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Investment insights

How do you cater for extreme events when constructing resilient multi-asset portfolios?

Over the past two months, we have had the privilege of meeting with many clients and advisers at our first in-person events in over two years, and via webinars. Top of mind during the Q&A panel discussions was how to position portfolios to withstand uncertainty. This makes sense bearing in mind the backdrop of the pandemic, the devastating floods in KwaZulu-Natal and the tragic war in Ukraine. Gladness Rupare and Martine Damonse, who hosted panels with members of the Allan Gray and Orbis Investment teams at the events, capture some of the key questions asked and insights delivered, which illustrate how the Allan Gray Balanced Fund is positioned to be resilient and deliver returns in different scenarios.

Since the start of this year, most equity markets have nosedived into negative territory. The same central banks that were printing money are now aggressively trying to rein in inflation exacerbated by the crisis in Ukraine, which has caused acute shortages in some areas of the global supply chain. Meanwhile, the South African market and the rand have remained surprisingly strong relative to our global counterparts, supported by commodity prices.

Given this backdrop, clients were keen to find out how we filter through all the information to make investment decisions.

What are our key focus areas amid the market noise?

As long-term investors, we try to ignore the noise and stay focused on the two things we can control when investing:

1. Buying assets for less than they are worth

The price we pay for any asset is the key determinant of the return from that asset in the future – regardless of the prevailing market conditions. Ideally, we want to buy a share when it trades below what we have calculated as its true worth, but this often happens when there is bad news and the share is unpopular. Buying an unpopular share with a margin of safety (a discount to our estimate of its intrinsic value) can feel uncomfortable, but it is the best way to reduce potential capital loss in the future, which increases the resilience of the portfolio. We sell an asset when it reaches our estimate of its true worth.

2. Diversifying the portfolios

The old adage of not putting all your eggs in one basket is sage advice. Diversification is an exercise in portfolio risk management that ensures you have a portfolio of assets that perform differently under different circumstances.

The Allan Gray Balanced Fund is well positioned for multiple possible outcomes, increasing the likelihood of its resilience through further extreme shocks.

Within a multi-asset fund, like the Allan Gray Balanced Fund, we have the ability to diversify across asset classes. For example, we can increase the bond exposure when bonds are cheap and equities are expensive, and vice versa, and we can increase the foreign exposure when South African assets look expensive. Right now, SA bonds and equities offer good value, but they may be exposed to SA-specific risks. A well-diversified portfolio also takes the position size of individual instruments and their risks into consideration.

Clients were hungry for more information about these aspects of investing, and had challenging questions about some of the equity holdings in our Balanced Fund.

What is the investment case for Woolworths?

Woolworths needs little introduction. The company has a presence in Australasia through David Jones and Country Road. We believe that the market is currently undervaluing Woolworths, presenting a buying opportunity. Many of the aspects the company needs to improve are within its control, as discussed below.

Opportunity to grow earnings in fashion, beauty and home

In recent years, the fashion teams at Woolies have lost track of their core customer, moving closer to fast fashion and away from the quality basics the brand was known for. Poor merchandising has meant Woolies has had to sell increasingly on promotion.

We believe Woolies has a credible strategy to improve full-priced sales in fashion, beauty and home. Despite the high execution risk, this represents the biggest opportunity for Woolies to grow earnings given the high revenue base. Woolies is also in the process of rationalising space, prioritising profit per square metre rather than market share.

Strong food business

Most investors recognise the high quality of Woolies’ food business, but are concerned that it may lose market share given its premium positioning in uncertain economic times. We believe Woolies should be able to pass on inflationary increases to its customers, making its food business defensive in high-inflation environments.

In our view, Woolies food is one of the best food businesses globally. It has grown its operating margin consistently over the last few years and offers a high return on capital with the ability to reinvest into the business. Although there is an increasing threat posed by peers, we believe its food business can maintain its strong competitive position given its supply chain superiority and entrenched supplier relationships.

David Jones issues ring-fenced; Country Road the hidden gem

When Woolies purchased David Jones in 2014, it not only overpaid for the business, but also overestimated its ability to turn it around quickly. This has weighed heavily on investor sentiment. While David Jones was a poor acquisition, the business is ring-fenced from both Woolies South Africa and Country Road. The requirement for a turnaround to be self-funding adds a floor to the value of the business.

Country Road, on the other hand, is one of the hidden gems within the Woolies group. Gross margins are in line with luxury companies’, and it has a large, growing online business reflecting more profitable sales than in-store. Debt concerns from two years ago have also abated, given the high-priced sale of two David Jones properties and reduced capital expenditure.

At a group level, Woolies had net cash on the balance sheet at end-December 2021. Its ability to generate free cash flow (the cash a company can generate after capital expenditures to maintain or maximise its asset base) remains high.

We still believe that Woolworths trades below its true worth.

While the Woolies story resonated with our audiences, it naturally elicited questions about SA-specific and other risks.

Are all the top 10 holdings in the Balanced Fund subject to similar risks?

There are some equities within our top 10 holdings that don’t have SA-specific risks, even though they are included in the FTSE/JSE All Share Index, such as British American Tobacco (BAT). BAT operates in over 100 countries, the largest of which is the US; a great example of a geographically diversified business.

While we have been finding more value locally than offshore, offshore exposure brings another important element of diversification to the Balanced Fund.

One of the biggest risks to the SA market is not obvious, but it affects our diversified miners, commodity shares and a few other large shares on the JSE, including Richemont and Naspers: SA’s reliance on China. These businesses depend on China continuing to demand as much in the future as it does today.

Interestingly, BAT has no exposure to China as its Chinese holdings were nationalised many years ago. We continuously monitor the portfolio’s overall direct and indirect exposure to China.

While we have been finding more value locally than offshore, offshore exposure brings another important element of diversification to the Balanced Fund. With the recent change in legislation allowing the Fund to invest up to 45% offshore, clients were keen to know our views on the offshore opportunity set – especially given that global markets have dropped dramatically since the start of the year.

Is local still lekker or is it time to go global?

Global markets, as represented by the MSCI World Index, have fallen by more than 20% in dollars on a year-to-date basis due to higher-than-expected US inflation numbers, which have sparked fears that central banks across the globe will be forced into aggressive monetary policy tightening and tip the world economy into a recession. In a tightening monetary policy environment, a reduction in the money supply, or raising interest rates, can significantly help slow down an economy and protect domestic currencies.

Despite these concerns and rising negative sentiment, the relative valuation gap within stock markets today is still wider than anything we saw during the global financial crisis or dotcom bubble in 2000, and even more extreme than the Japanese bubble of the late 1980s, creating opportunity for bottom-up investors.

Our offshore partner, Orbis, believes the price correction has created a measure of comfort on valuations, with prices of some of the high-flying technology stocks, such as Microsoft, Alphabet, Netflix and Spotify, declining considerably. Orbis’ analysts are starting to take a look at some of these “fallen angels”. For example, Alphabet was a significant purchase in the Orbis Global Equity Fund in May, as its valuation now compares much more favourably with those of the Chinese tech names without having the additional layer of China-related risks.

Active, contrarian investing has rarely looked more necessary than now …

Only time will tell how global stock markets will fare. However, Orbis remains excited about the prospects for its holdings and the opportunity to generate real returns. The average stock held is meaningfully cheaper than the MSCI World Index and has better fundamentals. This suggests that the opportunity to add value is still high.

One thing that became clear over the course of our interactions is that the recent extreme world events have shown clients the importance of building up a nest egg, but many have become more risk-averse and are wondering what the best approach is given the current circumstances.

Have we changed our approach given the current circumstances?

Active, contrarian investing has rarely looked more necessary than now, as the current market environment marks the end of “lazy investing” – i.e. the ability to get away with disregarding the fundamentals and simply following the trends. Our experience has shown that some of the best contrarian opportunities arise whenever fear or uncertainty gives rise to short-term thinking or forced selling on the part of other market participants.

Building a well-diversified, multi-asset fund with undervalued assets from the bottom up can deliver superior returns and protect investors’ capital over the long term. The Allan Gray Balanced Fund is well positioned for multiple possible outcomes, increasing the likelihood of its resilience through further extreme shocks.

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