Irrational selling makes it a buyer’s market

HANNA ZIADY: Welcome to this week’s Market Commentator podcast – Moneyweb’s series of interviews with investment professionals. Our guest this week is Greg Hopkins, chief investment officer at PSG Asset Management. Greg, thanks for your time today.

Now PSG Asset Management, I believe, is on a road show at the moment, engaging with its investors and reminding them of how important it is to take a long-term view when making investment decisions. Tell us a bit about why that is the case.

GREG HOPKINS: Hi Hanna, thanks very much for having us on the show. Ja, I think that’s very, very prevalent, especially at this time in the market, [when] there’s lots of fear and uncertainty, there can often be irrational selling, where people aren’t really thinking clearly. They’re selling for reasons other than on valuation or on fundamentals or what they perceive to be the fundamentals.

It’s at these types of opportunities/junctures, where you get an opportunity to buy potentially mispriced assets, where there is that irrational selling, where you can buy with a margin of safety. But you need to take a longer-term approach because sometimes the fundamentals don’t look very clear at the moment, but will evolve over time. If you don’t take a long-term approach you might just be drawn in with the rest of the crowd that are selling indiscriminately.

So taking a long-term approach, trying to work out what the underlying true intrinsic values of securities that you’re buying, and buying with a margin of safety sets you up nicely in these types of environments for long-term wealth creation.

HANNA ZIADY: Assuming that’s always been PSG’s strategy to take a long-term view, how has PSG’s positioning perhaps changed or evolved from last year to this year? What was it saying last year that it’s not saying now? Did it make any mistakes last year and how is it setting itself up for 2016?

GREG HOPKINS: If we go back a year, we’ve been quite concerned about the asset markets in general. We’ve spent quite a bit of time trying to speak to our investors about the fact that yields – and we talk about global yields because global interest rates are at very low levels – generational low levels and many asset classes priced off those low yields have been at very high levels. So we started last year almost a little depressed. We weren’t finding lot of opportunities; we had lots of cash in our funds. In fact, our cash balances peaked in April/May last year – roughly around the same time that the markets peaked.

We were avoiding bonds, we felt that bonds were overvalued; we were avoiding property equities – we felt that they were overvalued; we were avoiding some of the blue chip companies in South Africa because we felt that they were overvalued. The reason why we thought they were overvalued was because, as I said, yields were low and there’s been a push to take more in what is perceived to be lower risk, higher-yielding assets, and those are the three asset classes that I talked about. We were finding more opportunities in the more cyclical end of the market – and I’ll come back to that in a minute – and we were still finding good opportunities offshore. In fact, we felt that offshore opportunities were the one place in equities where you could buy very high quality companies at marginal safety and sometimes very cheaply.

So over the year that position has actually evolved. We had lots of cash; we were taking more of a cautious long-term approach.

Asset prices have come down; there’s been a lot of fear and uncertainty in the market – especially around December and January in South Africa, particularly in the bond market – and that’s been the one opportunity that’s been quite standout for us. Our yields in the South African bond market have actually risen quite significantly and that has been the last piece in the puzzle for us in terms of adding some duration into our funds.

So we’ve been adding in the fixed income space; we’ve been buying bank NCDs; the bank funding curve has shifted up; the sovereign curve has shifted up and that has created opportunities for investors who can take a little bit more of a longer-term approach. It’s very interesting because that’s often something that’s not counterintuitive. When there’s fear and uncertainty it does create opportunity, so bond yields have risen because there’s been a fear about a sovereign downgrade in South Africa. But you can’t have it both ways: you can’t have a very rosy outlook and feel very good about the future. Often at that stage yields are very low and you’re taking a disproportionate risk. So we felt that as security prices have fallen, risks have actually come down in certain asset classes. The one piece that is still missing is in the blue chip equity component of the South African equity universe – we still feel that that is quite expensive.

HANNA ZIADY: Let’s talk about that margin of safety quickly before we move on. Can you just explain to us exactly what is a margin of safety: what does it look like, what counts as a margin of safety?

GREG HOPKINS: Yes, so essentially that’s the job of any investment professional: to try to work out what the underlying value of that security is, whether it’s a bond, property company or equity. The markets swing between fear and greed. Sometimes they extrapolate the recent future into perpetuity: ie ‘the good times will never end’, ‘the bad times will never end’. The truth is somewhere in between – which is the intrinsic value of a security. And, if you can understand what that is, and then you buy often when there’s fear and uncertainty, when the market is extrapolating the recent past into perpetuity, you can buy assets with a large margin of safety that are trading at a discount to that intrinsic value.

Now you asked a question earlier about where we’ve made mistakes. The range of outcomes in certain of the securities has been a little bit wider than we were expecting, but that hasn’t precluded us from adding more to the security as they’ve fallen. We are often early, as value investors, in buying securities. We buy with a margin of safety and that margin might rise in time. But, that’s the job of a security analyst: to keep trying to understand what that intrinsic value is and what your current margin of safety is.

HANNA ZIADY: Would you say that the resource stocks are looking attractive now, considering they’ve fallen out of the Top 40 and perhaps are undervalued and perhaps offer quite a large margin of safety?

GREG HOPKINS: We do and we have been adding resources to our portfolios over the last year, year-an-a-half. The company that you will own typically will be quite cyclical; there will be a wide range of outcomes – it is quite difficult to work out what an intrinsic value is for a mining company.

But our assessment at the moment is we think that earnings are low and valuations and sentiment is low and that’s typically a good starting point for future wealth creation in any security. So we are cautiously optimistic about resources and we own them in our funds in moderate amounts.

HANNA ZIADY: That assumes, I suppose, an eventual turnaround in the commodity cycle?

GREG HOPKINS: It does, but if you go back over a hundred years you get these big swings where you add capacity, prices go up and then prices come down, and then capacity is taken out. We are seeing some signs now that there are very few new projects that are coming into this space; there is excess capacity that we have to work through. It will take time but, as I said, [for] those investors who want to take a longer-term approach, we think there is value in the sector.

HANNA ZIADY: Aside from resources stocks your equity portfolios have significant holdings, as you mentioned, in foreign listed companies and also in other companies outside the Top 40. Which shares and stocks are you in favour of?

GREG HOPKINS: Ja, we’ll just talk about one or two of our top ten holdings. As I mentioned earlier, we’ve been cautiously adding to some of the more cyclical elements of the market. We’re looking at a company like Imperial Holdings, which is now in our top ten holdings: the price/earnings ratio of that sock is around 6.5, 7 times. We think it’s a quality management team and a good business and we think that its earnings are relatively low.

We have been adding to banks over the past few months, particularly in December and January when there was a large selloff in this space. Once again I think you’ve got strong balance sheets, great management teams and good franchises and we’re buying them at what we think are attractive valuations with large margins of safety.

Our offshore exposure: we’ve been fully invested offshore in our domestic funds for a number of years. We’ve felt for a number of years that there’s been good opportunities for the local investor abroad, not only just in terms of the underlying opportunities but also to diversify their holdings over a larger number of geographies and that opportunity is still prevalent. It’s a much more difficult call now taking money from South Africa abroad, given the rand valuation. It’s moved significantly over the last couple of years.

We caution investors not to expect the same tailwind from the rand, if you are a local investor investing offshore, as you’ve seen over the last year or two.

HANNA ZIADY: You note that South African listed property is starting to look more attractive, after many companies traded its surpluses to their net asset value for some years – so perhaps that’s pulled back a little bit. Where are the opportunities in this space?

GREG HOPKINS: If you go back a couple of years, some of our companies are trading at significant premiums to their net asset values and those net asset values are struck at market value of those underlying assets. So the markets were pricing in significant growth in underlying market values. A company like Growthpoint was trading at over 40% premium at one stage to its underlying net asset value. Through December and January that has actually closed; at one stage it was trading at a discount to net asset value. So these companies are becoming more attractive. We still think they’re a little early; we still think that asset values are quite high and we think the market is underestimating some of the operating and financial leverage in these businesses. But, I think the sector could well start presenting some opportunities over the coming months.

HANNA ZIADY: Then to come full circle, what is PSG watching closely in terms of the themes driving markets globally and locally and, of course, those themes that are material to making investment decisions?

GREG HOPKINS: We are very much bottom-up investors: we look at each security on its own merit, we look for the range of outcomes in those securities and we try to buy with a margin of safety and take a long-term approach. It doesn’t mean that we are not cognizant of what is happening in the broad environment and the broader market, but it’s often an inverse: when the macro environment is very poor, often that is the best time to take opportunities because asset prices are falling and those margins of safety are rising. So we will be watching the macro environment: if it continues to deteriorate we will continue to sift through the universe of securities that we have to look for opportunities.

I think what’s on everyone’s mind in South Africa at the moment is the potential sovereign downgrade and the affect it might have on our local market. Our sense is that quite a lot of that is currently in the price already, in terms of our bond market and certain assets in South Africa we think are trading cheap – especially those that have got more of a domestic GDP-type focus. So a lot of the bad news is already in the price. Time will tell. I think we’ve got a little bit more of a constructive outlook on South Africa, just in the near term. We think our South African Reserve Bank is a very credible institution and we think our National Treasury is a credible institution and both of these are good custodians of, let’s call it, our sovereign risk premium and our inflation premium. I think we’ll be watching the developments in the South African landscape quite carefully to evaluate that assessment of ours.

HANNA ZIADY: Greg Hopkins is the chief investment officer at PSG Asset Management.

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