Investment Masterclass: PSG’s top performing money managers share stock picks

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PSG’s Balanced Fund is a regular among the unit trust award winners – delivering market-beating returns at relatively low risk. In this Investing Masterclass, we find out from fund managers Paul Bosman and Greg Hopkins how they manage to consistently outperform. What follows is valuable insights into how these ace stock pickers select what they buy; sharing their favourite holdings to help us understand the process that has delivered so much success. – Alec Hogg

Paul Bosman, PSG Asset Management

Welcome Greg Hopkins and Paul Bosman, the gents who run the PSG Balanced Fund which won another award recently. Is this something you strive for?

In fact, quite the opposite. If you’re investing client’s money and you’re focussed on what peers are doing you’re probably going to make some big mistakes in your career, so we really try and focus on achieving the funds, the benchmarks which are absolute return kind of benchmarks.

Paul, you’ve been at PSG since 2004….

Yes, so I started as a junior analyst in 2004, and the business evolved a lot at the time, but within our team and the portfolio managers, they’ve all been with the company 10-years and longer.

Greg Hopkins, PSG Asset Management

Greg Hopkins, apart from being the co-manager for the Balanced Fund, you’re also the PSG’s chief investment officer. Ex Merrill Lynch and Sanlam – what attracted you to this company?

Well, if you take a bigger picture view about PSG asset management it’s still a relatively small asset manager, in terms of assets. We have around R30bn worth of assets, which gives us a lot of opportunities to invest. Our process is a global process and we’ve been buying shares in our funds, in our offshore shares in our local funds since 2006, so we’ve had over 10-years’ experience in terms of investing globally. You can buy and have a bigger universe, a very stable investment team, with a great culture and a great track record of being able to buy low instead of high, and I think it’s just a wonderful place to be.

In your latest quarterly report you quote Daniel Kahneman, a Nobel Prize Winning behavioural economist, one of your heroes?

Yes, I think we quite often push to give an indication of whether we are value investors or growth investors and our style of investing. Our honest answer is that we’re rational investors. We want to not pay more than something is worth and we want to buy assets with some kind of inherent quality. To do that you’ve got to ensure that you’re thinking rationally, especially when the markets are moving in a direction where it’s tempting to be a seller rather than a buyer and we’re wanting to be buyers. So, you’ve got to make sure that you break down those biases and try to cut emotion and make sure you think thoroughly. I think we’ve learnt a lot from his way of thinking.

You know, if you look at the investment world, what often differentiates good and bad investors is temperament, and temperament is something we focus a lot on at PSG and having obviously, a lot of experience in managing through different cycles. That does help you understand some of those vices that Paul does talk about. One of the big things that I think one of the big advantages of being able to, if you can think independently of your peers and think independently of the market. You will have quite a big advantage in terms of being able to generate alpha, and understanding yourself will help you do that sort of thing.

Kahneman is also famous for the theory of loss aversion – that’s also a rational way of approaching investments because losing money really does put you on the backfoot.

It puts you on the backfoot and there’s another element to investing, which is client psychology and the biggest mistake a client can make is that they actually sell out of unit trust but that you can’t control. You can control what you do with the money but it’s very important to help clients to help themselves and prevent them from selling at exactly the wrong time. Funds with very wild swings, clients do panic and they run out of those funds and if you can build funds where the broader arms aren’t necessarily that dramatic, clients tend to stay invested, which is, in the long run is what’s important.

That’s a tough job though – the public tends to get it wrong, buying at the top of stock markets and selling at the bottom of stock markets. How do you communicate that it’s better try to ride it through?

We’ve found it’s actually a very important part of our job, which we mustn’t underestimate. I think one way of doing it is to build a trust of the philosophy and the process and consistency, and then also to be transparent in terms of what you’re buying. If clients can understand the securities you’re buying are reasonably simple, and they might even know their names. I think they take comfort in that.

Another fund manager, based in the UK, spoke to us about Sainsbury. I see it’s one of your fund’s top-10 holdings…..

Yes, it’s been a very long holding period. The obvious answer is that it looks cheap on a price/earnings ratio and a dividend yield and that kind of thing. But the real answer is that it’s a grocery market that went into a structural over-supply situation. It’s not something we really know in South Africa but as the more aggressive discounters came into that market, they really disrupted the market and consumers had much broader spectrums (price spectrums) to choose from and that resulted in profits being very challenged for many years. But we believe that market is starting to tighten a bit. There’s some inflation starting to come through, which enables them to hide their prices, and some of the bigger competitors are also closing space, which means that suppliers are gradually leaving the market, so it’s the classic example of where you’ve probably got a reasonably low multiple on profits that we think are low, and those are normally your best investments.

Going back to Daniel Kahneman, often the market extrapolates the recent past into the future and as Paul suggested, this is an industry that has been quite some distressed over the last 4 or 5 years, and we think the market is extrapolating that into the future and there’s a chance now that things are starting to change and the market is potentially missing that.

Greg, just to pick up on something that Paul also spoke about earlier. The importance of trying to keep the returns relatively stable. In a geography like South Africa that’s not always easy and in particular this past week, where we’ve had some serious politically impacted influences on the market. Take your holdings in FirstRand and Nedbank, which are interest rate sensitive. How do you in your own minds, philosophise on those kind of holdings, given their vulnerability?

Yes, I think that’s a great question. The way that we typically would look at these sort of things is they are often inverted and because the market is very fearful about the political situation in South Africa, and because I think investors are generally quite fearful about investing in South African assets. It has pushed down the share prices of a number of these securities to quite low levels. So, you’re buying them with a margin of safety and it’s often counterintuitive. It seems that the thing that you want to do is maybe run away but if you look at it from a bigger picture point of view – share prices are quite low, earnings are quite low, balance sheets are, especially in these banks are at generational strong levels. So, if you can take a longer-term approach there’s a reasonable chance that you’re actually buying with a regional margin of safety. If you can buy with a margin of safety it mitigates some of the risk around losses. You might get some temporary sell-offs and some volatility in these types of companies but if you take a longer-term approach, given the fundamentals, and given the price that you’re paying for those fundamentals, we still think there’s an attractive opportunity in these types of assets.

You’ve got a guideline that you can go up to 25% of this portfolio in foreign equities. Have you used the full amount?

We generally do. At the moment, we’re not fully invested offshore. We’re at 22% offshore. For us it’s opportunity driven, so when we find more compelling opportunities we would take more cash offshore. We generally don’t run with large amounts of cash in hard currency. We think that’s a strategy of effectively trading currencies, which we don’t do. So our offshore exposure would typically be at 25% if we’re funding buckets full of opportunities. Even in the developed markets, there’s not as much value around as there was a year or 18 months ago.

Brookfield Asset Management is one of your top ten holdings. I haven’t come across the company before and I guess many people listening to this podcast, haven’t either. What attracted you there?

It’s very interesting. They’re a massive manager of physical assets. I think the portfolio is $250bn of physical assets, which they manage. I think the first important point to make is that the management team was really what impressed us – a chap called Bruce Flack. He’s got exposure of about $1.1bn directly into the company and they’ve been very good at being calm when others are panicking. In the financial crisis, they bought half of Canary Wharf. They just wrote a cheque and it was done, and it was obviously at a very good price. Their business model is to invest in property, renewable energy plants, pipelines, and ports – those kinds of hard assets. They have a management company, which manages those assets. They get outside/third party investors to invest with them and then they earn a fee on the outside investors’ capital.

I suppose it’s almost like a triple dipping model where you’re investing your own capital, you’re earning a fee, and you’re earning an income from a management company. They’ve done phenomenally well. In fact, if you want to go and look at the compounding rate, its performed something like Berkshire Hathaway but as you rightly mentioned, it’s under the radar and therefore, trading at a price that we think is attractive.

I think that a lot of the opportunities (why it’s been presented to us) is that real assets have underperformed financial assets significantly over the last number of years because we’ve been in a disinflationary environment. If you do get a sense of some inflation coming back into the system, real assets and infrastructure/commodities, these types of assets. There’s a possibility that they will start outperforming financial assets and these guys are sitting with some high-quality assets.

That’s definitely one for the notebook to go and do a bit more homework on. Another stock in your top-10 is Hudaco. Again, for many South African investors, it would be a little under the radar.

You talked about it being a little bit under the radar and I think it is. A lot of companies within our mid-cap stage (companies with smaller capitalisation) are generally under the radar screen and a lot of that is symptomatic of the industry that we’re operating in, where it’s a very concentrated investment asset management industry in South Africa. Companies like Hudaco, which have a very good long-term track record and often fall under the radar… If you look specifically at Hudaco, it’s got a large South African-facing customer base – it sells into the mines and automobile sectors, and it’s a large distributor of products. A lot of these industries have had a tough time so we think it’s a business where the earnings are quite low but have a fantastic management team. They’re really ‘hands on’.

When you spend time with them, you realise that these are guys who know their business and have grown their business, and it’s trading at a very attractive multiple. If you look at their long-term track record…if you had held a share over the last 15 years, you would have compounded your total return at over 20% per year. You’re getting an above average quality company at what we think is at a below average price, which is trading at 10/11/12 times earnings at the moment and that’s a great opportunity.

Give us some insight on Discovery and its Asian partner AIA – both of those being amongst your top ten holdings.

Discovery has been unloved by the market now for quite a while, despite it being managed by the same team that built tremendous wealth for themselves and their investors over the last few decades. I think what happened is that they hit a bit of a lull in terms of obvious growth prospects for the market to understand where growth can come from. We’ve done a lot of work around the new growth strategy of partner markets in which they’re effectively licensing Vitality. They don’t only earn a fee. The real return is from sharing in the improvement – the insured experience. The write-up you get on the Enterprise Value can be higher than the initial assumption. They actually share in that, which can be very attractive. The players they’re partnering with are rapidly growing companies like AIA in Asia and they’ve got a stake in Ping An Health, which is a very rapidly growing health business in China.

We think the growth prospects are being underestimated by the market. In fact, at the current share price according to our valuations, there is almost zero value being attributed to the global growth prospects.

So the whole ‘shared value’ strategy is something that you guys buy into.

Absolutely. We don’t want to be too naughty in our assumptions but with reasonably conservative assumptions we get a value for Discovery significantly above the current rate.

I think the interesting thing for us is that some of the largest insurers globally, have done their homework on Vitality and are willing to partner with Discovery, which one can suggest is actually one of our better exporter teams at the moment.

Perhaps a question of the missionary not being recognised in their own country? Another South African firm operating around the world but with a completely different set of circumstances, is Old Mutual. One of your top ten holdings. Is the sum of the parts still significantly above what the current share price is?

Yes, very much so. We think that the value of the UK wealth business is maybe the one that the market’s really missing but the South African insurance business has tremendous distribution. It has a fairly wide moat around it and we think that business will probably grow quite a bit faster than the market’s giving them credit for. However, there’s another principle. When managers are forced to play in front of the stadium in the spotlight, rather than warming up behind the stadium, they tend to run faster and when you unbundle a group like this (and each one of the management teams are heading up separately listed businesses) you could very easily get a more efficiently-run company.

So Paul, your idea then would be to invest now and perhaps see how they perform once they’ve been unbundled into the different arms.

Yes. Once it’s all unbundled, we will obviously do our valuation. At the moment, we just think the share price is completely wrong for the true value of the business and if it was to trade at levels that we think is more fair value we would hold less.

You are both working together on this portfolio. Often, when one comes across a company that’s run by a joint Chief Executives, investors don’t feel so comfortable. But in the money management field, partners/joint managers sometimes get things very right. How do you guys split the disciplines between yourselves?

If you look at the philosophy of PSG Asset Management, we have a lead fund manager on the product and that lead manager is responsible for the performance of that product in terms of how it’s constructed but he’s backed by a co-manager who can act as a sounding board but more importantly, by a team. One of the hallmarks of what we do, is having a team-based approach. We’ve got a number of investment professionals who work together and who actually supported all our fund managers. It’s a collegiate approach with individual accountability and we think that if you can get that right, you’re going to generate very good returns for your client and you’d act as very good custodians of your client’s assets.

Greg, do you have a house way of working out intrinsic value. If you’ve got two people who have different views on how to work out an intrinsic value, you could have a clash from that perspective.

We have a lead analyst for all companies we look at and we’ve got a defined process that we will follow to generate what we think is an intrinsic value, but the intrinsic value is going to be an estimate. It’s not a precise number and there are a range of outcomes around that intrinsic value. Then we spend time with the team really unpacking that and attacking it, and just trying to work out what the true reality of the underlying investment that we’re investing in and we look at differences of opinion within the team. That’s what we really celebrate – when we do get differences, it means that we’re thoroughly testing that intrinsic value. If it still stands at the end of that thorough testing process, then we think we’ve got a good investment and we’re buying with a margin of safety.

Is it formulaic?

We have different ways of calculating intrinsic value and it depends on the company and the industry, but it will generally be quantitative although it’s backed by a lot of qualitative work as well.

I’m asking this because I often have trouble myself, when I look at South African stocks and international stocks, and I would use a shorter time period when working out the cash that I’m going to get back from a South African stock versus an international stock. Do you do that, too?

Not necessarily. We would have a discount rate, which is the required rate that we would like to get from any security. We adjust it for the quality of the business, which is effectively the range of outcomes but we use consistent methodology for investing in local/domestic companies. The discount rates/required rates would differ between the companies that we’d invest in. We often have a higher discount rate for some industries that we are less familiar with (with a bigger range of outcomes) and that could be companies in offshore markets where more often, you get less context compared to South African companies.

Paul, just to close off with: your breakdown of the portfolio…you can have up to 75% in equities. Where are you lying at the moment?

At the moment, we’re at 60%. We’ve actually moved from close to 70% down to 60% over the last year. That’s a function of a bottom up process. There are less undervalued equities at the moment and as a result of that, our cash holding has increased.

And you can hold up to 25% in property according to your mandate. Where are you sitting there?

On that one, we’re actually at zero. We’re not finding any value in property at the moment.

As you told us a little earlier, 22% in foreign stocks: I guess that’s pretty close to the maximum. You’re not overly bullish on the Rand from these levels.

Yes. We are very careful about taking a view on the Rand. Our decision in terms of how much we take offshore is very much opportunity-driven. If I find a compelling opportunity on the offshore side is when the portfolio manager would be taking money offshore. We wouldn’t be taking a strategic view on the currency.

You’ve consistently been telling us that, so it’s very much a ‘bottom-up’ approach. You find the right stock and that’s the one you invest in.

That’s quite right.

And your target of inflation plus 5%: are you managing to achieve that in the longer term?

Yes, we have. Since inception, which is many years ago, the fund has achieved 14.7% and the benchmark is 10.6%. More recently, if you look over the five-year period, the fund has achieved 13.3 and the benchmark is 10.7. Having said that, if you can achieve inflation plus 5% in the long run for clients with pension savings, I think you’re doing them a good service.

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