Why it’s ok to be ‘wrong’

By Piet Viljoen

Since June 2004, when RE:CM took over management, the Nedgroup Investments Managed Fund has delivered 14.5% per annum after fees. While this represents a solid real return of 9% above inflation per annum, concerns have been expressed regarding the recent relative underperformance of the fund versus its peers. 

Over the past year, the Nedgroup Investments Managed Fund delivered 8.5% against a peer average of 16.6%. Given that the local equity market has delivered 22.5% over the past year, this demands explanation. The answer lies in understanding how RE:CM invests and more importantly why they favour this approach. 

Our philosophy: Generate real returns, protect against capital loss 

RE:CM is first and foremost an absolute value-oriented asset manager. Our commitment to our clients is to deliver good long-term real returns above inflation whilst always protecting against the risk of permanent capital loss. Protecting against downside risk is a crucial component of generating the best real returns over time as this allows compounding off a higher base. 

The reason we focus on real return is because it is possible for an asset manager, focused on relative returns, to beat the market and peers and not deliver real returns above inflation – particularly when markets have fallen. In this instance, we believe the manager has failed to meet its investors’ ultimate objective, but may not be fired for doing so – as long as they have fallen by less than the market or their peers. 

Career risk trumps investment risk

Jeremy Grantham of GMO writes of this phenomenon, saying that the prime directive for any professional investor is first and last to keep their job. To do this, he explains, a professional investor must never, ever be “wrong” on their own. To avoid this, many professional investors pay ruthless attention to what other investors are doing. They 'go with the flow' which creates herding and momentum, driving prices far above or far below fair value. This is by far the largest source of inefficiencies in market pricing. As a value investor, RE:CM seeks to take advantage of such inefficiencies. This requires patience and conviction, however, since sticking to this philosophy means there will be times when we are “wrong” on our own. 

Naturally, these times are uncomfortable for our investors and also for us. The past year has been such a time. 

Fortunately, we have the structure, discipline and conviction to withstand this short-term external pressure, and this allows us to continue to do the right thing with our investors’ capital. We hope it will give comfort to investors to know that we’ve been here before, and it worked out well for our investors ultimately. 

What happened the last time we were “wrong” on our own? 

The year ending 31 May 2008, prior to the market collapse, saw the fund’s returns significantly lagging the market and peers by an even greater margin than today. Our return for the Nedgroup Investments Managed Fund was at -7.8% pa, compared to a peer average of 3.4% pa. 

The big resource stocks were being driven to new highs by the Commodity Super Cycle. The Nedgroup Investments Managed Fund held none of these and was severely criticised for missing out on relative performance as a result. Instead, the top stocks in the Fund included names such as Tiger Brands, Discovery and Richemont – all of which had substantially underperformed the market. Today no-one would question these stocks in a portfolio. Back then however, they were out of favour and cheap. 

Our quarterly newsletter in April 2008 stated the following: 

“In SA equities concentration is increasing with commodity stocks making up all of the top 20 performers this year while 75% of the ALSI stocks are down… The case for a demand-driven, China-led supercycle is quite persuasive. However, commodity stocks already look to be discounting it while at the same time ignoring the short-term business cycle. With the US economy close to recession and Japan and Eurozone looking vulnerable, investors are playing with fire. Even in super cycles, commodity prices can fall sharply, as they did in 1975. The current level of many commodities is so far above the five-year mean as to pose a severe threat if all the good news fails to come to pass.”

The market fell soon thereafter by more than 40%, with resource stocks such as Anglo American, Amplats and Billiton – which the fund had zero exposure to - falling by up to 75% in absolute terms. 

From bottom of the pile to top performer in just a few months 

The Nedgroup Investments Managed Fund fell by just 3% - less than a fifth of the peer average of -17% during the market collapse . RE:CM’s focus on managing absolute returns and absolute risk throughout the cycle protected its investors’ capital and saw significant relative underperformance dramatically change to outperformance. 

It is also worth noting that out of the funds that have been around for as long as the Nedgroup Investments Managed, the fund that was the top performer during the period prior to the crisis was also the very worst performer during the crisis with a return of -32% for the nine months to February 2009. 

Markets are typically driven to highs by expensive stocks becoming even more expensive, chased by euphoria-driven momentum. Participating in this momentum works well while it continues, but sadly there is no bell to announce a turning point. This sees many spectacular returns dramatically unwind during the inevitable correction in prices that follows. The only way to avoid permanent capital losses is to never pay more for a business than it is worth – not matter how popular it is. 

Does that mean the fund only performs well in bear markets? 

The Nedgroup Investments Managed Fund does not only perform well in bear markets – as value investors, we stick to the tried and tested formula of investing in undervalued (cheap) securities and waiting for this to be corrected over time. As such, the value philosophy also tends to perform very well in early bull markets when such opportunities abound. The year after the crisis for instance, the fund outperformed its peer average by close to 4%. It also outperformed significantly during the second year after the crisis. In fact, it has only been over the past year that the performance has lagged materially affecting all measurement periods to that point. 

For instance, the five-year rolling return to June 2012 saw the fund outperforming its benchmark by close to 4% per annum. Today, just nine months later, the fund is underperforming on a five-year rolling basis. The fund is not being invested any differently today than it was five years ago or indeed nine months ago. As in 2008, our principles remain firm: invest only where assets are cheap and avoid assets which are expensive and which, as a result, carry high risk of permanent capital loss. As in 2008, this has cost us in recent relative performance but we know that sticking to the value philosophy will ultimately deliver the returns our investors require, without exposing them to unnecessary risks that could see their capital destroyed. 

The most dangerous words in investing: “This time it’s different” – Sir John Templeton 

In every cycle, similar comments are made about value investing during the shakeout process. These comments include: 

“They just don’t get it.” 

“Can’t they see that the price of (insert name of popular asset here) will continue to go up?” 

“They are too stubborn for their (and our) own good.” 

“It’s different this time – the prices of (insert name of cheap asset here) will continue going down forever.” 

So what is it that gives us confidence that our funds’ returns will eventually improve? In short, it is our investment philosophy: we buy cheap, good quality assets that are priced at better than 60 or 70 cents in the Rand. Over time, if our work is correct, the market should realise that these assets are undervalued, and price them more correctly. 

Today, those assets include platinum and resource stocks such as Amplats, Implats, Lonmin and Anglo American as well as stocks in the gaming/ leisure sector which until recently were at cyclical lows and priced accordingly. Unlike many other resource businesses, the top three platinum producers are quality businesses by virtue of having delivered excess returns above their cost of capital over time with a significant barrier to entry – they sit on the majority of the world’s platinum reserves. 

Globally, we are investing in US banks such as Wells Fargo and Bank of America which have been tarred with the same brush as those that got the industry into trouble. We are also finding value in places like Europe and Greece where macro-economic woes continue to weigh heavily and indiscriminately on the prices of a handful of very high quality businesses. We remain resolute in our conviction to avoid popular, expensive, and as a result risky, assets in the local equity, property and bond markets. Unfortunately, as with the last cycle, cheap stocks often get cheaper, but this is a temporary loss of capital. The risk is not in the unpopular stocks that are cheap as a result of the bad news everyone already knows about. It is in stocks priced for perfection, where expectations are too high and will inevitably be disappointed. When you buy a business at a price well above what it’s worth, a decline from these prices is a permanent capital loss. 

We conclude with a quote from our letter to investors in similar circumstances in July 2008: 

“We hope investors will take comfort that we have been through periods like this before, and the end result was always the same: good returns were ultimately achieved by sticking to our guns. The fact that value investing is so difficult is exactly why it works: few investors are willing to do the right thing over the long-term; therefore few investors achieve good returns over the long-term.” 

Thank you for your continued trust in allowing us to manage your capital.