Market Commentator: ‘There’s value in the SA equity market’

WARREN THOMPSON: Joining me on the Market Commentator podcast today is Karl Leinberger, he’s the chief investment officer of Coronation Fund Managers. Good to have you with us, Karl.

KARL LEINBERGER: Thank you very much.

WARREN THOMPSON: Just to start off with, Karl, and in a nod to 2016, which was an unprecedented year from many perspectives, we had two very unlikely scenarios that came to the fore on the global agenda, which was Brexit and the Trump presidency. So my first question to you is just around what did 2016 teach you or reaffirm about investing in what is a very uncertain world?

KARL LEINBERGER: I think 2016 was a year of surprises, whether it was commodities rallying when people least expected it or emerging markets rallying, a crack in the global bond bull market, Donald Trump, Brexit, most of these events were not expected by people in the market. If you look at Coronation we didn’t anticipate one of those events playing out as they did and yet it was a good year in our portfolios and I think it points to our view on investing, which is that no one knows the future, we live in an uncertain world and I think the world we live in is more uncertain than ever. Your best protection as an investor – against the uncertain world we live in – is a disciplined, committed approach to building diversified portfolios of undervalued assets. It’s those who think they know the future and those who ride momentum that get caught out when the world surprises. Inevitably it’s the manager who stuck to a committed, disciplined approach of buying undervalued assets who does better when the big surprises come.

WARREN THOMPSON: You wrote to your investors and I think just a bit of context here that I found fascinating around the Trump presidency was the view that he wasn’t going to be elected number one, and number two, if he did the uncertainty around his agenda would cause gold to rally and probably equity markets to move sideways or possibly downwards, given the uncertainty around what his policy framework actually is. The complete opposite happened. So you wrote to investors and you said buying at the right price protects investors during periods of volatility. When you can’t call the outcome and the secondary effects of these big events that take place how do you protect yourself against volatility and how do you hedge your bets within the context of what you called a diversified portfolio?

Diversification is not the enemy

KARL LEINBERGER: I think that Warren Buffett famously said that diversification is diversification and it’s an investment mantra that’s been repeated around the world for decades ever since he said that. I think in some ways it’s been misinterpreted by a lot of people in markets, I think what he was saying was excessive diversification, where investors just fill portfolios with all the stocks in the market, and don’t take views is nothing more than producing the market and is taking diversification too far and adds no value in clients’ lives, especially when they can buy the market quite cheaply. But I don’t think he was arguing against diversification, I think that in markets that will always be daunting and challenging and humbling for all of us… the one thing that investors will have on their side is diversification.

We believe in diversification across geographies, across currencies, across asset classes, across sectors, we think that if you build diversified portfolios – and this is the key – [build] diversified portfolios of undervalued assets. So you are maintaining enormous effort in research, you’re fundamentally demonstrating conviction in the assets that you do own and in sticking to a strong discipline of buying undervalued assets with strong margins of safety, then I think you have a chance to prosper in an uncertain and demanding world.

So the key message from me is diversification is not the enemy, diversification is an asset, it’s something on your side and as long as you are sticking to that rigorous commitment of only owning undervalued assets.

WARREN THOMPSON: You refer again to that margin of safety, so if I’m understating you correctly, you are saying that you need to be diverse but you need to take the correct view. One of the quotes I remember from previous interviews with you, you said time horizon is the ultimate market inefficiency. So when you come to that view, as I understand it, from a Coronation point of view, you find safety in taking a long-term view on the valuation of those assets.

KARL LEINBERGER: We think that markets here and around the world are full of smart people trying to build portfolios with the stocks that they think will go up this year. Because of that, we think that with the markets’ collective attention on what’s likely to go up and down this year… there is very little attention and very little energy that goes into what is likely to go up or down over the next five to ten years and if that’s where your attention is then we think you have an advantage. So I think that anything can happen in the short term because we’re all responding to the news flow of the day, prices moving up and down, and I think they’re massively diverged from the underlying long-term value of those assets because all people care about is not the underlying value but what’s going to go up or down this year. If you can cut all of that noise out, if you can be indifferent to it and spend 95% of your time and energy over what’s likely to happen five to ten years out, you’re going to be quite a lonely person because no one else is thinking like you but I think you have an advantage and I think you can deliver compelling results if that’s what you stick to.

Social media’s impact on investing

WARREN THOMPSON: Karl, in Coronation’s letter to investors you make this point about not only investors making short-term decisions within the portfolios that they select but also, as you’ve mentioned, these investment managers focusing too much on the short term. Do you think that social media that’s at our disposal in the form of our smartphones is contributing to this overstimulation where there’s too much focus on the short term and, from a market’s perspective, an almost incessant focus on liquidity and being able to trade now and immediately. Is this just feeding into a short-term frenzy, which is forcing long-term investment decisions to suffer?

KARL LEINBERGER: Absolutely, I think it’s getting worse, not better. I think it’s getting worse at an accelerating speed and I think it’s not just financial markets it’s the extent to which we follow news, short-termism is evident in professional sports, if you look at the duration of tenure of a professional sports coach if he doesn’t deliver results in months he’s fired. It’s ludicrous to expect a coach to deliver results in months, these things take years. So everywhere in life we expect results today and what we end up doing in chasing results today is we undermine our prospects over the long term. If you look at the professional sports analogy, what Ferguson achieved at Manchester United, half of it was due to the individual himself but the other half is the fact that because of his status, he was given years to deliver and had the luxury of thinking over years and not months. It just gives you an enormous advantage, whether you are in business, whether you are a professional sports coach, whether you’re in financial markets, it’s what we teach our children as success in life and then when we live our lives out we so often forget it and chase the short term.

WARREN THOMPSON: Being able to chase the long term means that you’ve got to be able to take pain, Karl, and I actually remember meeting your resource portfolio manager, Henk Groenewald, at the Joburg Indaba in late 2015 and, of course, as I understood it at the time, Coronation was holding or buying Anglo American and at that time commodity prices were literally imploding in [the] second half of 2015, as well as the share prices of some of those large diversified miners. So the question to you is to be able to take the pain over what can be sometimes be prolonged periods, how do you set up your investment team and your mindset at Coronation to be able to do that because obviously while Anglo collapsed towards the end of 2015 we saw that magnificent recovery last year, which would have justified your conviction that the stock was undervalued. So what do you try to do from an institutional mindset to be able to see through those periods of underperformance and pain?

You’re always going to lose assets

KARL LEINBERGER: The one thing I can say is that every additional cycle I live through I just realise how hard they are. Even though you spend an enormous amount of time in the business and outside the business explaining what it is you do, when you go through it, it always feels like this time you’ve lost it, this time you’ve missed, this time you’ve made a mistake. It’s always painful, you’re always going to lose assets, even if you spent a lot of time when clients came on explaining that long-term philosophy. Trust and confidence externally, internally is always challenged at those times; it’s not easy, it’s not easy buying assets when they’ve halved.

If you look at a stock like Anglo [for example], it’s up four times from its lows in rands. You look back a year or two later and you say it was easy and it was obvious and the asset was very cheap, but at the time it’s nothing short of brutal.

At the same time you never get anything in life for free, so to expect it to be easy would imply that making money in markets was a free lunch and it isn’t. So I think that succeeding and delivering compelling results over ten, 20-year timeframes, which we think is what really matters, it will always be testing, always have the quiet periods when you doubted yourself, the clients doubted you, the market doubted you, the media doubted you and I think it would be naïve to expect it to be any other way. That just comes with the territory.

When we recruit people we often don’t look for the smartest person, the person whose lowest mark at university was 77%, we look for people who we think are high EQ people and who are naturally patient, disciplined, courageous, independent of mind. Those qualities count just as much as the most cerebral person you’ve met but someone who might not be able to take the type of pain we’re talking about when markets move against you.

WARREN THOMPSON: That’s very interesting, that performance that you talk about, the underperformance that you experienced, you had that across your funds in 2015 and 2016, and this is a very frank question but was there hubris after your incredible run up until about 2015? Did you find, looking back, you might have been, as an institution, a bit overconfident in your abilities and this period of underperformance has humbled you somewhat?

KARL LEINBERGER: Again, one thing I realise every year I have in markets is markets always humble you, it’s a beautiful thing about markets, they’re a great equaliser and just when you think investing is easy you experience a very tough year. So I think markets are always humbling. A key part of our culture is to be self-critical and in some of those exceptional years we did our very best to remain as self-critical as possible and to realise and to know that tough years would have to come because that’s the way we invest. So internally I think that we’ve done a decent job of not getting carried away in the good times and not beating ourselves up in the tough times. But inevitably it’s very hard to get that message out broadly, I think that when you [perform] exceptionally, people think that you walk on water and when you have a bad year, they think you’ve completely lost it and become arrogant. So I think that it’s just something that we have to live with and when you have a really great year not to get too excited about it because as sure as anything a tough year will come if you’re not managing money for those kinds of time horizons.

Allocating investment across the right assets

WARREN THOMPSON: Let’s just turn our attention to asset allocation, you’re obviously also the fund manager of the Coronation Balanced Plus Fund but, again, referring to the letter you wrote, allocating your investment across the right assets will dwarf the alpha delivered from any single building block. Can you just elaborate on that for us?

KARL LEINBERGER: Any major piece done anywhere in the world on the value from active asset allocation versus security selection has concluded that far and away the greatest value comes from successful asset allocation. So if you’ve successfully picked the right equity manager that’s done well and outperformed the markets but you had the wrong amount in equities you’re not going to perform well. So as important as it is to find good stock pickers, finding good managers who make good asset allocation decisions is more important, whether you are doing asset allocation yourself or whether you have given it to a manager to do, that asset allocation needs to be good. I think particularly in South Africa, where we’re on the southern tip of Africa, where our market represents 1% of global market caps, we’re a small part of the world, we’re a volatile part of the world, we’ve got mega drivers being currency, interest rates, commodity prices that double and halve quite easily. So I think one needs to be very thoughtful and one needs to ultimately add value in asset allocation. We don’t think you can stick with strategic asset allocations that have done well in the last 20 years, I think that the world is changing all the time and I think that one needs to be prepared to show conviction and do what’s right at a point in time, even if it’s maybe different to what would have worked in the last ten years.

WARREN THOMPSON: This idea of asset allocation, we’ve talked about the interconnectedness of the world through mass media, is it becoming more complex to untangle the underlying exposures in different asset classes? When you sit there as the portfolio manager of the Balanced Plus Fund and you think about I’d like exposure here, I’d like exposure there but when you get into it, and the Top 40 is a great example, what are you actually buying when you buy a stock or buy into an asset class, is that becoming harder for you to do as a fund manager?

KARL LEINBERGER: I think it’s such a good point because when I joined the industry you could look at a multi-asset class fund and conclude on the position of the fund and the risk embedded just by looking at the asset classes. Our markets have changed so much that these days if you don’t have a detailed understanding of every instrument in a portfolio, you don’t really understand the positioning of that portfolio.

The JSE today has a large number of global companies listed on it, so an SA equity portfolio full of banks and retailers will behave completely differently and will have completely different risk parameters to one full of British American Tobacco, ABI, Naspers. A domestic property portfolio full of Growthpoint and Redefine will behave completely differently to one full of Nepi [and] Rockcastle.

So I think you can’t just look at generic building blocks any more, one has got to really understand every single security in the portfolio, understand that the drivers and the risk factors and what that security brings to the risk metrics of a portfolio. It’s become a lot more complicated. A bond portfolio full of floating-rate notes is going to behave completely differently to one full of fixed-rate notes. So if one is doing asset allocation one needs to really understand what’s in the building blocks, you can’t just put a whole lot of building blocks together.

Global bonds

WARREN THOMPSON: We’ve got some time to talk about your current view in terms of your asset allocation and stock picks, I wanted to just start off with the one on global bonds, you call it a return less risk asset and I imagine with global bonds you are referring there to most of the developed markets, is there any way that that situation, in your view, is going to unwind, Karl, in terms of over-indebted countries that are forced to manufacture interest rates in order to support those levels of debt that they currently enjoy?

KARL LEINBERGER: Ja, first of all we think that the yields are just way too low for the risks that we see out there. As to what plays out in the next year or two, if I sat here a year ago I wouldn’t have been able to see much that could break the momentum but today there is a lot to worry about. The first six or seven years after the financial crisis saw authorities around the world pursuing stimulatory monetary policy, we saw negative and zero interest rates and the Zeitgeist is shifting very strongly away from monetary stimulus to fiscal stimulus. So governments want to try and spend their way out of their problems and want to stimulate growth through government spending. If you look at government levels of indebtedness around the world they are very high, many of them are at post-World War II highs, so I think that there’s a lot to worry about on credit risk sitting in sovereigns around the world today. I think there’s a lot to worry about inflation, I think the inflation is starting to increase and that could be very damaging, particularly if the US goes down the trade protection route. Globalisation has been the big driver of disinflation around the world and if it were to be arrested in any meaningful way it would be very damaging for inflation. So I think there’s actually more to worry about near term than there has been for many years. In addition the valuations just aren’t on your side. So we have no exposure to any of the major sovereign bond markets around the world.

WARREN THOMPSON: You noted that you’ve actually favoured listed property and global equities, just talk us through that.

KARL LEINBERGER: I think South African managers are typically quite low in SA property stocks and while we do think there were some poor quality property companies cobbled together in the bull market, we think that if you look at your higher quality stocks trading on dividend yields of 8%, 9%, sometimes 10%, we think that even with a conservative view on distribution growth over the next five years-plus, if you get 5% we think that will be a fair outcome, we think that will give you double-digit returns and that’s just the power of compounding over meaningful periods of time. We think that’s going to do a lot better for you than government bonds, which is where most South African multi-asset class funds are heavily invested. So we think you’ve got compounding on your side with the one and not on the other. So a big differentiator in our portfolios is quite a heavy position in South African property stocks, as opposed to South African government bonds.

Value in the local market

WARREN THOMPSON: Something I noted as well was you went from being…in the fund that you run, the Capital Plus Fund, you went from very low allocation to equities, which has swung up quite dramatically now, as I understand it, 66% weighting to JSE equities, you’re seeing value in the local market at the moment.

KARL LEINBERGER: We were very negative on SA equities two or three years ago and went to Coronation historical lows in terms of equity exposure in a lot of our products. What’s happened since then is that the JSE is where it was in June 2014, so if we don’t get a positive number from the market in the next three months we’re going to be at three years of zero returns, which in real terms means you are down 15% to 20%. We’ve got a much stronger rand in the base today, companies are battling in a very tough environment but most are growing their earnings, so what we’re seeing is much better value in the SA equity market. So we’re more excited about equities than we have been for two or three years and in response to that we’ve been increasing our equity exposure. What the man in the street so often does is when the equity market hasn’t delivered for three years he cuts exposure, he becomes frustrated and feels things are tough and can’t take the volatility. He should actually be buying, not selling and that’s what we’ve been doing in our funds.

WARREN THOMPSON: Any particular names that you’ve added to there? I see in your top ten holdings as of the end of December you had Naspers, you had Intu Properties, MTN Group, have there been any notable increases or have you been topping up positions that you’ve held there?

KARL LEINBERGER: I think it’s mostly the stocks that we have owned for some time, we’re just increasing exposure to them. The stock that we did increase in the second half of last year was MTN, we feel that MTN has come out of many years of being very undermanaged and we think that the devastating fine in Nigeria in time will be seen as a major turning point for the company, as painful as it was it’s resulted in a complete change in the culture and in the management, there’s a lot of Vodacom management in there running the company today, we know the individuals and we think many of them are exceptional. We think that the assets that they have around Africa are very high quality and we think that with a rejuvenated culture and management team, we think that there’s a huge amount of value that could be unlocked over the next three to four years across the group, whether it’s South Africa, whether it’s Nigeria or whether it’s Iran. We think the company has a history of under-investing in their networks, under-investing in their business and we think we are going to see all of that rectified in the next few years.

ANC Elective Conference, a defining moment

WARREN THOMPSON: Just time for one last question, Karl, and it’s one that you wrote about what’s happening at the end of the year, the ANC Elective Conference, to quote Coronation, will prove to be a defining moment in our country’s history. How do you anticipate this event playing out and why do you see it as such an important moment in the country’s history?

KARL LEINBERGER: I think we all follow politics and we all can see that it could go either way, some speculate one and some the other but it looks to me fairly evenly balanced. We don’t get involved in individuals and personalities and all that, I think what we’re saying is that if we have an outcome of someone who is more rational, more of a centrist, someone who has the country’s interests and the people’s interests at heart then I think that South Africa is still a place where there’s enormous opportunity and I think that if we have a rational outcome coming out of that I think it will be enormously positive for confidence, whether it’s business, whether it’s consumer confidence, for capital flows, for interest rates, for the currency. It will be an enormously positive reaction, it wouldn’t be technical in nature. I think in Africa and increasingly around the world, whether you look at the US or Turkey or Brazil or Russia, who runs the country matters, these things define the prospects of a nation. I think that if we have a good outcome, a rational outcome, it will be very positive for South Africa.

WARREN THOMPSON: Great, we’ll have to leave it there, Karl. Thanks very much for your time.

KARL LEINBERGER: Thank you very much.

WARREN THOMPSON: That was Karl Leinberger, the chief investment officer of Coronation Fund Managers.

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