South Africa’s domestic economic outlook is not particularly impressive. In fact, despite posting relatively good GDP growth figures last quarter to emerge from a technical recession the reality remains that we’re in for a tough time. South Africa is fortunate that Emerging Markets in general are being favoured by global investors for now – certainly not because of our political environment, and despite risks from Trump, Brexit as well as continuing threats from North Korea (who just launched another missile over Japanese airspace).
We’re also fortunate that inflation is relatively low against our bond yields when compared to the rest of the world. This means that global investors are piling cash into our Bond markets resulting in rand strength, creating desirable conditions for SA-based investors to allocate capital to global assets.
The Nedgroup Investments Global Equity Fund with sub-investment manager, Veritas Asset Management (UK), has a concentrated global equity mandate typically comprising 25 – 40 carefully chosen shares of high quality businesses from around the world. Given the thousands of listed global shares to choose from, this affords the fund managers the opportunity to be extremely selective about which companies to actually include in the portfolio. With a significant emphasis placed on capital preservation, Veritas are able to appropriately diversify and manage risk to produce outstanding long term outperformance.
How do they do it?
All of this would not be possible without the deep fundamental research process that is employed to identify quality and cheapness. The majority of companies that are initially identified as potential candidates are eventually discarded in favour of only the very best ideas for inclusion in the portfolio, which is then constructed in a benchmark agnostic manner. Typically, Veritas closely monitor approximately 250 stocks as part of their universe list. These are companies that have passed multiple filters and have also made it through their disciplined fundamental process while waiting for the right opportunity to present itself before they can buy in while paying close attention to key factors such as valuation and corporate governance:
Source: Veritas Asset Management
In fact, the Veritas process is so strictly disciplined that they are willing to allow cash levels to rise in the portfolio rather than invest in companies where they are not fully comfortable with the investment thesis and/or share price valuations. The fund managers would rather be patient to wait for the right opportunities to arise. An example of a recent purchase for the portfolio is Qualcomm, a US-based technology company that holds the key IP to the wireless semiconductor market. The company is also a global leader in semiconductor design. Qualcomm has undertaken a transformational deal to acquire NXP, a leading automotive and industrial semiconductor company. Given the increased usage of smart technology in cars such as self-driving algorithms and other driver assist systems, the deal is seen as a game-changer for the combined business.
Another important pillar of alpha generation is their sell discipline. Typically, Veritas look to achieve an absolute return of 15% p.a. over the next 3 – 5 years for a given stock at the time of purchase. This return requirement is increased to 20% p.a. for stocks that are more risky, and decreased to 12% p.a. for stocks that are of the best quality with the most predictable returns, as long as the valuations remain attractive. Stocks are sold when they reach their target intrinsic value, where there is a thesis breach or perhaps even when there is a significantly better opportunity that arises which will enhance the portfolio’s characteristics such as expected return and/or diversification.
A recent example of a company that was sold out of the portfolio due to reaching its target price was Julius Baer, the Swiss private banking group. Although Veritas still likes the business itself, the share price has increased significantly and, they believe, now discounts far too optimistic future outcomes based on their assessment of the company’s prospects:
Source: Thompson Reuters Datastream
Since November last year the share price has risen from a low of CHF 38 to CHF 55 today. The company remains on their universe list and will continue to be monitored closely for any potential purchasing opportunities that may arise in the future.
Edenred on the other hand is a business that was owned for quite a long period of time within the fund and was sold recently due to a thesis breach. The company previously held significant cash reserves as a function of their operational business, where there would often be a lengthy time lag between the point at which they received upfront payment for their services and when they would actually need to provide these services to their customers.
Due to the low interest rate environment globally, Edenred’s management team has been determined to increase ROE by now using these cash reserves for M&A activity. While the strategy could end up being quite profitable for the business, it does hugely increase earnings uncertainty going forward. As a result, Veritas chose to close out the position and remove the company from their universe list going forward.
The end goal: outperformance
Over the long term, this disciplined process has resulted in Veritas being able to outperform their peers by 4% p.a. since inception of the strategy in 2001. Interestingly, an analysis of their return profile over rolling three year periods does indeed show that they tend to lag their peers in upward trending markets, while strongly outperforming when market returns are more tempered:
Source: Morningstar, using three year data since 2001
On a three year rolling basis they have outperformed their peer group 80% of the time overall. Through their primary focus on downside protection, Veritas have again proved that the long term benefit of capital preservation when markets are falling far outweighs the strategy of trying to produce better performance than peers when markets are sharply rising.
Ultimately, the team at Veritas spend their time looking for companies that have these key characteristics:
- Distinct growth drivers that are independent of economic growth
- A moat to protect future cash generation such as a network that is extremely difficult to replicate despite large capital investments
- High levels of recurring revenues (at least 60% or more)
With their real return mind set and foremost focus on capital preservation, it makes the Nedgroup Investments Global Equity Fund a compelling proposition for investors seeking exposure to global stock markets. This is indeed an important differentiator to its peers.
By following a proven fundamental research process and maintaining their strict valuation discipline to be highly selective before investing in a company ensures that prospects for future outperformance remain very attractive.