Moneyweb podcast: Brexit means buying opportunities

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HANNA ZIADY: Welcome to this week’s Market Commentator podcast, Moneyweb’s series of interviews with investment professionals. Our guest this week is Nadir Thokan, investment strategist at 27four Investment Managers. Nadir, it’s good to have you with us, 27four is a multi-manager, tell us a little bit about what that means and how that differs to a regular asset manager?

NADIR THOKAN: Thanks for having me, Hanna. A multi-manager in essence, instead of going out directly into the market and buying securities we invest in underlying fund managers. So what our time, day in and day out, is spent doing is doing asset allocation research, so how much do you want to have in local equities, how much do you want to have in local bonds, how much do you want to have offshore and then looking for the best asset managers within those asset classes and blending together a variety of asset managers of different investment styles, different investment philosophies and processes to build specific building blocks. So for example, within the SA equity building block we’ll typically have two to three asset managers, within the offshore equity building block we’ll typically have an array of managers, within the global listed property building block we’ll have one to two asset managers and a similar kind of scenario in the local and offshore fixed income building block. So essentially the majority of our time is spent on asset allocation research and manager research. So being in the correct asset class at the right time and then picking the style that’s going to be in fashion or in vogue over a particular period of time or over an extended period of time depending on where markets are trading with regard to multiples or markets are trading with regard to macroeconomic variables. That all contributes to the asset allocation research, as well as which fund managers you want to have exposure to, do you want to be exposed to a value fund manager, do you want to be exposed a growth fund manager, a momentum fund manager and typically those are very large determinants of returns.

That’s why we believe the multi-management investment process works to give you longer-term better risk adjusted returns because you’re not taking a view on one specific style or one specific manager, which can tend to be fairly polarised over any given point in time. So for example, leading up to 2016, I’m talking about excluding year to date, if you’re an equity fund manager in South Africa quite clearly you would have battled, whereas if you were a growth fund manager you would have done phenomenally well and that’s flipped around really quickly into 2016. So the premise of multi-management is don’t put all your eggs in one basket, diversify your exposure across multiple styles, multiple investment processes and philosophies and in doing that you receive superior risk adjusted returns over a long period of time.

HANNA ZIADY: I think you have alluded to it but broadly speaking what is 27four’s investment philosophy?

NADIR THOKAN: It’s the power of diversification, so the only free lunch you get in finance is diversification. We’re not only diversified by asset class but we’re also diversified by fund manager and that comes back to the idea that not every single fund management house can be good at every single asset class. Typically what you tend to see happening is that asset management houses have a flagship product, which they are very famous for and which they are very good at, typically it’s either equities or fixed income or offshore. The idea behind our investment philosophy and process is one, asset allocation drives in excess of 90% of investment returns, so getting your asset allocation call right is first and foremost the most important part to delivering long-term investment performance.

Given that all our time is spent on asset allocation and manager research we believe that gives us a much greater probability of getting the asset allocation calls correct at the right period of time. So for example, being offshore for the last three years, that was quite clearly the right asset allocation call to make or being underweight fixed income. That’s severely changed over the last six months but I’m talking generally over the last three years.

So our premise is basically based on the greater the level of diversification the better and you’re not exposed to the risks of a single asset management house, you can pick the best of breed fund managers within each asset class, number one, and you can blend together different styles and philosophies within an asset class to give you more stable, better risk-adjusted returns, which compound into a better result over a long period of time.

HANNA ZIADY: You’ve made a very compelling argument for the multi-manager approach, presumably there are some downsides to the strategy, off the top of my head I could think of perhaps returns are watered down because they’re so widely spread and so significantly diversified. What are some of the downsides of this strategy?

NADIR THOKAN: I think if you are looking to be the best performing fund manager over short periods of time all the time, multi-management investment processes and philosophies are clearly not going to work. But then the argument is that there is no single fund manager that can be the best performing over every single time period and that’s why the multi-management process makes sense.

So for example, if we’re in a very value orientated market like we have been so far this year, we’ve seen the mining stocks come back very, very strongly, we’ve seen the bond market come back fairly strongly. In that kind of an environment typically value fund managers tend to be very concentrated in that area of the market and they’ve taken a lot of pain for three to five years but their view has come through in a very strong way in the last six months. So typically when markets tend to be very polarised and very sentiment drive, as opposed to being driven by valuations or economic fundamentals or business fundamentals, quite frankly, you are going to find individual strategies, which are going to outperform a multi-management process.

But it’s not about getting it right all the time, consistently over short periods of time, it’s about being consistently in the top quartile and that results in superior long-term risk adjusted performance, as opposed to being top quartile, fourth quartile, first quartile, second quartile. So it’s about being consistently there or thereabout, which compounds your returns over a long period of time.

I think to answer your question, typically in market environments which are very polarised over the short term you could find single strategy products outperforming a multi-management product if the market environment in which that fund manager focuses on is in vogue. So for example, value at the moment or growth for the last three years.

HANNA ZIADY: Right, there we go. Let’s talk a little bit about Brexit, now markets, of course, still reeling from the aftermath of that announcement on Friday. Policymakers, analysts, economists all trying to figure out what this means for the UK and certainly for the global economy. Arguably it’s too soon to tell exactly what it means, but having said that, what is your view on Brexit and what Brexit means for equity market returns here in South Africa?

NADIR THOKAN: I think we’ve got to take a couple of steps back. I agree with it’s probably too early to tell what the full impact of Brexit is going to mean. The policymakers are talking about the UK actually only leaving the EU in the beginning of 2019. So in that period there are going to be a lot of negotiations and I think particularly what the aim of those negotiations are going to be is going to be predominantly focused on keeping the beneficial trade agreement in place, because those are obviously mutually beneficial between the EU and the UK. Both the EU and the UK benefit off those.If you were following the leave campaign it was really centred around immigration and the free movement of people, so I think that’s going to be the one significant change.

But I think the big part with regard to the economics of it is that businesses are undoubtedly going to put on hold investment spend over the short to medium term and that’s really going to be the crippling effect on economic growth. Now in an environment where we already have very benign economic growth, both locally and globally, and we have stocks trading on above average multiples globally, I wouldn’t quite say in horridly expensive territory, but certainly above average multiples and in the South African context well above average multiples, a low growth environment, coupled with uncertainty, resulting in businesses hoarding cash, as opposed to spending, is clearly not good for future returns. That what we are seeing being reflected in equity prices over the last couple of days. Obviously, movements have been very drastic and it’s pricing in a lot of volatility and a lot of fear, and whether it’s going to be as bad as that I think only time can tell. I think a selloff of this magnitude surely must present some opportunities, not all these businesses which have sold off aggressively are necessarily very correlated to whether the UK remains within the EU or not. So that must surely present some opportunities.

If one looks at a business like Old Mutual, it’s obviously come under a lot of pressure, a business like British American Tobacco has come under a lot of pressure and quite frankly they derive most of their revenue outside of the UK. So, in fact, a depreciating pound is good for those companies, just like a depreciating rand is good for rand hedge listed on the JSE. I think the biggest impact is going to be on global economic growth with corporates not willing to spend the cash on their balance sheet and that’s not creating a conducive environment for top line earnings in growth and I think that’s predominantly the greatest concern at the moment, is how is the equity PE globally going to unwind without strong support for top line earnings growth and that’s why we’ve seen the reaction we have, predominantly within the UK and European markets and focused with banking stocks in those regions but broadly a selloff across the world. I think that’s really what the concern is at the moment, where is the earnings growth going to come through for the PE unwind to come and this is definitely not supportive for economic growth and top line earnings growth into the medium term.

HANNA ZIADY: You mention the fact that widespread selloffs in equity markets will lead to buying opportunities and you are not the first person to mention that, a number of analysts saying hang on, these kinds of selloffs mean that we can buy assets at attractive prices. You mentioned Old Mutual and BAT, where do you think those buying opportunities are likely to be other than in those stocks?

NADIR THOKAN: It’s fundamentally about who can deliver sustainable, long-term earnings growth and I think there are a number of those stocks on the JSE, which can do that but were trading on very demanding multiples. So a lot of the good quality was already embedded into share prices. So if you take, for example, a lot of our rand hedge industrial stocks, they’re great quality businesses, we know this about Steinhoff, we know that they are on a big drive to expand margins across the businesses and we see them going on an aggressive acquisition spree across Europe and essentially that acquisition spree is, one, about becoming a large scale discount retailer, so that procurement enables them to achieve great discounts in their procurement, which is margin accretive. Two, they want to acquire their entire value chain and at each point in the value chain eke out margin. Anecdotally if you relate that to their furniture business, they want to own everything from the forest to the logistics company transporting the wood from the forests to the manufacturer, to the end retailer and at each one of those points they want to eke out a little bit of margin.

Given Steinhoff’s focus on Europe we’ve seen an aggressive correction in the share price. I think the UK exiting the EU is not necessarily that much of a big deal for Steinhoff but what would be a big deal is if Europe fundamentally breaks up. So if France then calls for a referendum and if the Dutch and Eastern Europe and if the Germans then call for a referendun that would be harmful to Steinhoff’s business. But as things stand the UK exiting the EU is not necessarily that detrimental to Steinhoff’s business. So with the share price down in excess of 12% in two days, Friday and Monday’s trade so far, you’ve got to think that creates somewhat of an opportunity.

Then we’ve obviously mentioned British American Tobacco and Old Mutual, and I think there are a number of good rand hedge industrial counters, which have the exposure offshore. Nepi is another example that comes to mind, provided that Eastern Europe, which is where their focus is, provided there isn’t too much more volatility from the political side within Europe, the selloff we’ve seen in that business could create some buying opportunities. So fundamentally we are starting to see some good quality companies on the JSE, some good quality companies globally for that matter selling off on the back of this Brexit vote and those could present more attractive multiples of forward earnings to enter these stocks because fundamentally the earnings outlook haven’t changed all that much.

Another great example would be if you took Naspers. Naspers has almost zero to do with whether the UK is within the European Union or not, they are deriving all their growth from the online consumption boom in China and that story continues to remain intact for Tencent and yet we see the share price under pressure so far this month. There are a number of buying opportunities coming up but you’ve got to have the risk appetite and the timeframe to endure the short-term volatility because as long as we’re in a risk-off environment and as long as the gold price is doing well and as long as bonds continue to witness inflows, in the short term as markets remain sentiment driven these stocks can continue to be very volatile but over the longer term this does undoubtedly create a more attractive entry point.

HANNA ZIADY: I’m interested to hear your thoughts on banking stocks, now we’ve seen global banks significantly hit by Brexit but our local banks have not been spared either. Investec really bearing the brunt of that because of its exposure to the UK economy, but broadly speaking South Africa’s banks have come under pressure in the last few months, not really related to Brexit, certainly before Brexit, and there is some debate as to whether banks are cheap at these levels and offering good long-term value with favourable dividend policies or whether they are discounted for a very good reason because of the risks that they are fundamentally exposed to by being exposed to the South African economy, what are your thoughts?

NADIR THOKAN: Ja, Hanna, this is where the debate gets interesting because everybody wants to own the good quality stocks. The guys who are growing earnings north of 20 times and the guys who have attractive runways in front of them in terms of growing their earnings base, but unfortunately there is no such thing as a free lunch. I think before the Brexit scenario you were really paying up for those kinds of attractive growth qualities. I think the banking sector is probably on the other end of the spectrum, where valuation is very, very favourable.If we take Barclays Africa as an example, you’re trading on under nine times forward on something like a 7% dividend yield. Standard Bank is not very far away from that and FirstRand has probably been the quality pick in the sector, it’s probably a little bit more expensive than that but not that much more.

I think the biggest issue here is that these stocks haven’t been able to unlock value and rerate to a higher multiple because people are very concerned about exposure to the South African economy. We all saw the first quarter GDP growth numbers, they were a shocker with the economy contracting 1.3% in the first quarter. Growth touted to be 0.5% this year, not improving all that much into 2017 and 2018. So in this environment of very benign economic growth we’ve got something happening with the banks, they’re not extending credit and if they’re not extending credit they’re not growing their interest income and if they’re not growing their interest income they’re not growing their top line as aggressively as what they want to. The banks that are extending credit, the question is what is the impairment going to be on that credit? What are the non-performing loans at these banks going to be?

I think the argument is now they are trading exceptionally cheaply, so they are possibly better quality businesses than some of the mining businesses we see, who are very, very leveraged to the underlying commodity prices. What we do see in our banks is that they are fairly well capitalised, so I’m not going to be touting the fact that if non-performing loans go up to 8% or 9% they are going to be okay, but certainly if non-performing loans go up 0.5% or so to about 4% most of the banks will be able to absorb that shock, given how well capitalised they are and given their very strong dividend yields. So you really are being compensated for being in stocks which don’t have a very attractive long-term growth story, given the path of the South African economy.

But there are many people who are arguing that they are in a value trap and this Brexit vote fundamentally is bad for our growth because we know the UK is a very big trading partner, we know the EU is a very big trading partner and with companies there putting spending on hold massively one must ask what’s that going to do to South African economic growth. It’s very early to tell whether it’s going to be positive or negative economic growth because we look at factors like if the UK can’t achieve favourable terms of trade with the rest of Europe are they going to look elsewhere in the world to be receiving that, it’s still very early to come to those conclusions.

So yes, I think there is some risk embedded in banks but at 8.5 times forward and seven dividend yields for the cheapest banks, and not much worse for the better quality more pricey banks, there is an argument to have some exposure into the portfolio but you have to understand the risks that they are going to be very sentiment driven with regard to the South African economic growth story over the short term.

HANNA ZIADY: Does 27four have exposure to banks? Yes or no?

NADIR THOKAN: Well, we have exposure to fund managers, who have exposure to banks. Yes. We do have exposure to value in our portfolios because we do believe that banks are fundamentally part of the value bucket in the market because at these valuations you simply can’t ignore it. You don’t need much for a rerating to occur in these banks and if they move from an eight forward multiple to a ten forward multiple that’s quite a substantial move in the share price, particularly given the strong dividend yields they’re on and how well capitalised they are. So yes, we do have exposure to the value end of the market and we’re probably slightly overweight benchmark with regard to that.

HANNA ZIADY: Has 27four changed any of its exposures off the back of Brexit?

NADIR THOKAN: No, we haven’t changed any of our exposures in the last two days. I think trading events like this, you are just going to end up on the wrong side of it, you’re never going to get it right. Pretty much five hours before the British citizens went to the polls the consensus view was that the UK was going to remain the EU and we saw throughout last week, up until Thursday, we saw a strong relief rally, meaning that global markets were pricing in the UK remaining in the EU and we saw quite a nice rally in stock prices globally and on the JSE. Trying to trade these events is exceptionally difficult to get the timing right, so you’ve got to have a long-term view, you’ve got to have reasoning for your long-term view and you’ve got to fundamentally stick to that. Chopping and changing over the long term is just going to destroy value.

HANNA ZIADY: Absolutely and that’s good advice for any panicky investors out there. Nadir, generally speaking, what sorts of returns do you think investors can realistically expect to earn from the local equity market this year?

NADIR THOKAN: Hanna, it’s a difficult one because if we break down equity returns what do we have? You’ve either got to have earnings growth, you’ve got to have multiple rerating, so in other words going, for example, from a 20 PE to a 25 PE or you’ve got to have dividend growth. So where do we sit on the JSE, we’ve got a lot of companies that have got a lot of cash on their balance sheet, historically high levels of cash, somewhere in the region of about R730 billion of cash on JSE corporate balance sheets. So they’re not willing to spend that cash, which means that it’s very difficult to see where earnings growth is going to come from.

At 20 times forward earnings, possibly slightly below that given the recent volatility we’ve seen it’s hard to see how multiple expansion is going to come about and we’ve got a dividend yield of under 3%. So if corporates decide to declare special dividends to pay out that cash on their balance sheet we could potentially see that dividend yield uplift providing some tailwinds to returns. But certainly our base case is not north of 20% returns we’ve seen from the local equity markets consistently since the end of the global financial crisis.

We’re in more defensive mode, going to see mid-single digit to very low double-digit returns over the next 12 months, probably edging more towards high single digit returns over the next 12 months. In that environment we’re looking to scale back risk, certainly after the big selloff we’ve seen now we’re going to be looking at the equity markets more closely and seeing if there is an opportunity to deploy more capital and in what part of the market that’s going to be more appropriate as soon as the dust settles. But certainly our base case scenario is not for north of 15% returns, which we’ve seen consistently ever since the end of the global financial crisis. So more consolidation mode and looking for high single-digit returns from the local equity market for the foreseeable future.

HANNA ZIADY: Nadir Thokan is investment strategist at 27four Investment Managers.