Sumesh Chetty and Lindsay Williams discuss quality investing and current markets as they travel around South Africa presenting to financial advisors.
Lindsay Williams: Investec Asset Management’s Taking Stock roadshow is underway. We are in the middle of it at the moment as we pre-record this interview. I am with Portfolio Manager, Sumesh Chetty, with whom I have been chatting onstage in various locations around South Africa. Sumesh, I think the word is that we are slightly more optimistic than we were in previous years and previous Taking Stocks.
Sumesh Chetty: Thanks, Lindsay. Yes, we are actually and, when you talk about previous Taking Stocks, it has probably been about 5 or 6 years now since we have actually been this optimistic and it should come as no surprise, given the improvement we have seen in valuations, both in the local market and in the global market.
Lindsay Williams: We can’t go through the whole 35 minute presentation that you and I indulge ourselves in on the roadshow itself but I think the first thing we must look at is your offshore investments, which the slide says I think something like this remains one of our best investment ideas.
Sumesh Chetty: Yeah, that is true. So even though you have seen an improvement locally and globally, we still think offshore is the best. Now we are seeing very similar return potential out of both global equities and local equities but ultimately, when you think about global equities, the quality, the calibre of the businesses that you can find offshore are so much better than the businesses that you can find in South Africa. So we find a number of global blue chip businesses that have much lower economic sensitivity than the typical South African company.
Lindsay Williams: The typical company that you go for is a company that doesn’t have economic sensitivity. That is one of the things that came across. In other words, there can be shenanigans with Mr Trump and Mr Kim, there can be skirmishes on the Kashmir border between India and Pakistan but people still need to use, for example, their Visa card; they still need to use Johnson & Johnson’s cotton buds; they still use Moody’s and ASML (a Dutch listed company). Just give us a brief synopsis of why you like this one because that typifies the type of company that you like.
Sumesh Chetty: So ASML is not a company a typical consumer is going to be using because ultimately ASML supplies these $100 million machines to chip manufacturers. Now microchips are obviously very important to the future of our economy – you know you own a cell phone; you own computers. You have got microchips being embedded in different devices and, importantly, we are moving to a world where everyone wants 5G and there is this increasing demand (let’s say) for applications that are going to be driven by artificial intelligence, which means you need smaller chips, you need faster chips and ASML actually manufactures the machines that laser-cut the chip architecture.
So while demand for chips rises and falls based on economic growth and economic downturns, the chip manufacturers ultimately need to own these machines, they need to have these machines serviced and ASML benefits because, when it comes to the high end of these machines, the extreme ultraviolet machines, they have 100% market share. So we like this business because you have a high margin business that is completely dominant in its sector and doesn’t get impacted by supply and demand for chips going forward.
Lindsay Williams: Microsoft was the other one that was on the list. I was scribbling onstage with you and I wrote down pricing power, high barriers to entry and market domination, characteristics of most of the companies I think that you like.
Sumesh Chetty: Correct and, in the case of Microsoft, you have actually gone a step further because historically you have thought about Microsoft in terms of an Office operating system or Office work system and Windows operating system but ultimately you will remember there are a lot of people out there who just pirate these things and Microsoft is moving away from this - buy once and then ultimately when it stops working buy again and they have moved to cloud-based software where they are saying actually you need to have a monthly subscription in order to access our software so you are seeing revenue and cash come in at a far more consistent pace. Obviously, that makes Microsoft a business that is more attractive to us apart from Microsoft actually driving its business into the cloud even further.
Lindsay Williams: That was one of your best ideas and has been one of your best ideas for maybe 5 years, maybe slightly longer.
Sumesh Chetty: Maybe 10 years now.
Lindsay Williams: But there is a new contender to that crown of one of your favourite ideas and that is the local bond market. Now we spoke about inflation coming down to 4% but it is much deeper than that I think.
Sumesh Chetty: Correct. So inflation obviously is the underpin for bonds in terms of you want a real yield in excess of inflation but the shenanigans that we have seen, the political shenanigans that we have seen, over the last 2-3 years have actually meant that a risk premium is being embedded into our bond market and that risk premium has resulted in a 5% real yield coming out of bonds.
Now most investors look at bonds and they think South African government, I’m worried about investing in the South African government, but the South African government represents the risk-free rate to South African investors. They own the printing press.
Lindsay Williams: Just before you go on – the risk-free rate, the South African government – a lot of investors might say the Eskom debt is surely a threat to the South African government bond market’s security.
Sumesh Chetty: Correct because the Eskom debt is government-guaranteed and that is why the South African government bond yields are trading at the levels they are but we think that the market, especially foreign investors, has overreacted to the concerns around South African government bond yields and, while they should be elevated as a result of the risks presented by Eskom, we think that the yields are 1 to 1.5% too high and that is what represents the opportunity for South African investors, the fact that those yields should actually compress because, if you think about the insurance, the price of insurance, to cover yourself against the risk that the South African government bond represents, you have far too much yield being presented by South African government bonds.
Lindsay Williams: Okay, so you have got bonds, you continue to love offshore but also there has been a change. We put up a graph that showed your continuing dislike for South African equities, your continuing disinvestment percentage-wise in South African equities, but that is starting to change. That beautiful downtrend we saw, long-term downtrend, many years in place has probably started to threaten to break to the upside. The last graph that we put up, there was a bar chart that showed on the left-hand side 15% projected annual returns for 5 years for offshore and also for local equities I believe.
Sumesh Chetty: Correct. So it is the first time in many years where we are seeing exactly the same return expectation out of the SA equity market – sorry, not the SA equity market, our SA equities, the high quality stocks that we can find in South Africa versus the high quality stocks we can find offshore.
Now, to be clear, we still prefer offshore equities to local equities. By their nature, we can find those high quality opportunities I spoke about but on an expected return basis, we are seeing approximately 15% out of both those select offshore opportunities and the select local opportunities.
You are right – equity exposure in South Africa has been coming down as valuations have deteriorated but post the most recent pull-back in SA equity markets, we are saying that opportunity in terms of returns is very similar and you will see equity exposure in the Opportunity Fund going up. In fact, at the beginning of this year (because the graph you refer to obviously is to the end of December 2018), we have already seen a 2% increase in local equity exposure within the fund. So we are very excited about those potential opportunities.
Lindsay Williams: But it is not a shotgun approach here – you are being selective when it comes to sectors and individual stocks and I know, as you have only just started building your positions or rebuilding positions, I would presume you can’t give me individual stocks because it would be unfair to investors but give us the sectors that you like.
Sumesh Chetty: You are 100% right. That is the most important point because the market as a whole is sitting on what we would deem to be a fair value because there are still sectors that are expensive and there are sectors that are obviously very cheap.
So we are starting to become excited for the first time in many years about SA retailers, for example. They are not quite at the valuations where we would be including them in the portfolio but they are getting there, especially after 20 to 30% correction. Sectors that are looking materially cheaper than they were are SA general industrials, South African property and, of course, financials, which we have had very little exposure to over the last couple of years, and, believe it or not, even the global businesses that are listed locally have started looking very attractive to us.
Lindsay Williams: And the runt of the litter is?
Sumesh Chetty: The runt of the litter is cash, believe it or not, and it is bizarre because most investors are actually flocking to cash right now. I think, unfortunately, they are doing it by looking at what has happened over the last 4 years or the last 5 years where cash has effectively outperformed equities but what they should be considering is what cash is going to do going forward.
Now, inflation was printed at 4, as you pointed out, and we expect it to sit at about 5% over the next 4-5 years but the repo rate is 6.75. Now over the very, very long term, cash should only generate 1% real. So the real return available on cash is too high, especially in an environment where growth in South Africa is anaemic and so we think cash rates have to come down and investors who are buying cash on a historic view we think are in for a lot of pain.
Lindsay Williams: Which funds benefit from your wisdom? Tell us about your funds.
Sumesh Chetty: You can take offshore or even purchase our feeder fund, Global Franchise, of course. It gives you 100% foreign equity. Then for investors who are constrained by Regulation 28, the Opportunity Fund, with a maximum investment in equities of 75%, and then, of course, the more conservative Cautious Managed Fund, with a maximum investment in equities of 40%.
Lindsay Williams: Sumesh, thanks very much for your time. That is Sumesh Chetty, who is a Portfolio Manager in the Quality capability at Investec Asset Management in Cape Town.