Clyde Rossouw: Turbulent wages of QE – how it changed politics, investments

Clyde Rossouw proves the case for consistency in money management. Portfolio manager of the Investec Opportunity Fund for the past 14 years, his rational investment process is a rare outperforming beacon among actively managed funds. It comes from the combination of discipline and curiosity, attributes which shine through during this fascinating interview on the major issues confusing so many – the dramatic political realignments, the turbulence they are having on investment markets and the uncertainty of what might be lurking around the next corner. Clyde is a thoughtful, reflective investment manager who spends his life learning so that he can apply the lessons learnt to improve the yield of those whose money he manages. He is a great communicator, too. Attributes which make for a fascinating interview. Listen in or read the transcript and you’re bound to agree.- Alec Hogg

Clyde Rossouw
Clyde Rossouw

This special podcast is brought to you by Investec Asset Management and it’s a warm welcome to Clyde Rossouw. He’s the Portfolio Manager of the Investec Opportunity Fund. Clyde, it was launched way back in 1997 and it’s quite easy to work out what the return has been, given that you launched it at 100 cents. Is this the way that most of the funds are done?

Alec, I think if you look at the performance track record of the Opportunity Fund, what’s particularly pleasing for us is (a) the fact that we’ve been able to generate consistent returns through good and bad market cycles over a long period of time and (b) probably more importantly, it shows one the importance of sticking to a very strong philosophy and ultimately, just allowing the process of compounding successful investments to build your capital.

It’s nearly 20 years old and during that period you have managed to outperform.

Yes, that’s true, Alec and again, this Fund has had two managers during its lifespan and I’ve been running it for the last 14 years, so getting on for a couple of years, into my teenage years, with regards to running the Fund. So I think our performance is not a given and I think for us again, it’s important to make sure that we navigate the ever-changing market environments, and there’s certainly no shortage of changing cross-currents at the moment.

For an Investment Manager, you’re always trying to find 80 cents or assets that are priced at 80 cents that give you value of a Dollar, to use the American or to use our hero Warren Buffett’s perspective on this. Is it becoming more difficult in the current environment?

Alec, I think in the last, let’s call it 18 years, we’ve had two opportunities where you could buy the $1 assets, at 60 or 70 cents, and that was in 2002. Then another opportunity we had was post the ‘financial crisis’ in 2009. I think it’s fair to say that in today’s market conditions if you’re looking for a Dollar of assets that is likely to compound at maybe 10 or 12% per year, you probably are going to be paying 90 to 95 cents for that. There are no bargains on the market. In fact, there’s a lot of shares where you’re probably paying $1.30 for a Dollar’s worth of assets.

So, share selection or share picking becomes a lot or gets quite a premium, in this kind of climate.

Definitely. The market conditions, I think are definitely being driven by large holdings in the indices and those indices have continued to become important for investors. People tend to view the stock market as one instrument where you trade. Whereas our view has always been you want to invest in businesses that happen to have a connection to the markets, with their share price of the trade every day and that’s a very different mindset.

Just unpack the portfolio, if you would. I see that you’ve got 20% of the portfolio invested in something called Investec Quality Equity. Is that an offshore Equity Fund?

Yes, Alec, so in simple terms we see significant opportunities to invest in offshore equities. In fact, it’s still our preferred, highest risk adjusted return opportunity we see today. What that Fund essentially represents is our pool vehicle that facilitates the investment of the offshore assets, on behalf of our South African clients.

So how does that work, do you make the selections then of those shares or does someone else do it?

No, so the entire Fund is run by myself and the Quality team, and the offshore fund, which is domiciled in Luxembourg. At the end of the day I control and make the decisions on that component as well, so it’s an integrated strategy. It has to again, make sense for the individual investors in the Fund, plus the individual investors in the Opportunity Fund, in aggregate.

Clyde, so I guess people are wanting to get into your 14 years of experience with this fund and of course, the experience you had before that and there might be some misunderstanding. What you’ve just said to us now is that you actually control all of that.

Yes, that’s correct. Again, I want to stress that we have a team of people that could find the investment ideas and ultimately, the decision making has to be made by someone. We’re not big believers in committees. We do believe in responsibility, at a Fund level, and that’s very important for the way we structure our business. Yes, in the case of the Opportunity Fund that decision-making process has been mine for the last 14 years and continues to be, at this point in time.

Two big questions that one has to ask, particularly if you’re looking at overseas investments. The first of these is in this low interest rate environment, all those old, evaluations like price earnings ratios come into question because if your alternative is interest rates, they’re pretty much nothing. Then PE ratio presumably, also can be a lot higher than you would have been prepared to accept in the past.

Yes, again, I think that’s a fair point. Although, when we think about investing, we don’t typically tend to focus on spot valuations or current valuations, which are a function of disproportionately low interest rates. Now, fortunately in the last, I would say 6 months or so, the interest rate regime has been changing somewhat internationally. We still have a couple of bond markets that are yielding below zero, particularly the Swiss bond market, but in many cases international bond yields are rising, so that represents a bit of a normalisation of the interest rate environment. That probably is quite helpful in terms of re-benchmarking and ensuring that capital is allocated appropriately.

The last thing that one needs in a well-functioning capital system is inefficient allocation of capital, infinite valuations and therefore the ability for people to make decisions around what to invest in with zero as a hurdle rate – that is completely ludicrous. We certainly wouldn’t subscribe to that, so nowhere in our analysis, either in the past or in the present, do we think that those should represent the hurdle rates for investment. We certainly do think that there are prices that one shouldn’t pay for assets that one invests in. There are a number of shares on the market that we think are just absolutely ridiculously priced.

So, you get into the underlying company. You buy a stake of that company. You’re not working on a mechanistic PE ratio kind of judgement.

Yes, so for us, we focus principally on free cashflow and without getting too technical (for the purpose of our conversation), essentially that’s the cash that’s left after a company has paid out all of its stakeholders, paid the taxman, invested in working capital and has spent money to keep the lights on. How much money is there left in the business that ultimately can either be returned to us through dividends, returned to us through share buy-backs, or alternatively discretionarily applied to grow the company over time.

Now, that’s where we focus on and all of our evaluation metrics are focussed on that. A lot of people simply assume that the profits in a business equals the cash in the business, and that’s often not the case.

The other big issue that one has to ask, when you’re looking internationally, is the populist revolution that we’re seeing within countries? We saw what happened with Brexit here, in the UK. We’ve seen Donald Trump. There’s an Italian vote coming up in a few days. There’s the French election next year. Before that, the Netherlands election, all of which could see and are almost likely to reinforce this very, different geopolitical environment that the world is going into. Do you take much notice of that? Do you see it as a threat?

Alec, that’s a very good question. If you think back to 2009 (post the crisis), we had the first edition of quantitative easing, and then we became used to it and we called it QE1, and then we had the next edition, which we called the QE2, and QE3. It almost became natural to expect central banks to be providers of endless liquidity. If you take a step back and you think what’s happened, all of that liquidity has found its way into stock markets and if stock markets are rising without necessarily creating much economic growth, it does introduce more inequality in the system.

There’s been unrest amongst most of the broader population that this inequality is unjustified, so where we are today and the fact that there’s a rise of populism. Probably, in some respects it means that there’s a cry out from people that the current way in which the world economy is being run and functions, is not working appropriately. Therefore, is there not something else that we should be considering?

Now, when governments start taking over, and we’ve seen that, as you suggested in terms of both the UK and US. If governments take over and fiscal policy becomes the centre of the landscape, generally, those fiscal policies are geared towards spending on the real economy and the logic is that that might just benefit the broader population. In other words, keep the voters happy by making tangible investments and infrastructure, housing, schooling and all of those things where people are feeling that those have been cut historically.

I think it’s something to watch very carefully because it does potentially introduce a different level of risk into the system. Now, I’m not a big believer that Fiscal Policy will be a saviour or, ultimately create economic growth. In a similar vein to which Monetary Policy and extreme printing of money has not created growth but yet, there’s a new experiment underway, so I think what will happen is it’s likely to introduce different distortions in the system. We just need to be aware, from an investment perspective, what those potential distortions are.

Yes, and they are distortions but that means that there are opportunities, in other words if Trump does spend the trillion Dollars that he’s talking about. It’s going to clearly increase the debt in the United States but construction companies will surely benefit.

Well, certainly. If the argument is that a trillion Dollars is going to be spent on construction, I would imagine there would at least be 100 to 150 new construction companies that will come to light in the not too distant future. The problem with these kinds of messages is yes, I’ll agree with that. Construction, at the margin should benefit but these are typically low barriers to entry businesses, so it’s not obvious that additional spend on construction or infrastructure will necessarily all accrue to the account of the existing players.

At a broader point, though and I think this is one which has maybe been slightly lost in the markets in the last couple of weeks, is the increased debt levels, because if there’s additional spend by governments, all of that additional spend has to be financed somewhere and ultimately, the Bond Market is where all that money will be raised and the higher interest rates go, the less money can be raised without upsetting the natural balances in the broader financial system. For us again, we’re somewhat sceptical at this juncture, I think, whether or not Mr Trump can actually pull off the promises that he’s made.

Yes, but on the other hand the growth in the debt around the world and that is, you’re sitting in London and you feel the concern that the British people have for this escalating debt burden that is being put onto them. That does suggest that inflation is probably one of the options that will be considered.

Definitely, but again, if you think about it., if you’re going to expand your budget deficits, they are ultimately inflationary if they can be financed successfully, and that’s the key question that we need answering. I think in addition to that, the other development which one has to look at very carefully and, to my mind this is probably the mechanism by which we do create inflation in the system, is through increased inefficiencies.

Now, we know that for 20, 30, or 40 years we’ve had this continuous globalisation of economics. Comparative advantage, companies focussing on low cost manufacturing outsourcing, and if we’re going back into a populist, pro-national introspective kind of mindset, across many different countries. What that will also introduce is protectionist tariffs and essentially, distortions within those market mechanisms. That’s the way in which inflation comes back into the system because of an inefficient allocation of resources. Anywhere where governments or regulation entrenches competitive advantage, think about municipal rates, where government or local government is the only supplier of that or water, sewage, all of those. There’s essentially pricing power and because of no competition prices are whatever the governments decide they should be. A bit like taxation policies.

For me, in many respects, the way in which we will ultimately, if we do go down this route and to make that as a pronounced call, we could very well see inflation coming from nationalism, from protectionism, trade barriers, de-globalisation, and all of those, the unwinding, of what we’ve seen for many years.

But you are, in a degree, making that call? It’s interesting to see that you’ve got New Gold in your portfolio. At 3.5%, I suppose is not exactly a huge holding but it is certainly overweight, given the relative size that New Gold is, in the market.

Yes, sure. I think it’s fair to say that we’re watching the developments with care and we clearly see opportunities with regards to investing in natural resources, and we do have some exposure. Gold does represent, I guess, the ultimate call around a de-basement of currencies and potentially, high inflation. Gold has actually, interestingly enough in the last 4 or 5 months, not really performed as well. We know that the Dollar has certainly been pretty rampant. We don’t see the rise of the Dollar as being sustainable beyond where we are at the moment. In my mind, I would definitely see an opportunity for gold to perform better and that’s a clear signal that we’d be looking for, in terms of guiding us around the changing landscaper.

I’m interested to explore a little bit more about what you’ve just said about resources because in this new wave, this wider, populous revolution if we can call it that. The beneficiaries of globalisation have been tagged as being the elites and China. If China were a beneficiary of globalisation, surely it would be hurt, if globalisation were to become less or the world become less enthusiastic about it, what appears to be the case. If China is hurt, then what happens to the resources?

Again, I think you are right on that front. China has been desperately trying to grow its own economy, to the point at which it becomes more self-sufficient. If you think about the US economy. The US economy is large but it is quite insular, so trade as a percentage of overall economic activity is small, in comparison to other large industrialised countries, like Germany for example. Germany’s trade, exports and imports as a percentage of the overall economy, is probably 40% or 50%. Whereas in the US, it’s only 25% to 30%, and China is also comparably small. If it can develop a large enough, domestic only economy that caters for the needs of the internal people then ultimately, it may be able to insulate itself somewhat from a slowdown.

What does help China, and China is a complete paradox in many ways, but what does help China is the fact that they do generate enough of their own intrinsic savings. The nation saves close to 45% to 50% of the overall economic output every year. With that kind of level of saving there’s quite a lot of money that you can spend on infrastructure products and a number of intrinsic opportunities, in terms of trying to build up your own economic stock. If they can continue to spend those amounts of money they can, to a certain extent, determine their own fortunes but you are right.

There’s no transition that’s smooth, so if we do have a bit of a setback in the system because trade diminishes precipitously in the short term, I think you could see a correction or two, and in this kind of market environment those things are already starting to happen. The Chinese Renminbi has moved from 6.00 to almost 6.90 and the market hasn’t been particularly worried about that, so it has weakened material already and what I’m saying is, in simple terms is it would be remiss to expect these kinds of moves to be without some sort of shock every now and then. I think one has to continue to bear that in mind when you construct your portfolios.

I see you’ve got quite a big cash holding, 14% at the moment. Is that telling us anything?

Again, the beauty about cash, in a South African context is that the yields are extraordinary high and much in excess of inflation, which is not the case in most other parts of the world, where they’re either zero or definitely below the inflation rates. Cash, in simple terms, does offer attractive return and ultimately, has the highest probability of preserving capital, so therefore we see that as attractive.

However, if you think forward to 2017 and maybe towards the second half of 2017, we would be surprised if cash still yields 7% plus on let’s call it 1, 2, 3-month money and almost up to 9% on 12-month money. Those are extraordinarily high interest rates. We would expect that to normalise to much lower levels as we embark on a declining interest rate environment, into 2017.

For now, there’s a definite role that it plays. It’s a high hurdle rate for other investments. We find many other shares in the market expensive. Therefore, there’s no reason to own overpriced businesses when cash is offering an attractive return.

I guess it almost keeps your power to drive when opportunities do present themselves.

Absolutely, so we’re certainly hoping that in the course of the next couple of months some additional attractive asset prices will come to market because we’ve seen quite a lot of weakness in the retail shares, for example, in South Africa in the last couple of months. People have finally given up on the growth story. Those multiples have compressed from mid-20s to mid-teens and in some respects, like in the case of Truworths, (almost single digits), so we are starting to see better opportunities emerging even in the local interest rate sensitive parts of the equity market.

Then I noticed, in the recent past, you’ve also built up a position in derivatives. What’s that about?

Yes, so again, it’s not a position in derivatives per se. It’s really that we do use all share equity futures to protect our portfolios and to try and reduce some of the underlying market direction, so to speak. It’s really more to hedge some of the equity exposure in the portfolio rather than to take a speculative view on the direction of markets.

If I see 14% cash, 3.5% in New Gold, 7% in derivatives, as you’re saying hedging. You’re not exactly enthusiastic about a bull run in equities in the near future, or certainly that would be my interpretation.

No, again, so let’s be clear about what our positioning says. The rest of the portfolio there, on the offshore side, is quite heavily invested in equities, so we have our maximum offshore waiting in foreign equities. For us, that represents the best area of wealth creation and then, Alec, as you said SA equities trading on 21 times trading earnings. Even if you exclude Naspers, which is trading on let’s call it 58 times earnings, the rest of the market is still on 18 times. It’s not a dripping roast by any stretch of the imagination, so why would you want to allocate vast amounts of capital when assets are highly priced? Bond yields are over 9% and South African cash gives you 8%. You’re not getting paid to take extreme risks.

How extreme are those risks and perhaps you should close off with this, but it is relevant that we’ve seen the rating agencies express concern about internal ructions within the ANC. We’ve seen the Party try to get rid of its own President. There’s an economy that is stalled and, while political concerns dominate, it’s hard to see how the economy will get triggered back into life. When you look at all of that from a geopolitical perspective, does that start influencing your decisions to invest or not?

Again, I think it would be remiss for us to say that the politics and these events do not matter because we always seem to be lurching from one vote to some credit event, to the next. We’ve got an Italian Referendum, and as you’ve said we’ve got other very significant binary outcomes on the political front and politics is definitely dominating the economics and market landscape, as is being witnessed by every single outcome we’ve seen so far this year. Clearly, it factors into our thinking and that will determine very squarely where markets move in the shorter term.

At the end of the day what we need to recognise as investors that, whilst the companies we invest in do not operate outside of that environment., we would far rather invest in businesses that hopefully can navigate some of these market circumstances with more ease, are not overly reliant on the direction of markets, for either funding, capital raising, or to expand their business opportunities, and hopefully sell products and services that are in repeat and demand and that people will consume, irrespective of whether they’re happy or not happy with the political events.

For us, that represents a sensible way of thinking about investing, because then you can’t for a moment suggest that the people can purely live off a couple of bars of gold. At the end of the day people have the need to eat and drink, and they want to entertain themselves and that’s not going to go out of fashion any time soon, irrespective of how the landscape changes.

Clyde Rossouw is the Portfolio Manager of the Investec Opportunity Fund and this special podcast was brought to you by Investec Asset Management.

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