We need to mention from the outset that there’s a common misconception among investors about what constitutes outperformance of a portfolio or a fund. For many, the main concern is that their funds invested should beat the return on cash. In the current low-return environment, where both local and offshore equity markets didn’t perform much better than cash over the past year, this concern is understandable.
It’s not uncommon for cash or cash-equivalent investments to outperform equities over the short term. At SPW, our goal is to grow our clients’ wealth over the longer term, however. We define ‘longer term’ as an investment cycle that typically has a duration of five to seven years. History suggests that over the long term, equities are normally the best performing asset class, as investors require outperformance over cash as a reward for the additional risk they take investing in equities.
The skill of investment managers, however, is measured by their ability to outperform a suitable benchmark or create ‘alpha’, as it’s known, for investment portfolios. In the case of South African equities, the objective of portfolio managers is to beat the All Share index. This is what we’re mandated by our clients to do – seek index-beating returns over the long term or through the investment cycle.
The question is how to find the ever-elusive alpha in an extremely volatile macro environment? Fund managers use a variety of methods. Some hold that good-quality stocks will necessarily outperform over time, while others believe it’s all about buying shares when they’re cheap. In our view, neither of these two narrowly defined ‘recipes’ will work. If a ‘good-quality’ asset is overpriced at the time of purchase, it won’t generate outperformance over the long term. Similarly, buying shares simply because they’re cheap is too mechanical – they may be inexpensive because the company is simply not growing its intrinsic value over time.
So while price is crucial, we also need to look at whether the investment case for the company in question is likely to improve to such an extent that the market will recognise its value. It’s essential to build the correct investment thesis for the underlying asset – which isn’t necessarily the popular view or ‘story’ of the asset at the time. The bottom line is that alpha is only likely if you believe the market has undervalued an asset – if its price is materially cheaper than its intrinsic value. It isn’t always easy to find these assets as ‘the market’ is often correct in the price that it assigns to an asset. But the market is not always right.
WHY MARKETS GET IT WRONG
To generate outperformance, investors need markets to be inefficient or wrong to dislocate prices from the intrinsic value of assets. Markets tend to ‘get it wrong’ due to:
- Misinformation. Investors are often misinformed about the story around a particular asset, sometimes through deliberately false information disseminated by company management. The daily ‘noise’ from the media – including fake news – may also cloud investors’ judgement.
- Herd instinct. Investors sometimes give a particular asset the perpetual benefit of the current logical story. So when things are going well, the belief is that this will continue forever. The opposite is also true – a seemingly logical negative story may result in an asset being penalised into perpetuity.
- Investor sentiment. The two emotions that are often the most important drivers of asset prices are fear and greed. Greed is simply the fear of missing out, resulting in ill-considered investment decisions when investors buy into a popular but incorrect story of an asset. Of course, investors with the fortitude to realise when greed and fear have taken over can generate huge alpha if they take the opposite view to the prevailing market sentiment.
The opportunities generated by markets getting it wrong will therefore generally be contrarian, unpopular and perhaps even illogical, but in our view, always sensible. In essence, to find alpha, investors need to:
- Identify assets where the market under-appreciates the potential for growing profits
- Distinguish between general ‘noise’ and fundamental news
- Understand the cyclical nature of markets and that current trends may not last
- Recognise when fear and greed have taken over, and have the strength to act accordingly, even though this may be contrarian.
FINDING ALPHA IN PRACTICE
A good example of how applying these principles can translate to long-term success is our inclusion of Steinhoff into our model portfolios for R16.50 per share in 2009, at a time when the market was pricing the share for disaster. Investors had concerns about the group’s management, balance sheet and the geographical region in which Steinhoff was operating – Europe. The economic prospects of Europe were not looking rosy then.
Our in-depth analysis and research revealed a different picture regarding both management and the group’s balance sheet, and that demand for product was still robust despite challenging economic conditions. Our decision to buy Steinhoff when we did was vindicated when the market also recognised the value of the stock, which eight years later is trading at R68.00 per share.
In a similar vein, the current market view is that a share such as Impala Platinum is unlikely to deliver sustainable returns in future, especially after France’s recent announcement that it plans to ban the sale of petrol cars by 2040, and Volvo claiming all its cars will be electric or hybrid beyond 2019. The controversial proposed new Mining Charter will also undoubtedly have a negative impact on local mining shares.
We have, however, added Impala Platinum to our portfolios, since we believe the share will outperform the market. We don’t dispute the fact that electric and hybrid vehicles will have a negative impact on the demand and therefore the price of platinum in future. Nor do we deny the fact that policy uncertainty will damage confidence in the platinum industry. However, neither of these two factors is unknown to the market, and we therefore argue that they would reflect in both the price of platinum and the share price of the company. Since the company is trading at a discount to its book value, we’re of the view that investors are being overly negative.
If in future the outcome is less negative, both from a demand perspective and/or policy perspective, the share price should respond positively and generate alpha or outperformance for our clients (for more information, read the article by Equity Analyst Shiraaz Abdullah here).
In conclusion, the final word again belongs to Howard Marks: ‘To achieve superior investment results, you have to hold non-consensus views regarding value, and they have to be accurate.’ We couldn’t agree more.
