As we look back on 2015 a song by Roger Waters of Pink Floyd comes to mind. The song is titled “Goodbye Blue Sky” and describes in its simplest form, the Blitz; the German bombing campaign of British cities in World War 2.
Looking back on 2015, we in South Africa, as well as other emerging markets, have had our own Blitz to contend with. Certain sectors and stocks suffered catastrophic declines in value while others escaped relatively unscathed, and in some cases even thrived, despite the increasingly challenging circumstances. The FTSE/JSE All Share Index managed to end the year in positive territory with a meagre return of 5.1%. This however does not paint the full picture of the significant capital destruction that occurred in certain sectors. Hardest hit was the resources sector suffering on the back of falling commodity prices and, despite the benefit of a weakening exchange rate, ended the year down 37% (see graph below).
The platinum sector, after falling 32% in 2014, lost a further 62% in 2015. The telecoms sector also came under pressure, losing 28% for the year, largely as a result of MTN’s 39% decline due to a host of problems in its Nigerian operations. On the positive side of the returns spectrum, the big winner for the year was the industrial sector which delivered a stellar return of 15%. The Industrial Index is heavily skewed toward big rand hedge offshore listed companies such as SAB Miller, British American Tobacco, Steinhoff and Naspers; all of which delivered fantastic returns on the back of their own fundamentals, as well as benefitting from the weaker exchange rate.
Given the tough market conditions and the significant price declines seen in some sectors, we have still managed to achieve consistent levels of performance. Many factors have contributed to our performance such as good stock selection and portfolio diversification, but the one factor that is seldom highlighted, but which we see as one of our defining competitive advantages, is how we manage risk - not only at a total portfolio level, but also at the individual stock level.
Looking back on 2015 it is clear that understanding these risks and, more importantly, how the market was pricing these risks, was the differentiator between saving a large amount of money (by avoiding many of these disasters) or costing one dearly if one hadn’t.
We constantly question our base case valuations and ask ourselves, “what if we are wrong?”, in other words, “what is the potential for permanent capital loss in the event that our base case assessment of intrinsic value is wrong?”.
On one hand, we are trying to find those stocks that have return distributions that are skewed to the upside. An example of a share with a normal return distribution is shown below, with the blue shaded area showing the possibility of sustaining capital losses (a relatively large probability) (see graph below).
On the other hand, if we buy a share that has a return distribution that is skewed to the upside, and we end up being wrong in our base case assessment of its intrinsic value, at worst we would hope to get most of our money back, with no significant permanent capital loss, but with a far more likely chance of making an acceptable return on our clients’ capital (see graph below).
The market often underestimates or glosses over many of the risks in business, and only focuses on the potential upside based on their assessment of intrinsic value.
Much of Truffle’s industry-leading returns come not only from selecting winning stocks, but also from avoiding the disasters. This results in the fund’s value declining less than market indices when market drawdowns occur, but more importantly, increasing in-line or ahead of market indices when they rise. The rest is arithmetic: if you manage to avoid capital losses, and grow off a ‘bigger base’, the power of compounding does the rest of the heavy lifting. The result is benchmark beating returns.
Looking ahead to 2016
There are many signs which give us cause for concern. The South African economic growth outlook continues to deteriorate on the back of collapsing commodity prices, drought, infrastructural constraints, as well as higher expected inflation and interest rates. This suggests a significantly more challenging environment for companies, especially locally focused businesses, to grow their earnings. In addition, the possibility of a potential downgrade of our sovereign debt rating to ‘junk’ status could add further volatility to markets. Credit ratings are important because a downgrade to non-investment grade or ‘junk’ would not only increase our public sector borrowing costs, but also make it increasingly difficult for us to fund our annual current account deficit. If we don’t see meaningful evidence of government expenditure being curtailed (especially the public sector wage bill), we may well follow the likes of Brazil and Russia who were both downgraded to ‘junk’ in 2015.
Adding further fuel to the fire, the fiasco around our finance ministry leadership has put the world spotlight on South Africa. Any further non-investor-friendly economic policy changes would be met with a swift negative response from global investors.
Globally, all eyes are on the Fed as to the pace of further rate hikes as interest rate policy begins to normalise in the USA. Any upside surprises on the speed and scale of rate hikes will result in further pressure on emerging market currencies, including the rand. Emerging market equity funds saw record outflows in 2015, with US$63bn of sales, as investors switched into developed market assets.
From a valuation perspective we remain of the opinion that local equity markets are expensive, with ratings above their long-term median levels. Combined with the possibility of further earnings’ disappointments we could potentially see the equity market moving sideways to down until earnings catch up with valuations, while offshore markets still appear to offer better value on a risk-adjusted basis. As a result, we remain relatively defensively positioned with large exposures to non-mining offshore rand hedges, offshore property and local financials. Our direct offshore exposure remains at the maximum prudential limits, with equities comprising the largest proportion of the assets.
We have for some time cautioned co-investors that the quantum of equity returns achieved both in South Africa and to some degree globally could be significantly lower than those achieved over the last five years. However, we are confident that the Truffle process will continue to be successful in selecting the better performing shares in our available universe.