SA Unit Trust
Ninety One Opportunity Fund
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Sep 6, 2021
It is apparently customary to start articles on investing with clever-sounding quotes from famous investors. So instead of having one, I will use three, and to make it more interesting I am going to say that two of these quotes comes from investment guru Charlie Munger. Can you guess which?
The correct answer is number 2 and 3.
You have probably heard a lot of our peers refer to the first quote. This is not surprising as over fifty percent of the asset management industry in South Africa follows a value-biased philosophy,1 also known as ‘value investing’ or ‘valuation-driven investing’. Value investors make money by investing in businesses which are unloved, thereby generating an excess return from the change in the rating/multiple/perception of a business (when the rating reverts to the mean as the perception of the business improves).
Good examples currently of value shares would be ‘re-opening’ stocks, for instance, airlines, or ‘reflation’ stocks such as banks. These are stocks that were beaten down last year as negative sentiment, sparked by the COVID-19 pandemic, pushed their share prices sharply lower. Once these share prices have rebounded, value investors would then move on to the next beaten down sector, and so on. They have to move on because these businesses have typically not been good investments to own over the long term (more on that later). Hence, we would classify value investing as a medium-term investment strategy.
Various investment styles – considering duration and return drivers
|Time horizon||6 - 12 months||1 - 5 years||5 - 10+ years|
|What drives investment return||Earnings surprise||Multiple change (sentiment/cycle)||Return on invested capital|
|Style of investing||Momentum/earnings revision||Value investing||Quality investing|
Source: Ninety One.
Over the medium term, the price you pay matters a lot, over the long term it does not. Let’s back up this seemingly heretical statement with some numbers. Over the last hundred years, you would have earned roughly 10% p.a. investing in the S&P 500, of which 4% would have come from the dividend you received, 5.5% from earnings growth and a paltry 0.5% from the change in the multiple. In other words, the price (or multiple) that you paid hardly made any difference; what made the biggest difference was the underlying earnings growth. That makes intuitive sense: over the long term, the share price of a business should converge with its intrinsic value, and what drives intrinsic value are earnings.
The question then becomes: What drives earnings? Earnings are driven by the return on capital that a business earns. So, if return on capital drives earnings, and earnings drive intrinsic value, and intrinsic value drives share prices over the long term, then you can understand why Charlie is right (quote number 2 and 3).
Let’s use an analogy to explain how we think about investing. Imagine you have a 100 metre race between two cars, one of which is an Italian sports car and the other a jalopy2 (no disrespect to jalopy owners). The catch is that the jalopy gets to start halfway up the track. Who wins? I don’t know because I haven’t crunched the numbers, but it may very likely be the jalopy. However, let’s say that the jalopy crosses the finish line first and as it crosses that line the announcer says: “Apologies, we have extended the race to 100 kilometres.”
Who wins now?
Without having to reflect much, I think we can all agree that the Italian sports car would be the clear winner. In fact, the jalopy may not even finish the race! The point is that the jalopy loses the initial advantage when the race becomes much longer. The quality of the Italian car is accentuated over time. This is a good way of explaining the difference between value investing and quality investing (the jalopy’s mechanical disadvantages – its lower quality – is seemingly offset by its good value, i.e. lower price and having a head start in the race). To quote Charlie’s long-time business partner Warren Buffet: “Time is the friend of the wonderful business, the enemy of the mediocre.”
So, what does this all mean? There are three important implications:
Our portfolios are concentrated. As quality investors, we are drawn to companies which generate high returns on capital and can reinvest these returns back into the business to grow their capital. There are not many such businesses – quality tends to be scarce. Likewise, there are not many Italian sports cars on the road. The implication is that our portfolios tend to be concentrated – they typically contain less than 30 stocks each.
Our portfolio turnover is low. While price is an important consideration for our team, we mainly generate an excess return by relying on the earnings growth of our underlying investments to compound over time. The longer we own them, the greater the impact of the compounding (the longer the race, the greater the possibility that the Italian sports car wins). This means that we are truly long-term investors, not medium-term investors.
This in turn implies that our portfolio activity is low, which is indeed the case. Our average portfolio turnover is less than 20% (implying an average holding period of around five years). In fact, we have owned shares such as Richemont, Santam, British American Tobacco and Distell for more than ten years.
We view ‘margin of safety’ in a different light. A business whose intrinsic value is much higher than its share price, allegedly has a large margin of safety. In other words, to go back to the racing analogy, a value investor would say that the closer the jalopy is to the finish line, the bigger the margin of safety. As long-term investors, the only thing that matters to us is that the ‘Italian sports car’ does its job, namely that it really is an Italian sports car with superior build quality and durability.
This means that we tend to focus a lot more on business quality as a measure of the margin of safety, because ultimately it is the return on invested capital that determines investment success over the long term. Put another way, unless the quality of the business becomes impaired, it is very difficult to permanently lose capital on a high-quality business, even when paying a high price. This is because its intrinsic value is always growing over time (refer to the earlier quote about time being the friend of the wonderful business). The Italian sports car may be more expensive than the jalopy, but over the long term its value is far greater.
Our asset allocation views have remained unchanged over the last few years. We believe that global equities still provide the best opportunity for growth. Bonds are our preferred local opportunity.
We prefer global equities to SA equities because there are better quality businesses available offshore in which to invest, offering higher returns on capital and superior growth opportunities. As a result, this preference is highly unlikely to change regardless of an improvement in Eskom’s finances, a new government in power or even a change in the PE (price earnings) multiple of the overall SA market. Return on invested capital is our guiding light. While the market goes through waves of infatuation with ‘SA Inc.’, we are not swayed by changing investor sentiment. We stick to our investment philosophy and process.
That being said, we have been able to find some global best-in-class businesses in SA such as Clicks and Capitec. Both have played a huge role in lowering the cost of the products and services they provide to consumers, making a big difference to the lives of ordinary South Africans. Even though these are standout companies, they are often labelled as ‘expensive’ by the local investment community.
We believe that the market consistently undervalues quality businesses over the long term. While value investors exploit the human emotion of fear, we exploit the human desire for instant gratification (‘time arbitrage’).
Our philosophy is different to most of our peers in the industry and this is reflected in our portfolios: we own very different shares; we own very few shares, and we own them for a long time. We are amazed at how many of our peers say they invest in quality businesses (who would admit otherwise?) – yet their portfolios look and behave very differently.
We have found that over time a strict adherence to our Quality philosophy has led to very good long-term investment outcomes for the people who have entrusted their savings to us.
1 Glacier by Sanlam, 2018.
2 From Wikipedia: “A jalopy was an old-style class of stock car racing in America, often raced on dirt ovals”. Over time, it has become an archaic slang term for a decrepit car.