dates but we still donât know whatâs going to happen in South Africa off the back of the Public Protectorâs report. Thereâs still a lot of anxiety and uncertainty in terms of the political situation even though things are materially better.
You mentioned Brexit but the challenge to Brexit isnât over because the courts ruled that there needs to be a vote in Parliament and thereâs potentially going to be a push-back on the courtâs decision so itâs incredibly uncertain. Even off the back of TrumpâŚeven though thereâs certainty around that, the market seems to be very clear about the fact that there will be increased stimulus in the U.S. There are going to be infrastructure projects that drive U.S. economic growth but thatâs potentially 12 months away. Youâve already seen massively increasing commodity prices off the back of that but more importantly, youâve seen rising interest rates in a shorter term, given that thereâs been so much reliance on debt. I think the S&P 500 businesses are at their peak debt-to-equity levels right now.
You really have to worry about the potential risks/strains in the financial system and what they could mean in the shorter term even if you believe that the longer term is very beneficial to growth. From a cautious portfolio point of view, weâre very careful in terms of trying to exploit trends. It doesnât factor into our thinking at all because youâre looking âbottom upâ. Youâre looking for that security and sometimes, your holdings will be in favour and sometimes it wonât but as long as you continually have holdings that are generating cash (and that cash is coming back at you), thatâs a very powerful thing over time in terms of the compounding effect.
It can make you crazy, looking at these big trends and youâve highlighted some of the Red-letter days in the next month alone. Getting back to the portfolio itself: with 30% in equities and 20% in property, the other half of the portfolioâŚ
The potential for 20% in propertyâŚ
Youâre only at 2 right now, so you have well over 50% – well over half your portfolio that is in really safe (one would hope) fixed interest investments.
Correct. We currently have 30% of the portfolio just sitting in South African cash and cash right now (and itâs such an overused phrase) is king. Youâre generally king right now on cash right now over three months â approximately 7.3% and there are even better opportunities out there if you lock your money up with FirstRand or you lock your money up with Standard Bank for one year. You could generate a return of 8.5% as an institutional investor. On top of that, there are some great floating rate notes that have been issued. Theyâre like the FirstRand, Santam, Sanlam growth point. You can do an additional 2% with the credit risk of those high-quality companies over and above the 7.3% that you can earn on cash so thatâs already 36% of the portfolio thatâs cash-light. Importantly, weâre also holding nominal bonds â government bonds. Thatâs about 19% of the portfolio and weâre holding inflation-linked bonds.
Thatâs another 9% of the portfolio. It gives you a feel for the structure of the portfolio. We like nominal government bonds. Weâre on a yield of approximately 9% and very importantly, to come back to that point about caution in a portfolio: we spoke about the Rand hedge component of the equities. I said that the Rand is completely unforecastable. We talked about a range of 10 to 18 but obviously, that introduces risk into a portfolio and you need to offset that risk. One of the best offsetting factors is actually bonds. If you think about it this way; the Rand depreciates, you make money on it offshore but yields rise and you lose money on bonds. Similarly, if the Rand appreciates, typically bond yields tend to compress and you make money on the bond component so you actually have two great investments.
Global offshore equities and local bonds â both giving you great deals â but the potential volatility and the potential downside driven on the bond side by a potential ratings downgrade and higher yields and on the equity side, driven by a materially stronger Rand. In isolation, each investment could represent a lot of risk but combined in this portfolio, they actually give you a far smoother ride.
As you were saying a little earlier, itâs more like an Absolute Return Fund in that respect.
Correct. Correct.
You get the one balancing the other. Just from that downgrade prospect, do you think the bond market has priced in a downgrade of South African credit rating, to junk?
The higher yields definitely priced it in so you have an additional 1.5% yield on South African bonds, relative to our emerging market peers and if you look at the credit default spreads that are available on South Africa, relative to countries that are already trading below investment grade (such as Turkey, Russia, and Brazil), the cost of insuring our debt against the sovereign default is sitting at similar levels to the sub-investment grade countries. Having said that, it doesnât mean that on a downgrade, you donât see a further move in bond yields as global investors sell our bond market. Itâs priced in but it doesnât mean bonds arenât going to move on the announcement of a downgrade.
Just to close off with, can you take us through a couple of your favourite stocks?
In the portfolio in âcautious managedâ if you look at the local side, British American Tobacco is still a top holding in the portfolio. It hasnât done that well recently, given the headwinds that youâre seeing â this move towards more of a risk on trade/more of a cyclical environment. Effectively, youâve seen investors being less enamoured with a stable, steady income generators. Weâre very excited by businesses like Santam that have actually been gaining market share. Underwriting margins have been improving and itâs been a virtuous cycle for this business. Theyâve become more capital efficient. Theyâve been able to return more capital to investors so thatâs very exciting. Interestingly, Sasol (at current levels) have also become more interesting for us because it represents a natural inflation hedge in the portfolio.
We arenât in any way, suggesting that oil prices are going to be rising from here. Weâre not suggesting that oil needs to be $70 in terms of a fair value. What we are saying is that thereâs a natural cyclical shock absorber in terms of that inflation benefit and with Sasol trading on a 9 PE and no credit being given to the development of the ethane cracker in Louisiana in the U.S., we think itâs a very attractive holding. The JSE itself is very attractive because what investors often forget is that the JSE (the business) does incredibly well when volumes are up and trading is high, but that trading isnât driven just by rising markets. Trading is also driven by falling markets. Here, you have a business that benefits from rising markets. It benefits from falling markets and in fact, will only do poorly if volumes on the exchange dry up and you have very flat markets.
In a volatile environment like the one weâre operating in now, flat markets and zero volumes are highly unlikely so we like the cash-generative properties of the JSE.
Sumesh Chetty is with Investec Asset Managementâs Cautious Managed Fund of which, he is the Portfolio Manager and this special podcast was brought to you by Investec Asset Management.
