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Taking Stock Winter 2019

Managing downside risk in uncertain times

14 August 2019
Author: Clyde RossouwCo-Head of Quality

We’re in the later stages of the longest bull run in developed market equity history, which has exceeded ten years. Over this period, there has been a material increase in the market share of passive global equity market strategies. For instance, the market share of active US equity funds was 51.3% at the end of last year, versus 48.7% for their passive counterparts.1 In 2009, the split was 73% (active) versus 27% (passive).2 And while investors have enjoyed the tide of rising markets, managing downside risks have been less of a focus. But global growth concerns and geopolitical uncertainty are creating a challenging investment environment, with downside risks on the increase. Investors face a raft of issues that include:

  • Rising debt burdens across governments, corporates and households
  • Central bank policy beginning to shift away from the huge quantitative easing experiment that has supported asset prices over the last ten years
  • Volatility spikes in equities, bonds, currencies and commodities, which serve as an important reminder of the latent risk in markets at these levels
  • Technological change severely disrupting a variety of companies and industries, causing earnings forecast downgrades in many cases

We believe avoiding capital losses is just as important as achieving capital gains when it comes to generating sustainable long-term returns. This is where the value of good active management truly comes to the fore. Index-tracking passive strategies expect investors to put their faith in a basket of equities, regardless of their characteristics and inherent risks.

Quantitative metrics have flaws

We don’t believe a quantitative passive approach is able to fully capture mispriced opportunities that will generate sustainable outperformance (alpha) for long-term investors. As active managers, we believe that in-depth bottom-up qualitative research is essential to fully evaluate the sustainability of a company’s competitive advantage and profitability. Quantitative metrics may not reveal, for example:

  • The true strength of a company’s competitive positioning and market share
  • The impact of short-term currency movements
  • Its dependence on the economic cycle
  • Its relationships with key stakeholders
  • Business tail risks, such as regulatory/political risk or over-reliance on a single product, market or customer

Aggressive accounting and financial engineering can also give a false picture of the actual health of a company. This can distort earnings-based metrics on which quantitative passive strategies rely. Even accurately reported figures can be misleading. For example, high margins may reflect under-investment rather than pricing power or cost efficiency. Overall, different levels of disclosure, accounting treatments and calculation methodologies, as well as corporate activity leading to one-off gains or losses, all make cross-company comparisons difficult using a solely quantitative based approach.

In addition, quantitative strategies struggle to take advantage of forward-looking themes and trends, such as technological disruption, and social, environmental, political and demographic change. We believe in-depth proprietary qualitative research can exploit the long-term pricing inefficiencies not captured by a purely passive or quantitative approach.

Our Beiersdorf case study helps to further illustrate these points.

Case study – Beiersdorf

Beiersdorf, the German consumer goods company behind the Nivea brand, and a recent addition to our Global Franchise portfolio, is a good example of the pitfalls of following a quantitative only approach. This is explained below:

  • The company has a large net cash position on its balance sheet which results from holding the dividend flat for several years, in anticipation of future merger and acquisition opportunities. At current prices the cash balance of more than €4 billion equates to approximately 18% of Beiersdorf’s true market capitalisation. The large cash balance has a secondary effect of reducing the company’s overall headline return on invested capital (approximately 15%) which, on an operational basis, is greater than 70%.
  • Even if the cash balance is correctly reflected in the valuation, other issues persist. Beiersdorf’s market capitalisation is incorrectly reported by a number of data vendors who include shares held in treasury (approximately 10% of the share count). This means that even if an investor attempts to adjust for the large cash balance using an enterprise value to earnings before interest and taxes (EV/EBIT) multiple, the market cap used to calculate the EV is 10% too high.
  • Beiersdorf’s historical growth rates do not reflect the true underlying growth due to the company’s decision to re-position the Nivea brand by pulling away from certain adjacent personal care categories. This has constrained reported growth since 2012 but is now complete, with the company well positioned to grow from here.
  • Moreover, Beiersdorf’s treatment of sales in hyperinflationary countries means that even if you compare recent organic growth rates with peers, they are not comparable. For example, many European staples still account for Argentina at ‘constant exchange rates’ and have only recently dropped Venezuela from the calculation. Beiersdorf, in contrast, calculates its organic growth in these countries using the actual exchange rates – a more prudent approach.
  • The company’s margins are low relative to peers due to the active decision to invest heavily in advertising and promotion. At approximately 25% of sales within its Consumer division, it appears to us as though a normalisation of this cost line could represent a long-term opportunity within Beiersdorf’s profit and loss statement. Such insight can only be obtained by analysing the disclosures in the annual report and speaking with the company.

 

A high conviction portfolio

Concentrated portfolios allow portfolio managers to make high conviction allocations to their best investment ideas. We believe active management is most effective when conviction is at its highest. A portfolio investing in a high number of stocks can dilute the impact of a portfolio manager’s best risk/return ideas, particularly in broadly efficient markets where alpha opportunities are scarce.

Our Quality investment team scours a global universe of over 20 000 listed equities from which we select only 25-40 stocks for the Investec Global Franchise Fund. This translates into the fund having an active share of more than 90%, versus the MSCI All Country World Index (MSCI ACWI).3 Compared to the MSCI ACWI Quality Index, the fund’s active share remains a very high 80%. Clearly, we aren’t benchmark or index huggers and we follow a differentiated approach to stock selection.

Top holdings %
Visa Inc 9.1
Microsoft Corp 7.2
Verisign Inc 6.4
Booking Holdings Inc 5.5
Moody's Corp 5.3
Nestlé SA 4.6
Johnson & Johnson 4.2
Roche Holding AG 3.9
Beiersdorf 3.8
Philip Morris International 3.8
Total 53.8
Number of equity holdings 29

Source: Investec Asset Management, as at 30.06.19.

How do we define quality?

Fundamental research helps us to uncover what best reflects our definition of high quality franchise companies. We seek businesses that have the following key attributes:

Hard-to-replicate

Hard-to-replicate
enduring competitive advantages

Dominant

Dominant
market positions in stable growing industries

Low sensitivity

Low sensitivity
to the economic and market cycle

Healthy balance

Healthy balance
sheets and low capital intensity

Sustainable cash generation

Sustainable cash generation
and effective capital allocation

These exceptional qualities create barriers to entry against competitive threats and high switching costs for customers. The resulting pricing power, together with capital-light business models and financial strength, have enabled franchise companies to sustain high levels of profitability over the long term, far beyond market expectations.

Focus on sustainability

Because we invest for the long term, we have a strong focus on the future sustainability of companies. Our active approach allows us to gain an understanding of companies’ resilience to disruptive forces and whether they have taken steps to ‘future-proof’ their businesses. So, we pick companies with enduring qualities, and consequently, we have a low portfolio turnover. Since inception, the portfolio turnover for the Global Franchise Fund is only around 50%. This helps to minimise the investment cost drag on investment returns, which can prove meaningful over the long term.

Delivering long-term sustainable returns to our investors (durable alpha) requires ongoing analysis and engagement with companies and their stakeholders. We engage regularly with management teams and evaluate companies’ impact on their various stakeholders. Our active investment approach enables us to carefully assess the environmental, social and governmental (ESG) risk and opportunities that can affect the sustainability of a company’s business model; the quality of its accounting policies; and governance issues such as capital allocation, risk management, board composition, audit, remuneration, and shareholder rights.

Differentiated alpha

The Investec Global Franchise Fund has a long-term track record of delivering durable, defensive returns to investors, thanks to our differentiated, active investment approach (Figure 1 and Table 1).

Figure 1: Cumulative performance in US dollars since inception*

Cumulative performance in US dollars since inception*

Table 1: Annualised returns in US dollars

1 year 3 years p.a. 5 years p.a. 10 years p.a. Since inception p.a.*
Investec Global Franchise A Acc 10.7% 10.1% 8.1% 11.0% 7.0%
MSCI AC World NR** 5.7% 11.6% 6.2% 10.1% 4.5%
Quartile ranking 1 2 1 1 1

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, dates to 30.06.19, NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. **The comparative index changed to the MSCI AC World Index from 1 October 2011. Highest and lowest returns achieved during a rolling 12-month period (since inception): Feb-10: 54.4%, and Feb-09: -38.7% – Investec Global Franchise A Acc share class. *Launch simulation date: 10.04.07. Quartile ranking within the GIFS Global Large-Cap Blend Equity.

While Quality indices are still very overweight consumer staples, we have reduced our exposure to consumer staples over last few years, in favour of interesting defensive growth opportunities. Technology, which is now our highest sector exposure, has contributed materially to our alpha generation. Furthermore, our active bottom-up stock picking has also added alpha. This means that our differentiated approach to quality stocks is not replicable by investing in the market, or even in a quality index.

Managing risk

Avoiding capital losses is just as important as achieving gains when it comes to generating sustainable long-term returns. So, we seek companies which have defensive characteristics. We typically like companies that have recurring revenue streams, enduring competitive advantages, strong management teams, low debt levels and healthy balance sheets. This helps to reduce our investors’ exposure to operational, business and financial risks. On top of that, we manage valuation risk by investing in quality companies at reasonable prices.

Importantly, the Investec Global Franchise Fund’s outperformance against the comparison index – the MSCI ACWI – has been achieved with lower risk, both in terms of drawdowns and volatility.

Figure 2: Outperformance with low volatility – risk vs. return in US dollars

Outperformance with low volatility – risk vs. return in US dollars

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, 30.04.07 to 30.06.19. Performance for the fund is NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. *The comparative index changed to the MSCI AC World Index from 1 October 2011.

The portfolio has shown its mettle during severe market corrections, such as when the global financial crisis hit investors. For instance, over the period May 2007 to March 2009, the Investec Global Franchise strategy’s drawdown was 20.5% while the MSCI ACWI lost 37.7%. The quality stocks in our portfolio have also proven to be more defensive than the MSCI ACWI Quality Index during falling markets.

Figure 3: Average rolling 12-month performance in US dollars

Average rolling 12-month performance in US dollars

Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, 30.06.19. Performance for the fund is NAV based, inclusive of all annual management fees but excluding any initial charges, gross income reinvested, in US dollars. Rolling 12-month periods. MSCI ACWI Quality index launched 18.12.12 – synthesised performance history prior to that date.

Conclusion

There are clear risk and return arguments that support an active approach to quality equity investing. As active investors, we have the ability to manage downside risks, while still participating in up markets. This should provide some comfort to investors in these uncertain times where global growth concerns and geopolitical uncertainty are creating a challenging investment environment.

The Investec Global Franchise Fund has a long-term track-record of delivering durable, defensive and differentiated returns. Our portfolio companies have been less sensitive to the economic and market cycle and have offered an attractive combination of resilience and long-term structural growth – much needed attributes in this uncertain environment.

 

1Morningstar Direct data, as at 31.12.18.
2Morningstar Fund Flows and Investment Trends, 2009.
3Active share is the fraction of the fund’s portfolio holdings that deviate from the benchmark index – Investopedia.

 

Clyde Rossouw
Clyde Rossouw Co-Head of Quality

Important information

All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs. The current TER cannot be regarded as an indication of the future TERs. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). A feeder fund is a fund that, apart from assets in liquid form, consists solely of units in a single fund of a collective investment scheme which levies its own charges which could then result in a higher fee structure for the feeder fund. The fund is a sub-fund in the Investec Global Strategy Fund, 49 Avenue J.F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg, and is approved under the Collective Investment Schemes Control Act.
This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Issued by Investec Asset Management, August 2019.

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