Abrie Pretorius’s tightly focused portfolio – managing money New York style

Once its homeland lost polecat status, South African-born Investec became one of the earliest companies to globalise. Its strategy was to establish a solid base in London, with much of its early growth achieved through buying up in funds management businesses. A couple decades later and the fruits of that approach are well documented – Investec Asset Management continues to grow its market share in London by competing effectively against some of the largest money management firms on earth. Its portfolio managers often move between the company’s London and Cape Town offices, but the case of Abrie Pretorius is unusual. With over half of his fund’s money invested in US-headquartered companies, Pretorius relocated, instead, to New York – and explains why in our wide-ranging discussion which includes insights into his favourite stocks, the “Amazonisation” of retailing and why a fifth of his portfolio is entrusted in shares of cigarette makers. – Alec Hogg

This special podcast is brought to you by Investec Asset Management. Abrie Pretorius is with Investec Asset Management, based in New York. Abrie, most of your team is in Cape Town and London. What are you doing over in the U.S.?

Alec, it’s nice to speak to you. Yes, I recently relocated to New York. While our office has been here for over ten years, we’ve got a fairly small investment presence here now with around three investment professionals. The particular reason why I moved is really, because most of our assets and stocks is listed in the U.S. As you might know, a big proportion of our quality capability in terms of our research process is to be bottom-up and really engaging with the companies that we own. It just makes life easier to be on the ground and to really engage with the company.

When you talk about your portfolio, you work closely with Clyde Rossouw in the Investec Global Franchise Fund. It’s an interesting portfolio. You’ve mentioned quality. How do you determine that?

Yes, it’s very important. I think it’s a good question. Quality has become a very fashionable term. However, when you look through portfolios, you can see it can mean very different things across the board. For us really, we just want to invest in good businesses – companies that can earn a really high return for every Dollar of capital that they spend. What we have found is that over time, the competitive advantage must be sourced from an intangible asset. We like companies with brands, patents, and distribution networks. All the companies that can add returns through tangible assets such as machinery, mines, or that has a finite life because that really invites competition and that’s easily competed away – there are numerous examples in history where that really leads to overcapacity.

Read also: Clyde Rossouw explains how his Investec Opportunity Fund is beating the market

When you talk about brands and patents, is that the moat that Warren Buffett so famously discusses?

Yes. I think that’s very similar. While Warren Buffett and Charlie Munger might probably be more well-known as value investors. If you look at the actual factors in some of the books that they’ve published, five of those factors are quality factors where they looked at the quality of the business to invest in that. Then they’ve only got two valuation factors: price-to-book and PE. Interestingly, they use price-to-book and PE because financial statements were only required to be published in terms of cash flows and balance sheet from the 70’s. Really, when they started, that’s the only thing they could use.

You’ve got a highly concentrated portfolio – between 25 and 40 stocks – very different to most of what one sees in the asset management industry nowadays. I guess it does put a little more pressure on you.

Well, I think from a bottom-up fundamental basis and especially if you’re on a global portfolio, it’s just impossible to know stock number 100 the same as you know stock number one. Just from that practical point of view, it’s fairly important for us to buy something that we know well. Ultimately, if you look at business fundamentals, the truth and the fact of the matter is that there’s just not a lot of companies that meet our fairly strict investment criteria. Fortunately, we can choose the best businesses out there, out of the universe of 30,000 listed companies (probably) globally, but we will only permit capital to something where we believe there’s an absolute investment opportunity.

How big is your universe then, if it isn’t the 30,000? How large might it be?

As I say, we can invest in anything but ultimately, if we’re going to look at what we like, our investment hurdle is the portfolio and it’s not the market. For a new stock to get into our fund, it must really improve either the quality in terms of returns or return on investment capital. It must improve the sustainable growth rate or the valuation. Anything with a market cap above $1bn is eligible for the portfolio. If you look at the financial matrix as something that we’re interested in, it’s very unlikely that you’ll ever find a commodity business in our portfolio. It’s very unlikely that you’ll ever find a financial (in terms of banks) in our fund or a capital-intensive business. If you break that down, the market is fairly narrow for us and it’s probably less than 300 stocks that we will ultimately be interested in. if you consider the industries we like, which are typically fairly concentrated industries where you would know there’s probably only one or two players (typically) of interest.

It’s a fascinating portfolio, but maybe we can start at the bottom first. It’s not often that one sees a fairly significant concentration in tobacco companies. You’ve got three of them – more than ten percent of your portfolio. Is that telling us something?

Yes. I think tobacco has always been a cornerstone of our portfolio. We’ve got around 20 percent of our fund in tobacco, so it’s not only the ones that you see. Last quarter, which was quite interesting; the U.S non-financial debt-to-GDP is at an 80-year record. For us, if you look at what the characteristics are that we’re looking for, we’re looking for companies that has pricing power, ultimately and significant barriers to entry. I think tobacco is one of the few companies (or industry) globally that really show that they’ve got pricing power.

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Outside of that, your biggest individual stock is Johnson & Johnson and you’ve got Nestlé there as well, with the record being Kaiser so you do like those types of portfolio investments.

Yes. I think Johnson & Johnson is quite an interesting one. We’ve held that since inception – almost ten years now. However, the weighting over time has been fairly different. It’s been in our top ten and then it’s been as low – probably – as two percent. In the middle of the last year, we brought it back up to over six percent, and that’s after we’ve done a fairly thorough review of the business. They’re at a fairly interesting point in time now where it’s only one of two business globally that has an investment-grade balance sheet – them and Microsoft. If you look at their revenue prognosis, it’s really fairly unique where all three of their big business units are starting to deliver accelerated growth profiles. Their pharmaceutical business is overcoming quite a significant patent cliff of over $8m over the last couple of years and they’ve built one of the fastest-growing and biggest oncology franchises.

If you look at their medical device business, which is also the second-biggest business in their portfolio; they’re overcoming integration of the largest acquisitions they’ve done in their corporate history when they bought Synthes. That’s now being integrated. Innovation is returning and really, that growth profile is also accelerating. Then you’ve got the third-largest business, which is the consumer health business. They had quite significant manufacturing problems over the last couple of years. I don’t know if you recall that McNeill recall where they basically had to shut all their factories. They basically went through a remedial process now and those products are coming back to market so you’re in a fairly unique situation where you’ve got a business with a bulletproof balance sheet that’s showing you accelerating revenue growth profile in an environment where corporate profit is really declining and here, you have a very defensible asset that’s growing.

Last quarter, the U.S. business grew by 12 percent.

It’s the same as you said a little earlier. The business with the tobacco stocks – good, strong, and defensive businesses. Does that tell us that you are worried about the level of stocks generally?

Yes. I think ‘generally’ is very difficult to answer but if you look at the indexes and corporate profits globally, we’re in an earnings recession. We’re fairly excited that we can still find great companies in this environment that could deliver earnings growth. If you look at our portfolio then ultimately, that’s very important for us. We look at the portfolio level, aggregate all the financials of the company in our portfolio, and we basically take it through the same paces as what we take our companies. On a return on investment capital basis, our portfolio has got 18.5 percent return on investment capital*. That will compare to the market of around 9.5. On average, our companies are close to double digits in Dollars where globally, corporate profit is actually declining. If you look at their valuation in terms of free cash flow yield, our free cash flow yield is in line with the market so that still gives us a fair amount of comfort that there’s a handful of businesses that you can find globally, that are still very attractively priced.

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There’s a lot of number crunching that goes into finding me but being based in the U.S. (and you mentioned Johnson & Johnson as an example earlier as the biggest stock that you hold), does it mean you go out and see them, and kick the tires more?

Yes, most definitely. I think that’s probably one of the biggest advantages of being based here. Then it also helps our team to be plugged in, in general. We do have the technology, even if the corporates do come into our office, and then everyone in Cape Town and London can also dial into it through our tele presence and video conferencing facilities. Then all our team members will spend time in different jurisdictions. I was in London for two weeks and one of our team members is here with me in New York this week, and we all see companies all the time.

Another stock that we haven’t touched on (and I’d like to) is Visa. It is your 4^th biggest individual holding. The whole payment system around the world is coming under pressure with PayPal making a big run and of course, we see Bitcoin a few years down the road. Having Visa in your portfolio…again, it must be sending some kind of a signal of your research on this one.

Yes. Visa is fairly interesting. If you look at the valuation, it’s probably up there. It’s a high multiple that you need to pay for the certainty of growth. It’s currently on 3.8 percent free cash flow yield. However, if you look at earnings growth potential, it’s growing at 14.8 percent over the next three years. That’s our expectation and that’s in the face of a market that’s declining. You mentioned PayPal. That’s another stock that we actually do own in our portfolio and they recently combined in terms of a partnership (in terms of more mobile payments). However, you need to remember that the Visa network is incredibly powerful and that cycle is just likely to continue where people from paying with cash and cheques, to online payment. I was fairly amazed that even here in the U.S., I need to pay my rent for my apartment with a cheque so there’s still a significant amount of money that needs to evolve in terms of card payments.

The U.S. is a little bit far behind in terms of that regard. Not too many others, though. Talking about the U.S., the four stocks that did it all for American investors last year, the FANGS (Facebook, Amazon, Google, and Apple); you are light. I don’t see Facebook in your portfolio but you are light on the other three. What’s the thinking there? When I say ‘light’, that’s relative to their weightings in the overall S&P 500 Index.

Yes. We’ve never owned any of the FANG stocks, bar Google over the last ten years. However, we looked at all four of them. What’s interesting about Apple is that we just don’t think that competitive advantage is really sustainable. Ultimately, they made a significant bet on multi-size form factors and we think they’re close to the end of that innovation cycle. You can see that even with their most recent iPhone that they’ve launched, the only real innovation that’s happened there that you don’t have a jack for your phone anymore. Innovation is clearly stopping and it’s also the first time that the actual iPhone is declining so they need the next trick to improve and we struggle to see where that’s going to come from. Still, 80 percent of their profits are coming from handsets so we would rather own zero. I think that’s the fortunate thing about having a portfolio of only 32 stocks.

We don’t have to own a company just because it’s the largest in the index so the risk of us is clearly not tracking [inaudible 0:15:07.1]. The risk for us is the risk of losing money so that’s why last year, we didn’t panic because we didn’t have any of the four. We were still able to deliver absolute returns even though the market was down six or seven percent. Recently, we re-evaluated both Facebook and Google. As I mentioned, we owned Google in the past. We actually bought it when Facebook came to market in 2011 and most of the market was really pricing Google as if it’s going to go bankrupt. Everyone thought that you’re just going to search on Facebook. We did not believe that. Then the stock was trading around 12 times earnings. Clearly, since then, Google has done very well. The stocks re-rated and we thought that was an opportune time to take money off the table.

What about Amazon? Even Warren Buffett is worried about the impact that this is having on retailing stocks around the world. Clearly, you don’t share his concerns of the ‘Amazonisation’ of retailing, but what are your thoughts on that one?

Amazon is a very interesting stock. Clearly, they’re disrupting the marketplace all over. Almost every company these days that you look at…if it’s on the Cloud, if it’s in retail, if it’s in consumer staples, music, and books, they’re really busy disrupting. Unfortunately, they don’t really regard profits and cash flow as one of their key criteria so we will probably always struggle a little bit with that one but fortunately, we’ve got significantly other ideas where we can add value. Clearly, it disrupts in the marketplace and from a competitive point of view, it’s something that you need to keep your eye on but from a free cash flow and evaluation, it’s really very difficult for us to get our heads around it.

When you take the broad sweep of global equities – geographically and sectorally – where do you see the best opportunities right now?

I think that emerging markets have clearly been a very big topic and especially China, which has had a very strong run. However, if you look at the market output, it’s just under seven percent here today and most of that rally has been driven by emerging markets. I don’t think anyone would have predicted that at the beginning of the year with Brazil up almost 80 percent. Here today, in South Africa at 25, and Russia 32 percent. In my opinion, that rally has just been driven by the Dollar that stabilised and bond yields globally, that have been falling. Clearly, that’s showing you that there’s not a lot of growth out there. The risk to this EM rally has really been driven by three things that I think could unravel:

1. Inflation, which is going to drive interest rates higher. We saw Yellen last week, already stating that. I think that could be a big risk in unravelling it.
2. Earnings growth keeps on disappointing. We’ve probably had eight quarters now of negative earnings growth in the U.S. if you look at the S&P 500.
3. The resurgence and continuation of political risk.

Emerging markets remain a very tough place for us to get excited about. I think we would rather play or get exposure to emerging markets through some of the big multinationals. If you look on a ‘look through’ basis, our emerging market exposure is just under 30 percent while we only have on listed emerging market stock. That’s more on a geographical basis. I think Europe is still very tough. It was quite interesting being in London last week, talking to the different companies. I think they’ve got significant risk and structural problems coming, especially with Brexit in that they still need to invoke Article 50. In the U.S. it seems like inflation expectations are clearly starting to pick up so we would rather come back and focus on a stock-specific basis, look at list price opportunities, and companies that can continue to grow in this environment.

If you look at our portfolio over the last five or six years and you look at where we’ve started to find more and more opportunities, we moved from a consumer staples level… We moved from probably around about 80 percent of our fund in consumer staples to less than 40 now and we’ve reallocated that money more into technology and consumer services type of sectors. It’s really sectors where the companies can find annuity type of revenue. They’ve still got pricing power and there is growth. Faxet, for example, is quite an interesting one. For us, in the financial market, you only need two financial data points. You need company financials and you need share prices. They’re one of our only companies that can really provide that with any degree of integrity and it’s integrated into your back office and into your front office.

Once they’re in, you can’t get rid of them. They even grew their user base through the financial crisis. Stocks like that are companies that we continue to find fairly interesting within this environment.

Abrie Pretorius is with Investec Asset Management

• The return on capital investment will differ from the actual portfolio’s performance.
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